Banks are regulated and compelled by government authorities to report how much assets they have in their annual reporting so that customer funds are not jeopardized (well, let’s forget the 2008 crash ever happened.)
But how do crypto exchanges and custodians, which are not regulated by the government, provide this assurance?
This week’s explosive saga about the collapse of FTX–as well as the recent bankruptcy of the crypto lender Celcius shows just how important it is for users to be able to verify that the exchange/custodian they use is actually stewarding their funds safely and responsibly.
Proof-of-Reserve ensures this.
What is Proof-of-Reserve?
A Proof of Reserve (PoR) is an independent audit conducted by a third party to ensure that a custodian (such as a centralized crypto exchange) actually has, in its ownership, the assets it says it has.
Currently, most centralized exchanges and other CeFi crypto platforms like lenders and custodians keep their asset data in private, proprietary databases. As such, they can claim that their users’ funds are safe with them, but these claims are difficult to verify.
With a Proof of Reserve, customers don’t just have to take their word for it but have indisputable assurance of that claim, going back to the core tenet of crypto–“don’t trust, verify.”
Why Should You Care That Your Crypto Exchange Has Proof-of-Reserve?
Proof-of-reserve ensures that crypto custodians, exchanges and lenders do not engage in secretive financial transactions that put their customers’ funds at risk.
Proof-of-reserve ensures that a crypto lender does not loan out more money than the collateral it holds, so that its lenders can be compensated in full if anything happens.
Proof-of-reserve ensures that a custodian of wrapped tokens like WBTC (wrapped bitcoin), actually has the bitcoins in reserve, or that stablecoin issuers like Circle actually has the USD to back all the USDC it issues.
Proof-of-reserve ensures that a crypto exchange:
- Will not secretly park your coins in a third party
- Is actually in custody of your trading funds/assets–which means you can withdraw them anytime you want
If you want to put your funds at an exchange where all user trading funds are 100% in reserve (and gain VIP status at the same time) go here:
Deposit for Luxury – Get Phemex VIP by Depositing Now – Phemex. New and existing users can participate.
How Does the Merkle Tree Proof-of-Reserve Work?
What makes Proof of Reserve work is something called a “Merkle Tree” (also called “hash tree”). A Merkle Tree provides a cryptographically secured (i.e. tamper-proof) method of verification of assets on reserve (see below section for a more detailed explanation on how it works).
As a hash-based data structure, it is hypersensitive to the smallest change and can thus be used to prevent data fraud and manipulation.
A simple example–if an exchange tries to tamper with the records to reflect that it has $12,000,000,001 in reserves when it actually has $12,000,000,000, the hash changes completely.
(If it sounds familiar to you, this is the same Merkle Tree that underpins the way Bitcoin, and by extension, blockchain technology, works.)
As mentioned earlier, the Merkle Tree Proof of Reserve (PoR) is conducted by an independent third party. Here is how it works:
1) The independent auditor first takes a snapshot of all the user balances held on a crypto exchange and organizes it into a Merkle Tree.
2) This gigantic data set is run through a cryptographic hash function–a computer algorithm that scrambles up data and spits it out as just one single, 64-character string, like this: 3647fhhjryti57683jjkeurthcnyrisjfkemtik9900sjrglgrkb2647agffnd25
3) The auditor gathers the exchange’s digital signatures that show the total balances it has, and verifies that it matches user balances represented in the Merkle tree. This shows that all user assets are and therefore that all users’ trading funds are held in the exchange’s reserve (hence the term “proof-of-reserve.”)
4) The user can subsequently verify that his assets were accounted for in the Proof of Reserves audit using a unique record ID and comparing it with the Merkle root. (Phemex is working on rolling out the Merkle Tree Proof-of-Reserves)
5) If there was any change to his asset balance, no matter how small, or it is a fake balance, it would result in a change that cascades up the tree to the Merkle root and changes the value completely.
As such, the Merkle Tree is a single value that proves the integrity of all of the transactions, by making even the smallest tampering obvious.
A 3-Point Checklist To Ensure You Are Using A Safe & Secure Crypto Exchange
1) Your crypto exchange has, or is committed to, Proof of Reserve audits.
2) Your crypto exchange uses cold wallet systems that keep users’ funds isolated
3) Bonus: your crypto exchange focuses only on creating great user trading experiences instead of platform tokens that are subject to volatility, which then puts your own assets at risk.
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The Merkle Tree Proof-of-Reserve provides an assurance by enabling quick, easy verification of a large volume of data, for the purpose of transparency and customer assurance. As traditional banks and asset managers expand their services to include digital assets, proof-of-reserves will feature more prominently as an industry gold standard for credibility and trust.