The global financial system often works unfairly and without transparency, resulting in systemic risks such as boom-bust cycles and market-wide breakdowns. Decentralized finance (DeFi) offers an alternative by providing highly transparent, trust-less financial solutions driven by deterministic smart contracts and cryptographic security.
As DeFi grows, so does the need for additional collateral types beyond native on-chain assets, including cross-chain tokens, fiat-backed stablecoins, tokenized real-world assets, and more.
Reserves are assets a corporation retains that may be used for various reasons, including completely matching client deposits. Proof of Reserves (PoR) refers to an independent audit that verifies that the audited party has sufficient reserves to support all of its customer balances.
For crypto asset PoR, this implies that an auditor certifies that the company’s on-chain assets are at least 100% identical to the customer assets as indicated in their balance during the audit. It might reassure consumers that the firm is adequately liquid and solvent and that the money is available for withdrawal if they choose to do so.
What precisely is PoR?
Proof of reserves (PoR) is a transparent auditing practice for cryptocurrency firms that objectively assesses the assets in the company’s reserve.
Third-party auditors examine cryptographic signatures indicating the entire balance of client assets and check that the asset’s custodian has a similar (or larger) quantity of reserve assets to cover prospective customer withdrawals.
A third-party auditor provides proof of reserves by creating a snapshot of the business’s balances to offer visible “proof” that the crypto corporation has enough assets to satisfy its obligations at any moment.
Customers can see that they may withdraw their cash anytime, which gives them confidence that the crypto firm is not in danger of a liquidity crisis.
It helps to avert a liquidity crisis if there is a “run on the bank” and clients withdraw cash in large numbers, and it also informs consumers about the whereabouts of their funds. Proof of reserves uses blockchain technology to provide a safe method of auditing a cryptocurrency corporation without disclosing sensitive user data.
How is the PoR audit handled?
Before we understand how a proof of reserves works, let’s go through the auditing procedure in general.
In principle, the audit should evaluate an exchange’s solvency, yielding only two results: the exchange is solvent if its assets exceed its commitments or liabilities or insolvent in all other circumstances.
However, there may be times when this binary result is not sufficient, such as when an exchange must present fractional reserves.
In the case of fractional reserves, a part of an exchange’s deposits is held in reserve and made instantaneously available for withdrawal (as cash and other highly liquid assets), with the remaining funds leased to borrowers.
The audit process can be divided into three main stages:
Proof of Liabilities
The outstanding cryptocurrency amounts owed by the exchange’s customers are the exchange’s liabilities. The overall liabilities of the exchange are calculated by adding all client account balances.
The calculated sum is then compared to the total reserves to evaluate solvency. The component for proof of liabilities also computes the hash of the fraction factor and the root of a Merkle tree.
The user account information is utilized to build a Merkle tree using the customer’s cryptographic hash, and the amount owed to the customer is used to produce a leaf of the tree.
The nodes in the next tier of the tree are formed by pairing and hashing the leaves; nodes are combined and hashed to form the tree’s root.
Proof of Reserves
Reserves are the assets that the exchange has stored as cryptocurrency on the blockchain. The total assets are calculated by adding the balances of crypto addresses for which the exchange has private keys.
The exchange may show that they are the genuine Bitcoin address owner by supplying the public key and signing it with the private key.
For enhanced security, the exchange should sign a nonce (for example, the hash of the most recently added block to the blockchain), a value that may be used to verify the signature. The total and hash of the address balances are the outputs of the proof of reserves.
To identify which balances should be added up, the audit program does not need to interpret the full blockchain; instead, it uses a preprocessor, a deterministic aggregation of data easily available to the public.
A deterministic function will always generate the same outputs when given equal input data.
This is an essential condition for any blockchain since achieving consensus is only possible if transactions provide the same result each time they are done, regardless of who starts them or where they occur.
Proof of Solvency
The two components of a cryptocurrency exchange’s proof of solvency are the audit outputs and an attestation that can be used to validate that the auditing software was run in a trustworthy environment.
The end outcome of the audit is either true or false (a binary integer). If reserves outweigh obligations, it is true; otherwise, it is untrue. The attestation acts as a signature for the program hashes and platform measurements.
Using the Merkle tree’s root, the consumer may confirm that the computation takes its account balance into consideration.
The Goal of PoR
The purpose of proof of reserves is to provide financial transparency regarding a crypto company’s balance sheet, particularly regarding client cash. A third-party audit gives customers confidence that the cryptocurrency firm they are utilizing has enough liquidity to conduct day-to-day operations and, more crucially, client withdrawals.
Proof of reserves (PoR) is a positive step for any crypto corporation, ensuring client cash safety and demonstrating (cryptographically) that the organization has adequate liquidity.
While the approach has certain drawbacks (such as not monitoring firm obligations), it may offer customers comfort and boost their trust. As the crypto business becomes more regulated, every crypto exchange or organization that acts as a custodian on behalf of its clients would benefit from a proof-of-reserves audit.
Final thoughts
Proof of reserves is becoming more popular, particularly in light of the November 2022 collapse of the FTX crypto exchange and recent statements from Binance on the necessity of openness.
It will also become vital as regulators strive to develop industry norms to safeguard consumers since proof of reserves is a secure and transparent means to assure the safety of client cash.