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Mid Level Reading
25 May, 2024

Proof of Reserves

[ Proof uhv ri-zurv ]

Proof of Reserves verify that exchanges hold all user assets and can handle mass withdrawals.

Michael Healy
Written by
Michael Healy
Michael Healy Michael Healy Expert Author
Michael, an entrepreneur, and co-founder of Unit, is a full-stack, mobile, and blockchain developer with extensive experience in the crypto and blockchain industry since 2010. A leading token builder, Unit powers the token economy using the Polkadot-powered Unit Network blockchain. Michael has built a diverse portfolio with multiple successful exits, including encrypted P2P video conferencing,...
Massimo Moretti
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Massimo, a seasoned entrepreneur, and CEO of SIGNVM Group, has an impressive 6-year history in the Web3, Crypto, and Blockchain space. His key achievements include founding a pioneering VR/AR studio in Paris and serving as Huobi Global's Business Development Director and Country Director in France. Massimo excelled at building strong partnerships with top exchanges like...
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Proof of Reserves (PoR) is an asset verification method regularly followed by centralized exchanges (CEXs).

It results in a public report showing that the platform holds equal or higher balances than the total tokens provided by users—and, therefore, it can handle all withdrawal requests if needed.

These assets could be spread across the main blockchain, other networks, and off-chain balances (such as traditional bank accounts).

CEXs measure these using smart contracts and third-party auditing services. The audit report that shows the current total balance in reserve is called attestation.

proof of reserve
Example of proof of reserve | Source: nickcarter.com

Exchanges can also verify individual balances relative to the total assets with a data structure called Merkle Tree.

Users can confirm if the total has included their account balances without exposing private information. The cryptographic mechanism that makes this possible is called zk-SNARK, “Zero-Knowledge Succinct Non-Interactive Argument of Knowledge.” 

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Note: Exchanges aren’t required to provide PoR. This verification method was inspired by the FTX collapse and Celsius bankruptcy, first implemented by Binance in 2023.

What Is The Role of Proof of Reserve For Assets?

“One such solution emerging in the market goes by the moniker “Proof of Reserves” (PoR), which is a method that uses techniques of cryptographic verification to publicly demonstrate possession of digital assets sufficient to cover outstanding liabilities.”

Pines, M., Bitcoin Policy Institute

PoR aims to make crypto exchanges more secure and transparent. The balance attestation helps users understand the liquidity risk and whether or not it makes sense to hold or transfer their assets somewhere else.

As it becomes more common, exchanges that don’t offer PoR can deter larger investors from using them. To maintain user confidence and stand out, more platforms offer PoR and provide higher backing than 1:1.

In practice, however, assessing collateral risk isn’t as straightforward. For example, most exchange balances are composed of stablecoins, and each token has its own backing policies. Some stablecoins, like True USD ($TUSD), show real-time reserves for off-chain assets, while others, like Tether ($USDT), aren’t nearly as transparent.

Regardless, PoR does reliably on-chain assets held and its liquidity to fulfill all withdrawals. This reinforces other use cases:

  • Real-World Asset (RWA) tokenization. Properties and other assets can interact with the blockchain economy without compromising their tangible value.
  • Cross-chain bridges. Bridges have experimental mechanisms that sometimes lead to some of the most expensive crypto exploits. PoRs could both prevent and limit those losses.

What Is The Relation Between Merkle Tree and Proof of Reserves?

A Merkle Tree Proof of Reserves is a nested hash structure that combines large amounts of data into one hash and total balance. It’s an anonymous way to prove to users that the exchange holds their assets and has included their balances in the latest PoR.

Merkle Tree
Merkle Tree | Source: zebpay.com

The Merkle Tree concatenates two hashes at a time until all balances are combined in one, which is called the Merkle root (or Merkle hash). A hash is a one-way encryption function that transforms any length of user data into a text string. 

Below the root are the Merkle leaf hashes that exchanges assign to users. Users can look them up in the tree and verify them manually.

Conclusion 

Exchanges conduct PoR by providing auditor attestations, Merkle trees, and zero-knowledge proofs. The result is a snapshot of liquidity and balances that can change over time.

This doesn’t account for asset liabilities and neither shows where reserves are exactly kept. Investors shouldn’t evaluate the exchange solvency only using PoRs.

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Michael Healy
Written by

Michael, an entrepreneur, and co-founder of Unit, is a full-stack, mobile, and blockchain developer with extensive experience in the crypto and blockchain industry since 2010. A leading token builder, Unit powers the token economy using the Polkadot-powered Unit Network blockchain.

Michael has built a diverse portfolio with multiple successful exits, including encrypted P2P video conferencing, a large UK student social network, and the Wikileaks Android app. He has experience working with top organizations like Wellington Partners, Founders Forum, Google, KPMG, and Saatchi & Saatchi.

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