Proof of reserves and liquidity in crypto explained

By allowing independent verification of asset holdings, exchanges are less https://www.xcritical.com/ likely to manipulate data, and users can gain insight into the actual state of reserves. Moreover, PoR checks promote stability within the cryptocurrency industry. Through them, exchanges can demonstrate that they are operating transparently.

Proof of Reserves would have helped prevent Mt Gox, Quadriga, or FTX

This set the industry in motion, with Binance itself publishing its reserves on November 10. Other exchanges followed suit, including Kraken, Coinbase, KuCoin, Deribit, OKX, Gate.io, Huobi and ByBit among the platforms that shared (or committed to sharing) some form of data testifying to their holdings. In this climate, the cryptocurrency space is putting even more proof of reserves crypto exchanges emphasis on transparency.

Proof of Reserve in Traditional Markets And Tokenized Real-World Assets

Depending on how comprehensive the officially communicated proof-of-reserve addresses are, the total balance can also be very close to our reported exchange balance. This is in fact a validation for Glassnode’s methodology of accurately tracking exchange balances. Exchange balance metrics do not reflect the officially reported numbers by the exchanges themselves, nor do they always provide a bullet-proof, 100% guaranteed quantification of on-chain exchange funds. What Exchange Balance metrics do present is our best estimate of the true balance held on each exchange, quantified as closely, and as verifiably accurate as possible (see below). In fact, the way exchanges operate on-chain is highly complex, involve complicated and dynamic transaction patterns, and wallet management practices, which are unique for each exchange.

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It’s known in the accounting space as “window dressing” – manipulating accounts on a short term basis to make them look better for a specific filing period, say at the end of the quarter. Audit firms are quite familiar with the concept and know how to look for it. The fact that blockchains are innately transparent helps too – anyone can be on the lookout for this kind of misbehavior. At Glassnode we’ve pioneered the on-chain analytics of exchange balances and movements, and provide the most comprehensive suite of metrics across all major exchanges. PoR is a form of self-regulation, where an independent auditor generates a snapshot of the custodian’s balance sheet and organizes it using the Merkle tree. A Merkle tree is a data structure created by repeatedly hashing (transforming plaintext to a nearly irreversible value) a large data set.

Proof of Reserves is uniquely possible with digital assets

The audits help attract new users to the industry, encouraging wider adoption of digital assets. Without these audits, customers struggle to determine if an exchange holds the assets it claims to have. This can create loopholes for the platforms to engage in risky activities or fraudulent behavior. To those who reject PoR because it’s not perfectly trustless in its current implementation, I would respond that the perfect is the enemy of the good.

This transparency fosters a higher level of confidence in the system and helps build trust between users and service providers. Suppose you want to prove that your account balance of 10 units is included in the Merkle Tree. First, you would need to provide the root hash of the tree, which is publicly available. At #2, we have Uphold – an increasingly popular exchange boasting a wide array of supported assets, and more importantly, a real-time look at the company’s reserve assets, obligations, and transaction details. While exchanges like Binance, BitMEX, and more each offer proof-0f-reserves, for the time being they are simply self-attestations and not completed by an independant third party – hence their exclusion from the following list.

• This aggregate of publicly available data ensures consistent and reliable results.
• Trusted by Gate.io, Crypto.com, and Bit2Me, Hacken’s PoR audits help you build credibility, strengthen trust, and stay ahead of competitors.
• Exchanges may also choose to engage an impartial third party to audit its reserves.
• However, while the phrase ‘proof-of-reserves’ has now become fashionable within the cryptocurrency community, there’s considerable confusion as to what it actually means.
• We create a unique, anonymized hash ID for every client reference number and every new attestation.
• If we were just talking about demonstrating some quantity of assets held, we would say Proof of Assets.

The PoR from decentralized services such as these guarantees an institution cannot transfer more tokens than it has assets in reserve. Only exchanges that have more assets in reserve than they have debt (or liabilities) can achieve Proof of Solvency. If all of an exchange’s users try to withdraw their funds and it can process every single request simultaneously, an exchange will pass the audit. If an exchange fails this test, it’s running on fractional reserves, meaning it’s using customer funds. Chainlink PoR feeds can be used for a wide range of tokenized real-world assets (RWAs), such as real estate properties that generate verifiable cash flows.

Deterministic functions produce the same outcomes given identical inputs, crucial for consensus in a blockchain network. In traditional finance, banks use PoR to show they possess the funds they’re holding for customers. This prevents banks from lending out more money than they actually have. The platform is capable of covering user withdrawals, even if 100% of user assets are withdrawn. Exchange Balances are often more dynamic as they represent a more comprehensive set of addresses, while proof-of-reserve addresses are often only a small subset of (cold) wallets. Below is an example for OKEx, showing Exchange Balances in blue, and Proof-of-Reserves in orange for BTC.

Luckily, blockchain is built for transparency — as an immutable, decentralized ledger, it’s quite easy in crypto to share your financial reserves with irrefutable, blockchain-based proof. First of all, for modern PoR like the ones done by Derebit of BitMEX, the entire liability set is released, so there’s no real uncertainty around the completeness of liabilities. Any standard PoR is also user-verifiable, so presumably any user could blow the whistle if they found that their liability entry was understated. Today, most PoRs are done with the Merkle proof method where liabilities are only disclosed on a per-client basis, which creates more possibilities for liability hiding.

They never had sufficient reserves to honor all possible client withdrawals. The moment an exchange was even under-reserved, the PoR would have been impossible to pass. So PoR makes it virtually impossible to behave badly for any meaningful period of time. If any exchange did PoR and became insolvent, they would stop doing PoRs. Either way, if you are publicly revealing your addresses, it would be come very clear very quickly if you were borrowing large amounts of funds every month to ‘pass’ a PoR and then sending them back.

But if digital assets are held off balance sheet (as is common), they wouldn’t necessarily be within the scope of a FS audit. A controls audit would focus on things like key management and internal controls. In many cases, management simply signs off on the effectiveness of those controls, rather than the auditor investigating them. A SOC II covers controls, but that doesn’t prove the money is actually there, just that the controls are reasonable and active over the coverage period. PoR is simply a different (and complementary) part of the stack, and a vital one, in my view. The proof of reserves audit involves an independent third party reviewing and verifying the financial records and holdings of a financial institution.

And proof-of-reserve does not provide customers with greater control over their funds; it just provides information. The idea for proof-of-reserves based on Merkle trees became particularly popular after the collapse of FTX. Binance’s CEO, Changpeng Zhao, tweeted that his exchange would begin to implement proof-of-reserves. The cryptographic nature of this process ensures that any alteration to the data would be instantly detectable. This attestation confirms the trustworthiness of the environment in which the POR software was executed and verifies the hashes of executed programs and platform measurements.

If there was misrepresentation, it was on the side of the exchanges — and admittedly, some of them used “audit” in a more colloquial sense to refer to their PoRs. Calling them audits probably implies an unearned rigor, so I suggest moving away from that. A crypto exchange could lie outright, and a third-party attestor could still uphold the lie. If the attester is corrupt or incompetent, perhaps by overlooking missing wallets or failing to understand how an exchange had structured customer holdings, the whole purpose of proof of reserve would be undermined. The challenges include limitations in verifying certain assets and the credibility of auditing firms, which can affect users’ trust in the process.

Proof of reserves contributes to the overall stability of the market by reducing the risk of a liquidity crisis. Fractional reserve banking is a practice in which banks keep only a fraction of their customers’ deposits in reserve, lending out the rest. This system can be risky, as it relies heavily on the assumption that not all depositors will simultaneously withdraw their funds.