What is Proof of Reserves and can it restore trust in centralized platforms?

What is Proof of Reserves?

The Proof of reservesor Proof of Reserves in English, is a concept that gained popularity in November 2022 the fall of the FTX exchange platformwhich follows other bankruptcies such as that of Celsius Network or Voyager Digital.

The FTX implosion had dramatic consequences on the cryptocurrency industry. Investor confidence in such centralized platforms is rightly drying up. Many investors then wonder how this is possible to trust to a centralized platform to secure their cryptocurrencies.

Platforms that are still active have need a way to gain investor confidence so as not to lose them. This is where the concept of Proof of Reserves comes into play.

This is a method that solves transparency problems on cryptocurrencies held in the reserves of centralized platforms.

Proof of Reserves uses cryptographic proof and ownership of public wallet addresses in conjunction with periodic audits certifying that a platform holds enough cryptocurrencies to cover its customers’ deposits and withdrawals.

In particular, this helps to fight against the fractional reserve banking system, which makes it possible not to keep all of their customers’ deposits in their reserves. This approach also gives each customer the opportunity to verify for themselves whether their account balance is included in the Proof of Reserves.

Specific, a trading platform uses an external auditor whose mission is to ensure that the platform does indeed hold the cryptocurrencies it claims to hold on behalf of its clients. This ensures that clients’ cryptocurrencies are not used unfairly and that there are genuine cryptocurrencies backing users’ assets.

At the process level, the auditor takes an anonymous snapshot (capture) of all trading platform balances and aggregates them into a mark tree (Merkle tree), a structure for consolidating very large amounts of data. A Merkle Root is then obtained, which identifies and combines all platform user balances into a hash.

Naturally, snapshot anonymity is crucial so no one can link an account balance to a user.

Figure 1: Illustration of a Merkle Tree

These balances are then verified on the public blockchains where the cryptocurrencies are held by the platform. The latter serves one for this purpose digital signature of her wallet to prove she has the money.

Once verified, these numbers should balance as follows:

Total client account balances on the platform = amount of assets held on blockchains by the platform.

Any user can do that see if their account balance is included in the Merkle Tree. It is enough for this “hash” their account balance and unique identification number, then look it up in the Merkle Tree.

Please note that data manipulation affects the Merkle Root, which may indicate that the data has been manipulated or tampered with.

The Proof of Reserves thus makes it possible, through the Merkle Tree, to check the integrity and consistency of all data. The goal is to provide transparency about an exchange platform’s cryptocurrency reserves and therefore about it restore investor confidence.

Each user can consult the Proof of Reserves and thus ensure that his balance is included in it.

Note that some trading platforms have not waited for the FTX affair to be as transparent as possible to their clients. Thereby, Kraken introduced its first Proof of Reserves in December 2021the French platform StackinSat in June 2022 and Coinbase, a NASDAQ-listed company, regularly publishes its financial documents.

The table below summarizes the situation, at the time of writing, of the major Proof of Reserve exchanges:

After the FTX affair, Binance announced its intention to use Proof of Reserves on November 10, 2022 to be more transparent with its users. Note that as of November 16, 2022 this has not yet been verified, but here is an example:

Figure 2: Evidence of Binance Reserves (Unverified as of November 16, 2022)

Other exchange platforms have committed to implementing Proof of Reserves such as KuCoin, Crypto.com, Bitfinex, Huobi or ByBit.

Can Proof of Reserves Prevent the Next Fall of a Stock Exchange?

The Proof of Reserves therefore aims to establish a relationship of trust between investors and trading venues. Anyway, This method is not without flaws. and can give a false sense of security.

Indeed, the choice of an independent auditor is crucial to ensure the validity of the Proof of Reserves. Thereby, a possible conspiracy between the accountant and the trading venue can disrupt this method. However, both entities risk their reputations by submitting to Proof of Reserves.

In addition, such an audit only provides a picture of the cryptocurrencies that the platform owns, but corporate debts are not considered here. So a platform can use the evidence of reserves to appear solvent without revealing the actual solvency risk it may face.

A combination with a concept of proof of debt could then provide a more transparent picture of the true solvency of a centralized platform.

There can also be inconsistencies if a platform has been a victim of theft or if it has lost the keys to some of its wallets. Moreover, it is not not possible to determine with Proof of Reserves whether funds held were borrowed solely to pass the auditwhich remains a significant risk as the audits cannot be performed in real time.

So it’s not the perfect solution. on the issue of transparency, it is possible for an exchange to fall FTX’s way, even if the latter has published Proof of Reserves apparently proving its solvency.

It is a yet effective method to ensure that an exchange does nothing a priori with its clients’ cryptocurrencies.

Conclusion on Proof of Reserves

Despite its imperfections, Proof of Reserves offers a new way of standardization which is welcome in the cryptocurrency industry. With the fall of FTX and Binance’s subsequent initiative, Proof of Reserves became a real necessity. For a platform to remain attractive to its users, it must be transparent.

Most major exchanges have already announced their intent to provide Proof of Reserves, and some have already done so. So we are witnessing one real change that promotes the transparency and security of users’ cryptocurrencies.

From now on, the new centralized platforms that will emerge will probably submit to Proof of Reserves under penalty of not being able to find a place in the market, because gaining investor confidence is more important than ever for this kind of business.

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Sources – Figure 1: Kraken, Figure 2: Binance.