The global financial system often operates in an unfair and opaque manner, leading to systemic risks such as boom-bust cycles and market-wide disruptions. However, decentralized finance (DeFi) presents an alternative approach, offering highly transparent and trustless financial solutions driven by deterministic smart contracts and cryptographic security. As DeFi expands, the demand for diverse collateral types is also growing, including cross-chain tokens, fiat-backed stablecoins, tokenized real-world assets, and more.
In corporate finance, reserves refer to assets a company retains that can be used for various purposes, including fully matching client deposits. PoR signifies an independent audit conducted to verify that the audited party possesses adequate reserves to support all customer balances.
For crypto asset PoR, an auditor certifies that the company’s on-chain assets are at least 100% identical to the customer assets represented in their balance during the audit. This verification assures consumers that the firm possesses sufficient liquidity and solvency, ensuring the availability of funds for withdrawal if desired.
Definition
Proof of Reserves (PoR) is a transparent auditing practice used by cryptocurrency firms to assess the assets held in their reserves objectively. Third-party auditors examine cryptographic signatures that indicate the entire balance of client assets, ensuring that the asset’s custodian has an equal or larger quantity of reserve assets to cover potential customer withdrawals.
A third-party auditor creates a snapshot of the business’s balances to provide visible “proof” that the crypto corporation possesses enough assets to fulfil its obligations at any time. This process allows customers to verify that they can withdraw their funds whenever they please, instilling confidence that the crypto firm is not at risk of a liquidity crisis.
Proof of Reserves not only helps prevent a liquidity crisis in the event of a sudden surge in customer cash withdrawals, but it also provides transparency to consumers regarding the location of their funds. Utilising blockchain technology, this auditing method ensures a secure way to verify the financial soundness of a cryptocurrency company without compromising sensitive user data.
Functionality
To better understand the concept of PoR, let’s delve into the auditing procedure in general. An audit’s primary goal is to assess an exchange’s solvency, resulting in either one of two outcomes. If the exchange’s assets surpass its liabilities or commitments, it is deemed solvent. However, in all other scenarios, it is considered insolvent.
Nevertheless, there are instances when this binary outcome is insufficient. This is the case with fractional reserves, where a portion of an exchange’s deposits is held in reserve and immediately available for withdrawal in cash and other highly liquid assets. The remaining funds are leased to borrowers.
The audit process consists of three main stages:
PoL
The first stage is proof of liabilities, which involves determining the outstanding amounts owed by the exchange’s customers. This is done by adding up all client account balances. The total liabilities are then compared to the exchange’s reserves to assess the solvency. In this stage, a Merkle tree is created using the customer’s cryptographic hash and their owed amount is added as a leaf to the tree. The next tier of the tree is formed by pairing and hashing the leaves, and this process continues until the root of the tree is generated.
PoR
Proof of Reserves is a process that verifies the assets held by an exchange in the form of cryptocurrency on the blockchain. The total assets can be determined by adding up the balances of the crypto addresses for which the exchange has private keys.
To demonstrate ownership of Bitcoin addresses, the exchange can provide the public key and sign it with the corresponding private key. To ensure enhanced security, the exchange should also sign a nonce, which is typically the hash of the most recently added block to the blockchain. This nonce can be used to verify the authenticity of the signature. The proof of reserves consists of the total and hash of the address balances.
In order to identify which balances should be included in the calculation, the audit program does not need to analyse the entire blockchain. Instead, it utilises a preprocessor that aggregates data readily available to the public in a deterministic manner.
A deterministic function always produces the same outputs when given the same input data. This characteristic is vital for any blockchain, as it enables consensus to be achieved regardless of who initiates transactions or where they occur.
PoS
The proof of solvency for a cryptocurrency exchange consists of two parts: the audit outputs and an attestation. These elements allow for the validation of the auditing software in a reliable environment.
The result of the audit is presented as either true or false, representing a binary integer. If the exchange’s reserves are greater than its obligations, the result is true; otherwise, it is false. The attestation serves as a signature for the program hashes and platform measurements.
To further ensure transparency, consumers can use the Merkle tree’s root to verify that their account balance is taken into account during the computation process.
The Goal of PoR
Proof of reserves plays a vital role in providing financial transparency for crypto companies. It specifically focuses on the balance sheet and the amount of client cash held by the company. With a third-party audit, customers can trust that the crypto firm they are using has enough liquidity for everyday operations and client withdrawals.
Implementing PoR is a positive step for any crypto corporation as it ensures the safety of client funds and demonstrates, through cryptographic methods, that the organization has sufficient liquidity. While this approach may have some limitations, such as not monitoring firm obligations, it still provides customers with peace of mind and strengthens their trust.
As the crypto industry becomes more regulated, it is beneficial for all crypto exchanges or organizations acting as custodians to undergo a proof-of-reserves audit. This will not only enhance the safety of client funds but also contribute to the overall credibility and trustworthiness of the organization.
Conclusion
PoR is a mechanism that is gaining popularity, especially following the collapse of the FTX crypto exchange and the recent statements from Binance emphasizing the importance of transparency.
It is expected to become even more crucial as regulators work towards establishing industry standards to protect consumers. By providing a secure and transparent way to verify the safety of client funds, proof of reserves ensures the protection of customer assets.
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