Proof of reserves is performed by a third party to verify the existence of the reported holdings. While there are various ways to generate Proof of Reserve systems, the blockchain community has developed an on-chain, trust-minimized method for recording such proofs that are open to everyone’s verification.
In reality, an exchange can report on the assets under the institution’s custody, link these assets to specific accounts, and keep some of this data on-chain. Without disclosing the users’ identities, individual users or any interested third party can confirm that the institution has particular assets corresponding to the individual account balances.
Benefits and Limitations of Proof of Reserves
The system of Proof of reserves is both criticised as well as appreciated for its process and ability.
Before the creation of this method, users’ account balances showed records of their assets, but they were non-existent, and there was a lot of mismanagement. Proof of Reserves solved this major issue. It is beneficial to provide a way to verify proper custody of assets. Investors can use this application to track changes made to their accounts and keep track of their assets.
It helps to carry out basic research on any institution before investing in it. It provides a background of the client’s assets, the methods used in an institution, etc. It also presents records about the transactions immediately. Similarly, it facilitates custodial duties like providing a means to regain and maintain users’ trust, avoid shady business, and transparent transactions.
However, there are some limitations of the system as well. One, it shows balances at one specific point in time and no in and out movement of assets. This movement might help in maintaining balance. Another major flaw of the system is the lack of proper mention of liabilities. This absence of liabilities makes the assets look misleading.
It also doesn’t separate a customer’s fund from a company fund. Thus, creating a more complex and confusing picture. Though the Merkle Tree system of Proof of Reserves provides real-time data about the transactions, it can still put the exchanges in danger due to riskier borrowing and lending and improper governance of funds.