In November 2022, the crypto market faced a big crisis after the collapse of FTX. There was a lot of mismanagement of the assets, which led to withdrawal demand by the holders. As a result of this lack of transparency and proper auditing of company reserves and users; holdings, a new system was launched by Binance, World's largest crypto exchange platform.
Proof of Reserves uses the Merkle tree method to carry out the auditing process and provide the facility to the users. Here is a detailed explanation of the Proof of Reserves and its components.
What Is a Merkle Tree?
A popular data structure mainly used in computer science, the Merkle tree is now emerging as very useful in cryptocurrency technology. The main reason is the efficient data encryption that brings more security to blockchain transactions.
Merkle tree, also called a hash tree, is a string of numbers and letters that can help verify a given data set with the original set of data. This makes the process authentic and assures security. Bitcoin's software does not show the entire block of transaction data because it is too long and confusing. Instead, each transaction is hashed (compressed), and each pair of transactions is concatenated until there is one big block with the entire data.
This process enables quick, secure content verification across different datasets. The main advantages are deterministic, preimage resistant, maintain consistency, easy to read, collision resistant, etc. It also confirms that there is no modification and validates the transaction data. They compute the entire data for bitcoin, ether and other cryptocurrencies.
What Is Proof of Reserves?
With the increasing concern about safety in the cryptocurrency market, many users are moving away from the market. To address this problem, many exchange platforms have developed new methods to authenticate transactions and avoid discrepancies. One such method is the Proof of Reserve method. The Proof of Reserves (PoR) uses a Merkle tree to create hash strings for the transactions on the blockchain.
In centralized exchanges, there is often an ability given to the customers to verify the state of their assets in different institutions. Similarly, the Proof of Reserves system allows verifying and tracking holdings. It is a statement outlining the holdings of a custodial financial institution. PoR includes customers' token deposits and a pool of tokens held within a set of exchange addresses. These are known as its liabilities and assets, respectively.
The system is a method to bring transparency in the exchanges and ensure that real assets are back in crypto.
How Does the Merkle Tree Proof of Reserves Work?
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.
How Are Audits Conducted?
Under the PoR, the audit helps to ensure that the assets on an institution's balance sheet and balances of customer holdings are tallied. The customer holdings can be saved from misuse and real assets can be used to backup the currencies. The main method used for this is Merkle Tree technique.
A Merkle tree is created by the third party using the information regarding all of the retained balances.
The balances of all the accounts used are then added together and uniquely identified by a Merkle root which is then obtained.
The exchange's digital signatures are used to authenticate these balances on public blockchains where assets are stored.
The balance information and asset information on public blockchains are validated. These figures should be in balance to ensure consistency.
Additionally, systems will be set up so that clients may verify the validity of the assets they own.
Any data changes will affect the Merkle root, which could indicate suspected asset tampering.
How To Verify a Company's Reserves?
Several exchanges have voluntarily provided PoR on their portal to make the process easier. Many of them use the Merkle Approach. Some of them are Kraken, BitMex, Coinfloorm Gate.io, HBTC, CakeDeFi, Nexo, etc. While some of them are self-assessment, others are audio-assisted. They can be daily, monthly, quarterly, or semi-annually.
You can verify your audited account by using the Record ID. The following is the process:
Make a copy of the Record ID associated with your account and the relevant audit.
Go to the independent auditor's website responsible for the Proof of Reserves audit.
In the portal for the independent auditor, enter your Record ID. The auditor's website will use this ID to locate a record of the bitcoin that was held in your account at the time of the audit on-chain.
Check the balances.
Do Proof of Reserves Have a Place in the Future?
While centralized exchanges are starting to support the use of PoR, and many are beginning to provide PoR audit data, there is still the problem of crypto platforms shifting their cash immediately after the audit snapshot was taken. While some exchanges provide comprehensive analyses of their reserves during a PoR, other businesses just issue brief statements saying they are profitable.
The industry is pressuring centralized exchanges to offer more openness, and users may soon have tools to confirm and hold exchanges accountable. Industry participants can also use the technologies mentioned above to guarantee the availability and safety of the funds, establishing a procedure that may help make the cryptocurrency market safer for investors.
With proper knowledge about the technology in the market and community and fool proof method, Proof of Reserves might have an opportunity in the future.
How Do I Verify Crypto Holdings?
Every exchange platform has its own tab or option to verify personal crypto holdings. After logging into the exchange, users can click on 'wallet' and then click on 'audit,' which will generate a unique record ID, for each user. This ID includes users' asset balance at the time of audit.
People aware of Python and programming can use the source code to cross-refer to Python applications. Binance provides its Merkle tree feature too. This makes the process easier.
Why Is Proof of Reserves Important?
In November 2022, long-running mismanagement of funds under the custody of FTX started trailing. While users' accounts showed records of their assets, these were non-existent. This led to a huge withdrawal request, but the exchange could not honor the users' assets. Proof of Reserves was introduced in response to this.
Recently, many crypto exchanges audited their Proof of reserves, demonstrating their desire to boost client confidence and increase transparency. By auditing the chain's hash from the Merkle Root for independent auditors like Hacken.io, a PoR can assist in validating the transaction's integrity.
PoR is a technique for self-regulation. PoR makes it harder to cover up unethical and unlawful company actions, such as rehypothecation of user deposits. It brings about trust, auditability, and customer protection and curbs fraud and counterparty risk.