Cryptocurrency exchanges and other firms use proof of reserves to show customers they have the funds they claim to have. Proof of reserves helps to provide transparency between the exchanges and customers. It ensures the customers that their funds are safe with the exchange.
With Proof of Reserves (PoR), the exchange can demonstrate whether they hold the equivalent amount of assets the customers had deposited. If the customers have bought assets, and the exchange has the exact amount of those assets, it is 1:1 backing. For instance, if you buy $50 worth of Ethereum on an exchange, the exchange should hold $50 of Ethereum. The exchange cannot convert your Ethereum into any other token or use that token to its advantage.
The 1:1 backing is necessary because, let's say, some black swan event occurs in the market, and users want to withdraw the fund. Now, if there is 1:1 backing, it will be enough to fulfill withdrawal requests. Otherwise, that would lead to pausing the exchange's withdrawal and cause a bank run. Therefore, the users need to know if the exchange has enough liquidity to handle all the withdrawals. With PoR, that’s possible.
Methods of Proof of Reserves
There are different methods to provide PoR. Let's discuss the methods in brief.
- Merkle tree-based PoR- Merkle tree is the most efficient and widely used method by the exchanges for providing proof of reserves. It is also known as a Hash tree. A hash is a unique hexadecimal code. Just as the trees have leaves and roots, in the same way, the Merkle tree is made up of Hash leaves and Hash roots.
The users' account data or transactions are converted to hash nodes or leaf nodes, and then these nodes are combined and connected to the Merkle root. Let's say the data of A, B, C and D are converted into hashes or leaf nodes, H(A), H(B), H(C), and H(D). These leaf nodes are then paired into H (A, B) and H (C, D) and then connected to the Merkle root as H (A, B, C, D).
This data can then be traced by any user without revealing the data of other users and see if the transaction details are genuine or altered by any means. If a transaction is altered, the leaf nodes will also change, resulting in the change of Merkle root as well. Hence, Merkle tree-based proof of reserves is efficient in verifying the authenticity of data and cannot be tampered with, as the data is cryptographically encrypted.
- Snapshot method:- In this method, the exchange takes a snapshot of all the funds in customer accounts at a specific time and then provides it to a third-party auditor to verify if the exchange holds the assets it claims. This provides an accurate image of the fund holdings and provides transparency for the specific time being.
After the collapse of FTX, the investor community is demanding proof of reserves from all the centralized exchanges to safeguard users' interests. Many exchanges have launched a proof of reserves, namely, Gate.io, Kraken, Nexo, OKX, Crypto.com, BitMEX, and ByBit.
Proof of reserves is the need of the hour for crypto exchanges. Exchanges need to implement PoR to be efficient in the long run. The exchanges can prove their liquidity status and build customer trust by providing the Proof of Reserves. It assures them that their funds are safe with them.
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