Proof of Reserves (PoR) is a method that verifies a crypto exchange’s liquidity and solvency by demonstrating it holds the digital assets it claims to, ensuring the security of user funds.

Understanding Proof of Reserves (PoR)

Proof of Reserves (PoR) is a vital verification method for crypto exchanges. It demonstrates an exchange’s capability to maintain and fulfill its obligations towards users’ digital assets. This process ensures that the exchange possesses enough liquidity in relation to the assets stored by users on its platform.

What is Proof of Reserves (PoR)?

The debacle of FTX in late 2022 highlighted the risks involved with centralized exchanges. The mismatch of users’ assets and the exchange’s actual holdings led to a deficit and FTX’s inability to meet withdrawal demands, culminating in bankruptcy. This incident underlined the importance of crypto audits and led to the adoption of Proof of Reserves by custodians to rebuild trust.

Function of Proof of Reserve Verification

Proof of Reserves (PoR) verification acts as a safeguard, preventing the misuse of users’ assets. It provides transparency and assurance that an exchange can meet withdrawal requests, thus protecting investors’ interests. PoR also serves as a verifiable source of truth, potentially reducing the risk of audit tampering by documenting all on-chain activities.

Merkle Tree-based Proof of Reserves

Proof of Reserves employs a Merkle tree to organize a snapshot of an exchange’s balance sheet. This cryptographic tool hashes user account balances into a Merkle root, preserving individual privacy. Although PoR increases transparency, it is not foolproof. It may not account for an exchange’s off-chain activities and liabilities, potentially masking insolvency.