What and Why Are Proof of Reserves Important?

Proof-of-reserves audit matches on-chain holdings with balance sheets, ensures custodians' financial stability, and gives confidence to consumers.
Saif K.
10:04 16th Jan, 2023

Let’s dive a bit deeper into what Proof of Reserves are and how are they important when we talk about cryptocurrencies.

More about Proof of Reserves in Cryptocurrency:

The phrase "Proof of Reserves" (PoR) refers to an external inquiry to confirm that the entity being audited has sufficient reserves to support all of its client balances.

Proof of Reserves Zelta
Credits to coinstats

When it comes to cryptocurrencies PoR, this implies an auditor confirms that the company's on-chain holdings are at least 100% identical to the client assets shown in the customer's balance just at the time the audit was performed.

This can reassure clients that the business is solvent and liquid enough for them to retrieve their funds if they decide to remove them.

Additionally, proof-of-reserves audits help cryptocurrency organisations serve as custodians by preserving client trust and providing complete asset backing. The possibility that firms will maximise the profits from their customer assets is reduced by PoR's prohibition on centralised exchanges investing depositors' money in other enterprises.

It’s been a long since we have been reading about PoR Audits and how it helps in verifying the recorded balance sheet. But, how are these audits conducted? Let’s have a look.

How are PoR audits conducted?

In principle, the audit should determine if an exchange is a solvent, which can only have one of two results: either the marketplace is bankrupt in all other circumstances or solvent if its order to maintain and increase its commitments or liabilities.

It is possible that there are situations when an exchange must show fractional reserves when this single result is inadequate.

Fractional reserves refer to the practice of keeping a part of an exchange's deposits in reserve and making it instantaneously withdrawable while lending the remaining balance of the money to borrowers.

Building a data structure known as a Merkle tree is the most typical method used in the cryptocurrency industry to confirm that client balances are properly backed.

What is Merkle Tree?

A data structure called a Merkle tree is created by periodically hashing a piece of data. The amount of data points, or Merkle leaves, decreases exponentially with each layer of hashing. Blockchain data is encrypted more effectively and securely using the Merkle tree in cryptocurrencies such as bitcoin.

Merkle Tree Zelta
Credits to ZebPay

The auditor can maintain client privacy by using a Merkle tree to combine information about all customers' account balances into a unique Merkle root without disclosing any specific customer's account balance to the public.

But, what would happen if cryptocurrencies did not include Merkle Tree in their network?

Let’s consider Bitcoin as an example.

(Click here to learn Why Bitcoin is a Good Investment)

If the Bitcoin protocol didn't support Merkle Trees in general, every node in the network would need to store a complete copy of each and every Bitcoin transaction ever done and that's a lot of data.

You will need to independently verify the data because any authentication request on Bitcoin would need a huge quantity of data to be delivered over the network.

A computer used for verification would need a lot of processing power to examine ledgers in order to verify that there were no alterations.

Merkle Tree Proof of Reserves are indeed a remedy for this problem. They separate the data itself from the data's evidence by hashing accounting records. Demonstrating that, a transaction may be legitimate with just a little quantity of information sent over the network.

You may also use it to show that both ledger types use the same amount of notional computing power and communication bandwidth.

Advantages of Proof of Reserves Audit:

The Proof of reserves audit has a number of benefits since it demonstrates how users' balances and the cryptocurrency exchanges keep on-chain. One way to determine whether coins like Wrapped Bitcoin (wBTC) are indeed backed by Bitcoin is to conduct a proof-of-reserves audit.

Additionally, regulators like proofs of reserves since they are a self-regulatory mechanism that aligns with their overall industry strategy. In addition, eliminating the mistrust caused by exchanges' failure to back client deposits with enough assets boosts product adoption.

Additionally, by employing a Merkle tree hashing technique, users may independently confirm the integrity of the proof-of-reserves audit. Similar to this, investors will have a tool for doing due diligence to get pertinent information about the client asset management strategies of certain institutions, lowering the risk of financial loss.

Disadvantages of Proof of Reserves Audit:

Despite the benefits mentioned above, there are several drawbacks to proof-of-reserves audits that must be ignored. The major problem with a Proof of reserve audit is that the competency of the auditor determines if it is right.

In addition, a third-party auditor working with the custodian under review may provide a false audit result.

A crypto exchange may also falsify information because the accuracy of confirmed balances is only valid at the time of an audit. Loss of private keys or user money may also have an effect on the validity of the proof-of-reserves audit.

Furthermore, a Proof of Reserve audit cannot reveal whether funds were borrowed in order to pass the audit.

Now you might know all about Proof of Reserves and how the audits work. Happy Investing!!