Proof of Reserves (PoR) Meaning

What is Proof of Reserves (PoR)?

In late 2022, the FTX collapse raised serious questions about the trustworthiness of centralized exchanges for cryptocurrency. Events leading to its collapse pointed out misuse of users’ assets, which were in the custody of the exchange. The digital assets deposited by the users did not match the assets in FTX’s custody, with a deficit of nearly $10 billion. During the collapse, FTX experienced a massive surge of users withdrawing their funds. But because of its lack of a proper reserve, the firm couldn’t fulfill users’ withdrawal requests when the users went to withdraw their assets, and it eventually filed for bankruptcy. 

The abrupt bankruptcy and its ripple effects in the industry demonstrated the need for crypto audits. Centralized custodians responded to investors’ concerns by publishing “proof of reserves” in an effort to regain the public’s dwindling trust.

Proof of reserve (PoR) is like a receipt that shows a crypto exchange has the digital assets it claims to hold for its users. PoR proves the solvency and liquidity of a centralized custodian and assures investors that the custodian can fulfill their withdrawal requests when the need arises. 

What Does Proof of Reserve Verification Do?

Proof of Reserves (PoR) verification prevents custodians from using users’ deposited assets to acquire loans or make investments. The goal is to offer transparency and protection to the users’ assets. Investors can rely on PoR verification to monitor activities in their individual accounts and gain clarity on how the custodian is managing their funds. 

Furthermore, PoR offers users a verifiable source of truth. Internal audits may be fabricated or tampered with. PoR is thought to reduce audit tampering by documenting all on-chain activities, including monitoring wallets to track asset movements.

Merkle Tree-based Proof of Reserves

PoR is a form of self-regulation, where an independent auditor generates a snapshot of the custodian’s balance sheet and organizes it using the Merkle tree. A Merkle tree is a data structure created by repeatedly hashing (transforming plaintext to a nearly irreversible value) a large data set. 

By using Merkle tree-based PoR, the auditor can aggregate all the users’ account balance data into a Merkle root (the single hash at the top of the tree). In return, the account balance of any individual user is not exposed to the public.

However, exchanges can still hide their insolvency while appearing transparent using PoR. This is because PoR provides attestations of assets and leaves out custodians’ off-chain activities and liabilities to customers.