You are reading an excerpt from our free but shortened abridged report! While still packed with incredible research and data, for just $20/month you can upgrade to our FULL library of 50+ reports (including this one) and complete industry-leading analysis on the top crypto assets. 

Becoming a Premium member means enjoying all the perks of a Basic membership PLUS:

• Full-length CORE Reports: More technical, in-depth research, actionable insights, and potential market alpha for serious crypto users
• Early access to future CORE ratings: Being early is sometimes just as important as being right!
• Premium Member CORE+ Reports: Coverage on the top issues pertaining to crypto users like bridge security, layer two solutions, DeFi plays, and more
• CORE report Audio playback: Don’t want to read? No problem! Listen on the go.

What is Proof of Reserves?

Proof of Reserves is a method by which a cryptocurrency exchange can prove to its clients that it holds enough crypto assets to cover its liabilities. This ensures that the exchange can meet user withdrawal requests and minimizes the risk of insolvency. To achieve PoR, exchanges must present a cryptographically-secured, signed message verifying their holdings. This message can be independently verified by users.

PoR typically involves two components: a record of customers' token deposits (liabilities) and a pool of tokens held by the exchange (assets). By using trust-minimized, on-chain approaches, PoR allows exchanges to present a report of assets in custody and map these assets to individual accounts while maintaining user anonymity. This makes it possible for users and third parties to verify that the exchange holds assets matching specific account balances.

PoR is only possible with cryptoassets because ownership can be proved to a third party on a purely peer-to-peer basis without any third party or intermediary needed. This isn't possible with other financial assets, such as equities or dollars in a bank account. Digital assets are genuinely unique in this context and exchanges can be made more accountable than any other type of custodial institution. This introduces a new model of custody where the assets held on behalf of depositors can be proven and demonstrated to clients or any type of third party at any time. Traditional modes of oversight are upended by this, making PoR a truly remarkable quality of the asset class.

PoR History

While Proof of Reserves has been around for some time, it gained renewed attention in the aftermath of the Mt. Gox scandal. BitMEX and Kraken were among the first exchanges to publish Proof of Reserves and liabilities, but progress was slow until a new wave of enthusiasm emerged following FTX. Many leading exchanges, such as Binance, Gate.io, KuCoin, Poloniex, Bitget, Huobi, OKX, Deribit, and Bybit have since committed to publishing PoR. Preliminary proof of assets has been released by some exchanges, such as Crypto.com, Bitfinex, and Binance.

Part of the reason for PoR’s lack of adoption thus far is the challenge for exchanges is to match the assets with the outstanding liabilities. A true audit or understanding of a company’s solvency is incomplete without corresponding liabilities. To achieve PoR, an exchange anonymizes user balances and publishes the data in Merkelized format. Depositors can then verify that they're included in the liability set. If enough depositors participate, they can have strong confidence that the exchange isn't omitting liabilities. An auditor's oversight can provide additional assurance that no liabilities are being excluded.

Why Is Proof of Reserves Important?

Proof of Reserves can serve as a crucial aspect of cryptocurrency exchange’s ability to ensure users that their funds are safe and secure. PoR helps in establishing trust between the users and the exchange by providing transparency into the CEX’s funds on hand and continuously holding them accountable rather than onces a quarter. Without Proof of Reserves, there's no way to ensure that an exchange is holding the amount of cryptoassets it claims to be holding. This puts users' funds at risk and makes it easier for exchanges to engage in fraudulent activities.

PoR helps prevent scams and fraud by providing a transparent, accountable mechanism for verifying an exchange's assets. Because of this, PoR is an exciting development for the industry, as it allows organizations to leverage the immutability of a public blockchain and cryptographic mechanisms to provide proof of the existence and control of customers’ digital assets held by centralized organizations. This can significantly enhance the industry’s security and trustworthiness in a sector that has a long history of hacks and insolvencies.

Proof of Reserves offers significant benefits to both users and custodial institutions. For users, PoR enables the verification of asset custody, allowing for informed decision-making and accurate transaction records. This ensures confidence in the safety of their assets.

For custodial institutions, PoR helps regain and maintain user trust, which has been eroded by recent events in the industry. By developing robust PoR facilities, reputable institutions can demonstrate their commitment to transparency and accountability. Additionally, PoR provides an immutable, on-chain record that can be scrutinized for accuracy, further bolstering trust in the industry.

How Does Proof of Reserves Work?

Proof of Reserves works by having an exchange sign a message that confirms it holds a certain amount of crypto. This message is usually a cryptographic hash that contains the following:

• The exchange’s public address
• The amount of cryptocurrency held in the address
• The date the message was signed

The exchange can then share this message with its users, who can verify that the exchange has the requisite amount of cryptoassets to cover its liabilities.

To elaborate a bit further, custodial institutions in crypto typically use a hot wallet for day-to-day operations, such as fulfilling withdrawal requests from users, and a cold wallet for long-term storage and security of a portion of users' deposits. Users are typically given a unique wallet address to make deposits, which are then moved between the hot and cold wallets as necessary.

While details of the institution-held assets can be partly obtained by tracing the details of transactions involving their hot and cold wallets, this only presents an aggregated view of the total assets in custody and doesn't provide any information about which users own what portion of the total assets.

A PoR audit involves a deeper study to collate the total assets held by the institution and prove that the institution holds the appropriate amount of assets to cover the users' deposits. This process typically uses Merkle tree technology, which creates a hash tree to organize and verify the data’s integrity. By publishing a Merkle root of the users' balances on-chain, a custodial institution can provide proof of the amount of assets it holds on behalf of its users, while still preserving the anonymity of individual user account balances.