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It’s like a digital receipt that allows anyone to verify the presence of a particular piece of data in the Merkle Tree without revealing any sensitive information. Cryptographic proofs provide a way to mathematically prove the integrity of data. So, let’s take some time to talk about the mechanisms involved in ensuring the safety and security of your https://www.xcritical.com/ funds. Anytime you trust a 3rd party with your assets, you introduce a point of failure. In this article, we’ll break down what Chainlink Proof of Reserve (PoR) is and how it helps provide stronger security guarantees and more transparency in the cryptocurrency ecosystem.
Why Is Proof of Reserves (PoR) in Demand After FTX Collapse?
Proof of reserves audit is a method used to verify that an exchange, wallet or other financial service is holding sufficient reserves to cover customer balances. This audit confirms that the exchange, wallet or other financial service provider holds the correct amount of cryptocurrency or other digital assets that correspond to their liabilities to customers. The auditor will then compare these lists and verify that the reserve balances held by the exchange or financial service provider match the total proof of work cryptocurrency of the customer balances. The stunning collapse of crypto exchange FTX near the end of 2022 sent shockwaves through the crypto industry, rattling trust and pushing asset prices into freefall. The events ignited conversations about the security of users’ crypto, and widespread concern over whether they could trust their holdings in the hands of custodial wallets and exchanges. The proof of reserves audit involves an independent third party reviewing and verifying the financial records and holdings of a financial institution.
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It only tracks holdings and would not prevent an exchange from, say, lending money to dodgy borrowers who have no hope of repaying. Implementing a proof-of-reserves program makes it easier for anyone to verify a company’s reserves. One of the most straightforward steps is downloading the latest audit or attestation report published by the exchange’s third-party auditor. Proof of reserves audits are essential for building trust, transparency, and security in the crypto ecosystem.
Why is market liquidity important?
By employing proof of reserves, financial institutions can demonstrate their solvency and establish trust with their clients. Proof of reserves serves as a mechanism to validate and verify the existence and availability of funds held by a financial institution. It provides transparency and reassurance to customers, offering them peace of mind that their funds are indeed present and properly managed. By reviewing these reports, you can ensure that the exchange has undergone a thorough assessment by a reputable auditing firm, which adds credibility to the proof of reserves process. While the whole aim is to become more transparent, tradFi institutions will only share this important information with stakeholders and board members.
User & Platform-level Benefits of PoR
So, to put briefly what proof of reserves is – it’s not just a technical concept; it’s a crucial element for ensuring the safety and security of funds in both traditional and digital financial systems. It provides customers with confidence that their assets are being handled responsibly and protects them from potential fraud or insolvency. In addition to providing proof of reserves audit reports, some exchanges offer users the possibility to verify this information themselves. This can be done by making the exchange’s wallet addresses public and / or granting users access to Merkle data. A crypto auditing company tallies the on-chain holdings of the company with the client assets on its balance sheet.
Exchanges can prove ownership of these specific wallets simply by signing a transaction. To understand where your funds are being stored, let’s first explore how centralized exchanges work. Wrapped token bridges help create more capital efficiency in the DeFi ecosystem but introduce risks through the potential of undercollateralized wrapped assets.
This attestation confirms the trustworthiness of the environment in which the POR software was executed and verifies the hashes of executed programs and platform measurements. FTX’s collapse in November 2022 and Binance, another crypto exchange, stressing the need for transparency are among the factors behind this shift. Millions of crypto traders rely on MetaMask to interact with Web3 and blockchain tech. And proof-of-reserve does not provide customers with greater control over their funds; it just provides information. The idea for proof-of-reserves based on Merkle trees became particularly popular after the collapse of FTX. Binance’s CEO, Changpeng Zhao, tweeted that his exchange would begin to implement proof-of-reserves.
That means that when a platform offers Proof of Reserves, you will be able to review the report to see whether the platform has sufficient assets to cover its liabilities. Therefore, the best reserve assets include bitcoin (BTC), ether (ETH), and stablecoins such as tether (USDT), USD coin (USDC), Binance USD (BUSD), and dai (DAI). Although the exchange may hold a portion of its reserves in other cryptocurrencies based on user deposits, a substantial part of the portfolio must include hard, highly liquid assets. Pending the release of a frontend feature for users to verify their balance inclusion in ongoing audits, BitMEX currently provides a comprehensive guide for technically-savvy users to audit the exchange’s balances independently.
Exchanges may also choose to engage an impartial third party to audit its reserves. It does so by signing a transaction to prove ownership of the private keys to its crypto wallets. This way, the interested parties can view its balances to see if they match its claims. Practically speaking, audits are expensive and cumbersome, and CPA firms are very averse to working with crypto companies. This isn’t helped by folks like Sen Warren trying to bully audit firms into further spurning crypto.
All of these checks and balances ensure that a crypto company has the reserve assets that it needs to serve all customers, and that liquidity is maintained no matter the market conditions. With the PoR system, the exchange’s reserves are expected to hold in custody the total amount deposited by its users (or more). If this criterion is satisfied, the exchange can be said to be “fully backed.” However, it’s important to note that the exchange can’t substitute one asset with another.
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- Specifically audit firms stake their reputation on their oversight in a financial statement audit – they are actively determining whether the financials surveyed appropriately reflect the firm’s financial position.
- They provide a single hash for a large set of data, ensuring that none of the included data has been tampered with.
- With Bitcoin and other cryptocurrencies, all the transactions inside a block are summarised in a Merkle tree by producing a digital fingerprint of the entire set of transactions.
- The introductory guide on Proof of Reserves crypto platforms can offer now also emphasizes the importance of Proof of Reserve.
- Crypto.com and Gate.io announced that the transaction was a mistake, and the funds were later returned.
- Reference to any specific strategy, technique, product, service, or entity does not constitute an endorsement or recommendation by dYdX Trading Inc., or any affiliate, agent, or representative thereof (“dYdX”).
Another issue is that exchanges could have unaccounted-for liabilities that a mere cash flow analysis might not capture. For instance, given that many exchanges exist under muddy regulatory regimes and legal contexts, it’s not guaranteed that depositors would be senior to creditors in the case of bankruptcy. This means that it’s possible that large debts could consist of a hidden liability that would weaken depositor claims on reserves in a worst case scenario. This is why I recommend including an auditor in a PoR process, so these more complex liabilities (and an assessment of the seniority of depositors) can be understood. More generally, exchanges should adopt a legal policy in which depositors are absolutely privileged and senior to all creditors. According to its “inexhaustive overview” of the digital assets it holds in custody, Huobi currently holds around 32,000 BTC, 274,000 ETH and over 800 million in USDT stablecoins.
Ledger’s hardware wallets are the prime example of safety and accessibility. Your private keys are safely stored on a physical device only you can access. Further, Ledger’s secure element chip ensures your assets are safe from physical and software hacks. Put simply, an institution showing Proof of Solvency, via the audit of its assets against its liabilities, can guarantee users access to their assets. While that may not seem immediately concerning, it means if the exchange fails, you lose your funds. You may think that sounds like a worst-case scenario, but unfortunately, it’s more frequent than you might think.
In effect, it is a bona fide verification tool to prevent exchanges from surreptitiously running off with customer deposits. In a world where exchanges and stablecoin issuers must periodically prove their reserves, users will use products that offer the highest degree of fund safety. In the long run, a safer ecosystem would attract more investors and provide a springboard for more institutional capital to flow into the crypto market. Meanwhile, individual users should also have the option to verify reserves cryptographically. The custodian typically provides all the required documentation and tools for independent verification. If users are technically experienced, they can independently verify reserves by reconstructing the specific Merkle tree node hash provided by the exchange.
The root stores all of the data – in this case the wallet and transaction data. At the end of each branch, there is a node – with each node capable of storing information. With this in mind, crypto audits – such as Proof of Reserves – are conducted with increased transparency. Here are the prominent benefits for custodial institutions with Proof of Reserve evaluation.
With Hacken’s PoR service, you can generate on-demand proofs at any time, giving your users confidence and peace of mind about your platform’s solvency. Receive a detailed, easy-to-understand audit report that provides a transparent snapshot of your platform’s financial health, along with actionable insights for continuous improvement. Generate proofs of solvency at any time with Hacken’s flexible PoR solution, empowering your platform to stay ahead with timely updates that users and stakeholders trust. Ensure the integrity of staked assets, prevent double-counting, and verify validator set security for a transparent staking process. In the meantime, investors’ best course of action is to check the PoR balance of any platform they are dealing with and store their crypto in non-custodial wallets.
Cohen & Co and Withum, and Grant Thornton are all active in facilitating attestations in the stablecoin space, though none have overseen an exchange PoR as far as I know. All of the big four as well as RSM, in my esteem, have the technical competency to undertake a PoR but have thus far appear to have been unwilling to on a perceived risk basis. The platform currently has more than 108% of client liabilities in Bitcoin (BTC) and 104% of the same in Ethereum (ETH).
Since 2017, Hacken has expanded beyond smart contract audits, completing numerous PoR audits for leading industry projects, like Gate.io, Crypto.com, Bybit, among others. We evaluate the audit scope, timeline, and costs based on your project’s documentation to set clear expectations from the start. Now they can see the actual proof, returning to the basic principle of cryptography – “do not trust, verify.” In times of high volatility, the crypto market liquidity will be lower because the fluctuating market prices discourage trades, causing buy and sell orders to take longer to fulfil as there is less activity in the market. However, in times of stability, the crypto market will experience high liquidity because more people invest, meaning buy and sell orders are quicker to execute.
Another option (currently unique to BitMEX) involves downloading their open-source proof-of-reserve software and running the provided commands on their computer. Alternatively, if the custodian uses Armanino as its auditor, users can usually verify the company’s reserves by visiting their Trust Explorer page. On the dashboard for each company, it is possible to verify individual balances or review the current status of the company’s reserves.
