The recent FTX contagion, which has caused arguably the biggest upset in cryptocurrency history, has impacted individual and corporate investors, causing negative market sentiment as well as stricter regulations. The event has also ushered in a new phase for recently popularized terminologies and practices. 

Proof of Reserves (PoR) is one such crypto phrase that shot into the focus frame since its implementation by leading exchange Binance. Changpeng Zhao—CZ, CEO of Binance, took to Twitter on November 9 to announce the exchange’s plan to implement a proof of reserves system, citing “full transparency” as the goal of the move. Following the announcement, a publication on the Binance website explaining what PoR is all about was made.

All crypto exchanges should do merkle-tree proof-of-reserves.

Banks run on fractional reserves.
Crypto exchanges should not.@Binance will start to do proof-of-reserves soon. Full transparency.

— CZ 🔶 Binance (@cz_binance) November 8, 2022

What is Proof of Reserves (PoR)

Proof of reserves is a method of verifying that a company that holds money or assets from public users has enough funds (fiat and cryptocurrency) in its reserves, plus a little extra to cover the total deposits. Although PoR is just gaining traction in the cryptocurrency space, it is not a novel concept in the traditional financial market. For example, financial institutions, such as banks, use the fractional reserve system, which requires them to keep a portion of their customers’ deposits in liquid assets as a reserve available for customer withdrawals. 

Proof of reserves, on the other hand, employs blockchain technology to transparently audit centralized crypto exchanges and provide accurate data on the assets stored in their reserves. Reputable third-party auditors have access to cryptographic signatures that represent legitimate public wallet entries by customers, as well as sufficient or abundant reserve balances that can cover all potential customer withdrawals.

How Does Proof of Reserve (PoR) Work

It is critical to understand that Proof of Reserves is not a consensus method, but rather a publicly disclosed and verifiable background check or an independent audit of crypto exchanges conducted by a third-party auditor. 

Typically, the system involves two main parties: the crypto exchange and a third-party audit firm. To begin, the exchange generates a cryptographic hash of the total amount available in the reserves (a random computer program-generated number between zero and 100 million). The total balance and hash generated are then published on the exchange platform for investors and others to view. Furthermore, the exchange includes a link to a third-party audit report confirming that the published hash corresponds to the actual assets held by the exchange. 

To repeat the process, the hash is added to the new reserve balance to generate a new hash, which is then published on the exchange platform and verified by a third-party audit firm. Any attempt to mismanage customer deposits would necessitate the system and an audit, which would be extremely difficult and would almost certainly raise suspicions. Because the information on the balance and audit report would be made public, it would be more difficult to misappropriate without being caught.

Proof of Reserves (PoR) and Confidence in CEXs

The collapse of the FTX centralized crypto exchange signaled a wave of distrust and lack of trust in centralized exchanges, which have become a popular way to store and transact cryptocurrencies. Investors who lost assets in the fall, as well as others who are afraid of a similar fate, sought to conduct business elsewhere or not at all. To back up this negative sentiment, The Block, a crypto research and news firm, confirmed in a report that the volume of decentralized crypto exchanges nearly doubled in November, increasing by 93% to $63 billion amid the FTX crisis. 

Several exchanges, including Binance, Huobi, Crypto.com, Kucoin, and BitMEX, have adopted the concept and recently audited their proof of reserves in order to restore investor confidence and promote transparency. The purpose of PoR is to ensure that exchanges and their partners do not engage in financial transactions that expose users or exchanges to insolvency risk. It also ensures that investors can withdraw at any time, without restrictions, even when a company’s life is threatened, as happened with BlockFi and Celsius.

Proof of Reserves (PoR): Solution or Hoax?

As is customary with hot topics, the cryptocurrency community and industry experts weighed in. The first major deal breaker, which was later echoed, was a tweet by Kraken exchange’s CEO and co-founder, who highlighted that “The statement of assets is pointless without liabilities.” Off-chain assets, loans, or other forms of liabilities that can affect liquidity are not properly accounted for because the system only shows on-chain assets of the exchange and not the source of transactions.. “An exchange could have lots of assets, but have used them as collateral for a loan that gives a lender first claim,” says Mark Lurie, CEO, and co-founder of Shipyard Software.

Many others saw the PoR introduction by CEXs as a hasty move to divert investors’ attention away from the FTX contagion and the use of Merkle trees as a de facto measure to project an exchange’s transparency. In this regard, Martin Hiesboeck, crypto analyst and Uphold’s head of blockchain and crypto research, told Bitcoin.com News that “The Merkle Tree PoR has seen increased adoption and interest in the past few weeks due to shaken trust in centralized exchanges. CEXs [centralized exchanges] needed a fast and public ’emergency response’ to restore public and user trust, and this is why the so-called Proof of Reserves method became so popular and is currently touted as the best way to prove an exchange’s transparency — at least on paper.”

Hiesboeck shares Lurie’s stance on the exclusion of an exchange’s outstanding liabilities, and further adds that the PoR system also has the issue of the “inherent opaqueness of a Merkle Tree model.” Hiesboeck’s argument focuses on the model’s design, which only allows for a single snapshot in time rather than a live accounting of balances over time.. “Regular onlookers have no means to verify the results of PoRs nor assurance that funds weren’t moved from these addresses immediately after the audit. To solve this issue, at least partially, there needs to be some kind of a real-time independent reserve monitoring system to provide up-to-date information over time,” he said to clarify his position.

Bottom Line

Some experts maintain that only a combination of assets and liabilities on display can make this model work, while others have continued to advocate for the outright sidelining of CEXs altogether as a means of storing crypto assets. In any case, with regulations looming and lower price bottoms still a possibility, the coming months will almost certainly reveal events that will reshape the crypto market as we know it.