Have you ever wondered what a centralized exchange does with your coins? You deposit crypto, withdraw fiat, and trust your balance will always be there. Until one day it’s not.
Maybe your money is working for someone else. Lent out for interest, used for fake trading volume, who knows. No one does until there’s a bank run in a bear market.
That’s where Proof Of Reserves comes into play. To prove 1:1 deposit backing. And if you think that’s enough to protect your balance, this article will be an eye opener for you.
Proof of reserves (PoR) works as the centralized equivalent to crypto audits for blockchain projects. There’s a third party running tests to find out how protected the platform is against different threats. In the case of crypto institutions— namely custodial exchanges— financial management is the greatest risk, not code.
Crypto platforms aren’t like traditional brokers. Because most cryptocurrencies use public networks, transparency isn’t an option. Client or not, anyone can see company balances on every wallet and network.But do those balances match with depositors’ ones? That’s what proves the Merkle Tree technique. Merkle Tree PoR involves grouping customer “hashes” (Merkle Leaves) in pairs over and over until there’s only one hash left— the Merkle root.
A hash is an unreadable string of letters and numbers that results from applying an algorithm to other data— such as wallet balances. Hashing is irreversible, but entering the same data should result in the same string. It’s a compact and useful way to prove balances without revealing them.
On centralized exchanges, each balance is hashed then paired to another one and hashed again until there’s a single balance and hash. So with 1,000 balances, 1,000 hashes will pair and convert to 500 hashes, then 250, and again until the last. This way, exchanges can prove total deposits without revealing individual balances.
The problem is, exchanges can still manipulate data. They can borrow tokens from DeFi apps, include wallets that they don’t own, exclude depositor wallets, or switch balances from fiat. Even with third-party agencies, all of the above can still happen.
Doing PoR once would be like auditing Ethereum in 2015 and expecting it not to have bugs with the 2023 version. It’d be ideal to show PoR in real-time, or at least bimonthly. Many exchanges still haven’t passed the first PoR.
If you’re only comparing on-chain assets vs deposits, there’s a lot you still don’t know. You don’t know how many of those assets are borrowed to pretend there’s 1:1 backing. You neither know which depositors were fabricated or excluded.
But at least, you can prove whether or not your balance was included in the last PoR:
If it can’t find your Merkle leaf, it might mean:
It’s not uncommon for crypto audit agencies to also offer PoR services. That’s because both require blockchain data to be verified. Both transactions and the code that makes them possible are public in blockchains like Ethereum, Pulsechain, or BNB Chain.
PoRs and crypto audits have major differences in:
What is PoR? Verified crypto assets minus deposits. If it’s positive, everyone can cash out without hassle. Liquidity.
Solvency? Different story. Then you need to disclose liabilities like lender debt and operational costs. If the exchange can’t offset those liabilities long-term, eventually those “reserves” run out.
PoR is a secure and simple way to aggregate millions of balances and contrast with the exchange’s claims— but it’s not difficult to trick. Especially when you have a one-month window between each update. Hypothetically, an FTX with PoR would seem safer but still collapse due to undisclosed liabilities.
Whether you want to trust the exchange or the PoR agency, this choice is an illusion. The most accurate PoR should be decentralized and real-time. Chainlink seems to provide just that for brands like Gemini and Paxos.
At the end of the day, businesses run by humans are susceptible to malpractice.
Even with a system such as Proof of Reserves, we need blockchain solutions which remove the humans.
The system maintains a total collateral ratio over 1.10/1 by an instant liquidation method.
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Max is a European based crypto specialist, marketer, and all-around writer. He brings an original and practical approach for timeless blockchain knowledge such as: in-depth guides on crypto 101, blockchain analysis, dApp reviews, and DeFi risk management. Max also wrote for news outlets, saas entrepreneurs, crypto exchanges, fintech B2B agencies, Metaverse game studios, trading coaches, and Web3 leaders like Enjin.