Proof of Reserve is a vetted technique that employs Merkle-Tree-based data structures to ensure real assets back cryptos. This helps address transparency concerns on centralized crypto exchanges, custodians, and financial institutions. This form of audit confirms that the assets held by these organizations are indeed what they claim them to be. This process involves verifying an institution’s assets and liabilities with a third-party crypto auditor, who publicly reports their findings.
By providing evidence that a trusted third party attests to their holdings, customers can be assured of their funds not being misused. It allows users to track if the assets they hold are verified through the PoR(Proof-of-reserves) system. As the balances are verified on the public blockchains, there is no room for tampering or demonstrating fraud. Moreover, any changes in the data will affect the Merkle root, indicating tampering with the asset balances.
To provide proof of reserves, an exchange must publish a list of the addresses where it holds cryptos and the corresponding balances. This information can be verified using publicly available blockchain data, thus ensuring the absolute backing of assets.
Leveraging the PoR method helps restore the users’ confidence, enhance trust in the operations and support the crypto markets to recover for the greater good. Apart from demonstrating financial solvency, the PoR audit method brings transparency to asset management and the privacy of user funds in a secure manner, thus benefitting the crypto industry. Moreover, crypto exchanges and custodians are forbidden from deploying customer funds in other companies, thus decreasing the possibility of financial fraud and crisis.
Benefits to proof of reserves for both users and exchanges
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Increased transparency: Proof of reserves helps ensure absolute asset backing and determine the exchange’s solvency. The Merkle tree hashing approach allows customers to independently verify exchanges’ PoR audits, thus bringing greater transparency.
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Improved security: Demonstrating the funds on a public blockchain reduces the likelihood of a financial crisis and minimizes the depositors’ risk of losing funds, thus bringing in a sense of security amongst customers.
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Greater accountability: The ability of the Merkle root to determine any changes in the data or the possibility of tampering makes it difficult for exchanges or institutions to carry out malicious practices, thus making them more accountable for their actions.
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Enhanced reputation: The PoR increases the integrity and reliability of crypto institutions, thus driving more users and creating a trustworthy environment for businesses to flourish.
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Regulatory Appeal: On-chain holding of cryptocurrencies corresponding to user balances’ could be an interesting approach to appeal regulators. This advocates that crypto institutions are willing to work in a compliant manner for the best good of their customers.
How can Users Verify the Authenticity of Proof of Reserves
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Scanning the blockchain: By reviewing the transactions and verifying the balances of official exchange wallets, users can determine the amount of funds exchanges hold in their ho and cold wallets.
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Seeking third-party verification: Some exchanges have their proof of reserves independently verified by a third-party crypto auditor.
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Requesting additional documentation: Users can also ask the crypto institutions for further documentation, including bank statements or proof of ownership, to verify the exchanges’ current holdings.
Despite the above methods, the financial health of a crypto exchange or financial institution cannot be wholly determined by these methods. The PoR audits can be manipulated; exchanges might have several tracked and untracked wallets, and funds can be borrowed quickly to inflate wallet balances.
