How does a Proof of Reserves Audit work?

Proof of Reserves has existed for a long time in the blockchain ecosystem. The recent events in the crypto industry have caused a wave of demand from investors to fetch Proof of Reserves from centralized crypto exchanges. Proof of reserves provides transparency by giving accurate information about the exchange’s assets and liabilities. It shows the users that the exchange holds the funds it claims and is liquid enough to accept the withdrawal requests of the users.

What is Proof of Reserves Audit?

Proof of Reserves audit is done cryptographically, where the auditor takes a snapshot of the balance details and then uses it for verification.

The process of Proof of Reserves Audits work is as follows.

1. The firm to be audited appoints an independent third-party auditor.
2. The auditor takes snapshots of the users’ balances.
3. The users’ balance is converted to a hash, and these hashes are paired together. The hashes are paired until the last two hashes combine and form a single hash known as Merkle root.
4. The Merkle root consists of all the users’ balance data and can be traced back.
5. The auditor then collects the digital signatures of the account holders on the exchange to verify if they are the actual holders.
6. The amount on the Merkle root is then matched with the amount on the crypto exchange’s on-chain wallet addresses.
7. If the balance on the Merkle root tallies with the balance of the on-chain wallet addresses, it is proved that the firm has the funds it claims.

Merkle tree proof of reserves is a structured database. It proves that the exchange holds the users’ assets and has not used them for their benefit or to lend to someone. The auditor also ensures that the firm’s assets are segregated from the users’ assets.

Importance of PoR audit

PoR audit helps the firm prove that the users’ cryptocurrencies are safe. It builds credibility for exchanges to show that your cryptocurrency is backed by absolute assets instead of being lent out to some third-party obligations. Regular audits can help the firm identify and prevent potential risks. Any difference between the records and actual assets can be determined, and necessary steps can be taken to avoid financial losses.

If the exchange does not hold enough assets, it will have to freeze the withdrawals of users during a bank run, which can cause substantial financial losses for users.

Concerns regarding PoR Audit

The Proof of Reserves audit does not guarantee the solvency of the firm. Audits are mostly done annually or semiannually; however, some exchanges might move funds from the users’ accounts for other purposes after the audit. The reserves are guaranteed only when auditing is taking place. There is a high possibility of firms borrowing funds to show their solvency and return the funds once the audit is done.

How to check your holdings on an exchange?

Famous data analytics platform, Nansen, has collaborated with several exchanges to prepare a dashboard of the exchange’s holdings. Users can check assets of exchanges like OKX, Kucoin, Crypto.com, Binance, etc., through the same. The collapse of FTX, Celsius, BlockFi, etc., has taught crypto investors the importance of Proof of Reserves. It is the right of users to demand a PoR audit and the wallet address of the exchanges. It is necessary to provide a sense of relief to the users by confirming the exchange’s liquidity to have a good reputation in the industry.