Although centralised cryptocurrency exchanges are crucial for trading digital assets, concerns surrounding these platforms' transparency and security persist. These concerns grew after the collapse of the centralised crypto exchange, FTX in 2022.

Because users entrust their funds to these exchanges, they must verify that the claimed reserves match the actual holdings. This is the best way they can build users' trust. And this is where the concept of Proof of Reserves (PoR) comes in.

What is Proof of Reserves (PoR)?

Proof of Reserves (PoR) is a method employed by centralised cryptocurrency exchanges to show that they have an amount of crypto assets they claim to have in their custody.

In essence, PoR offers a means to confirm that exchanges indeed possess the funds they agreed to hold on behalf of their users. And it achieves that without compromising the confidentiality of individual user data.

How Does Proof of Reserves (PoR) Work?

The process of executing Proof of Reserves involves a meticulous series of steps. These steps are aimed at confirming the existence of reserves while safeguarding the privacy of individual user accounts.

Here's a breakdown of how PoR audit works:

Snapshot of User Balances: Think of it like taking a secret picture of everyone's money in a way that keeps their identities hidden.

Merkle Trees and Aggregated Balances: Imagine organising all these secret money amounts in a special way that still hides who owns what, creating a summary of everyone's money in a secret code.

Verification via Cryptographic Signatures: People from outside (auditors) ask the company to prove they control the money they say they do, using secret codes only they should have.

Comparing Signatures with Merkle Root: These outside people then check the secret code given by the company against the secret summary of everyone's money. If they match, it means the company has the money they claim to have without exposing who owns what.

Advantages of Proof of Reserves

Enhanced Trust: PoR serves as a means for centralised exchanges to build credibility. This helps in boosting user trust by providing verifiable evidence of their holdings.

Sustainability: It encourages exchanges to prioritise the safety of user funds, ensuring the long-term sustainability of the crypto industry.

Limitations and Necessary Improvements

While PoR offers significant benefits, it also faces certain limitations:

Third-Party Dependency: Exchanges initiate PoR audits with the help of third parties. Relying on third-party services for PoR audits contradicts the decentralised nature of the industry, potentially exposing data to manipulation.

Lack of Real-Time Audits: Many PoR audits are not in real-time. They occur as one-time checks, leaving gaps that could be exploited for data manipulation between audits.

Essential Components for an Ideal PoR

To establish a robust PoR framework, certain essential components must be in place:

1. Proof of Liability: This demonstrates the level of funds in exchanges to assure users of their financial stability.

2. Anonymized Balances for Transparency: PoR reports should not disclose usernames and funds. It should provide a high level of privacy while still showing accurate results.

3. Real-Time or Periodic Audits: There should be regular checks to minimise the possibility of manipulation or mismanagement of funds in centralised exchanges.

4. Publicly Available Verified Wallet Addresses: Users should be allowed to track on-chain activities associated with their accounts by themselves.

5. User Verification Option: Users should be given the option to confirm if they are included in PoR audits to foster trust and confidence in the exchange's transparency efforts.

The bottom line

Proof of Reserves is an important way to reinforce trust and security for the crypto ecosystem's growth.

While PoR isn't without its challenges, implementing its key components enhances transparency. It also encourages user confidence in centralised exchanges, paving the way for a more secure and trustworthy crypto ecosystem.