Proof-of-Reserve: what is it and can exchanges be trusted?

Over the past few years, increasing the transparency of centralized crypto exchanges has become one of the key aspects of the development of the entire cryptocurrency market.. After the FTX crash in 2022, which hit both the cryptocurrency industry and the traditional financial sector, the largest platforms began to publish proof of their reserves — Proof-of-Reserves. OKX Chief Commercial Officer Lennix Lai told BeInCrypto about how the scheme works.

In this article: Why Proof-of-Reserves is needed How Proof-of-Reserves works The most reliable crypto exchanges with Proof-of-Reserves Disadvantages of Proof-of-Reserve Prospects of Proof-of-Reserve

Why do we need Proof-of-Reserves?

Unlike decentralized exchanges (DEX), where transactions are made directly between user wallets, centralized exchanges (CEX) are custodial. This means that users transfer their cryptocurrencies to the exchange’s accounts, partially transferring to it the responsibility for the safety of these funds. The exchange client does not have direct control over his deposit. But there is a risk that the exchange will not fulfill the request to withdraw the deposit.

If the exchange reserves provide user deposits in a ratio of 1 to 1, then the risk of losing funds on the exchange is significantly reduced. At least there is no threat that the client’s deposit will not be returned simply due to the lack of funds from the exchange. The history of the already mentioned FTX clearly shows that the lack of reserves is a very real problem, which has already led to the collapse of a large exchange.

“The monthly publication of reserve confirmation reports demonstrates the trading platform’s desire to be a reliable user partner in the world of cryptocurrencies. Proof-of-Reserves serves as a transparency standard and allows users to get a more complete picture of the crypto exchange, helping to check whether this site is worth trusting. The publication of PoR is very important to build trust and create a healthy and sustainable cryptocurrency ecosystem,” said OKX Chief Commercial Officer Lennix Lai.

Thus, proving that there are sufficient reserves to cover all obligations is an excellent way for an exchange to show that it is stable, reliable and wealthy.

How does Proof-of-Reserves work?

The volume of exchange reserves itself is not so important. The ratio between reserves (coins and tokens in exchange wallets) and liabilities—user deposits—is important.

Accordingly, the task is divided into two subtasks — proof of reserves (Proof-of-Reserves) and proof of liabilities (Proof-of-Liabilities).

Proof-of-Reserves is a relatively simple task from a technical point of view.. In public blockchains, the balances of all wallets are visible to all users. The exchange’s task is to prove that a particular wallet belongs to it.. To do this, just sign the transaction from this wallet.

Proof-of-Liabilities is a much more difficult task. The industry standard for solving this problem has been to use evidence based on the so-called Merkle tree.

In short: a Merkle tree is a one-way hash function that can be visualized as a tree. In the case of Proof-of-Liabilities, the “root” of the tree contains data about the user’s wallet, and the “leaves” contain data about the deposit made on the exchange. Both the “root” and “leaves” are hashed, after which the entire tree is hashed. It is impossible to “expand” the hash and extract user data from it, but any discrepancy in the source data will lead to a discrepancy in the final hash.

The Merkle tree, the hash of which the exchange presents when publishing proof of reserves, is collected from the entire set of such trees for wallets that sent funds to the exchange. With its help, the exchange proves that it really owes users this amount and this is one hundred percent cryptographically confirmed. But at the same time, it is impossible to obtain specific information about from which wallet which deposit was made.

An important clarification — such a proof is valid only at the time of compilation of the Merkle tree. Therefore, the practice of regular (on some exchanges — monthly) updating it was introduced.. After all, the data that the exchange was doing well six months ago says little about the current situation.

Once Proof-of-Reserves and Proof-of-Liabilities are obtained, there is a simple comparison of the volume of reserves in the exchange’s wallets and its obligations to users, which leads to the concept of Proof-of-Solvency.

Proof-of-Solvency

Proof-of-Solvency is perhaps the easiest to understand component of the entire proof-of-reserves system.. If the assets of an exchange are equal to or exceed 100% of its liabilities, it is solvent. And if all its users simultaneously request the withdrawal of their deposits, the exchange will be able to fulfill all their requests.

The most reliable crypto exchanges with Proof-of-Reserves

In the last couple of years, regular publication of Proof-of-Reserves and the ratio of reserves to user deposits has become a “rule of good manners” among large centralized crypto exchanges. On the one hand, this is due to regulatory pressure, on the other hand, due to competition and marketing.. Those platforms that avoid publishing reserve data appear less reliable than their more open competitors.

OKX

According to blockchain expert Nick Carter, OKX demonstrates the best quality of reserve confirmation reports among crypto exchanges. According to a December report, OKX reserves support user deposits of 100-104% across 22 coins and tokens. The amount of security for user assets amounted to $14.9 billion.

Since the fall of 2022, when OKX first published Proof-of-Reserves, the reserve ratio has never dropped below 100% for each of its assets.

OKX has public on-chain wallets. These addresses contain a signed message “I am an OKX address”, thereby confirming the exchange's ownership of these wallets. In April 2023, OKX introduced Zero-Knowledge Scalable Transparent Argument of Knowledge (zk-STARK) technology into the PoR process. All this allows users to independently check the solvency of the exchange and ensure that assets are backed by reserves.

Binance

Binance implemented a system for publishing proof of reserves a little over a year ago.. As of January 1, 2024, the exchange controlled 597,658,074 BTC and 4,265,238,882 ETH. There are 575,852,891 BTC and 4,002,782,994 ETH in the accounts of exchange clients. That is, all customer deposits are secured by more than 100%. A similar situation is observed for the remaining 29 coins and tokens for which data has been published.

Kraken

Kraken became the first crypto exchange to regularly publish Proof-of-Reserves, which is not surprising given the platform’s registration in the United States and the close attention of regulators. As of November 30 last year, the exchange's assets covered liabilities by 78%. However, it must be taken into account that Kraken’s liabilities, unlike other exchanges, also include derivatives, including futures and margin trading positions.

Gate.io

Gate.io last updated PoR on November 10, 2023. Total assets amounted to 115% of user deposits. Although, of course, the indicators differed significantly for different coins. Gate.io’s approach to proving reserves is also significant in that the platform is not limited to data on the largest coins — information on reserves in 112 cryptocurrencies and tokens has been published.

Huobi

Huobi updated Proof-of-Reserves on January 1, 2024. User deposits are secured by 100-103% of exchange reserves. True, it is necessary to note the exchange’s unique approach to the audit — it was carried out on only five assets. So the question of actually providing liabilities with reserves remains open.

Disadvantages of Proof-of-Reserve

Proof-of-Reserves is perhaps the best existing solution to the problem of proving the financial stability of crypto exchanges. But it is also far from ideal.

Firstly, PoR does not provide complete information about the platform’s assets. It is impossible to obtain information about the fiat assets of the platform in this way.. And it is equally impossible to imagine a large centralized crypto exchange that would not have significant fiat assets.

Secondly, using a Merkle tree to prove liabilities does not provide any complete information about the liabilities of the exchange. PoL provides only data on user deposits and their ratio to exchange assets. But, for example, it is impossible to find out whether user deposits are used as collateral for exchange loans using PoL.

Thirdly, as clearly shown above, different sites and auditors use different methodology when determining assets and, especially, liabilities, so comparing reserves of different sites is very difficult.

In other words, Proof-of-Reserve and Proof-of-Liabilities should not be confused with a full-fledged financial audit. The latter, however, also does not provide any guarantees — FTX successfully passed the audit just a few months before its collapse.

Prospects for Proof-of-Reserve

At the moment, the concept of proof of reserves is far from perfect.. However, we are already seeing its active improvement and work on the most serious problems. Thus, regular publication of PoR by large exchanges is becoming increasingly common — monthly updating of proofs is gradually becoming standard practice.

For users, PoR is becoming one of the key factors indicating the reliability of a crypto exchange. According to surveys conducted by the OKX exchange in August 2023, 84% of respondents consider monthly PoR reports to be “somewhat important” or “very important”, and 88% of participants consider transparency to be “somewhat important” or “very important” when choosing a cryptocurrency platform. In addition, work is already underway to use oracles for decentralized proof of fiat assets and liabilities of platforms, which are currently a blind spot.. So, increasing the transparency of large crypto exchanges is almost inevitable.

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