Binance launched a proof-of-reserves system for bitcoin holdings. What are proof of reserves?

The popular crypto exchange called FTX collapsed two weeks ago due to a liquidity crisis. As a result, the exchange stopped processing customer and investor withdrawals. Since the fall of FTX led to a lot of mistrust in the crypto community, crypto exchanges, including Binance, started to offer more information around how it handles people’s funds.

What are proof of reserves?

Proof of Reserves are one way that Binance is offering that transparency to users. It refers to an independent audit completed by a third party to verify the assets that are held in custody for users. Proof of reserves show evidence that Binance has funds that cover “all of our users’ assets 1:1, as well as some reserves,” the company website states. Reserves are cryptocurrencies, or other types of assets that offer liquidity. It tells users that the company could sell off its assets to cover withdrawals if needed, regardless of market conditions. It also shows that Binance has slightly more Bitcoin
BTCUSD,
+0.27%
in the wallets it controls than the amount that is deposited by users.

Binance clarified that these numbers do not include corporate holdings, which are kept on a separate ledger. Binance also claims to have zero debt in its capital structure and an emergency fund for extreme cases.

How does it work?

To show proof of user assets, Binance is using a Merkle tree (also called hash tree), which allows people to verify the assets they hold within the platform. The verification is done by a third party auditor. The auditor takes an anonymized snapshot of all the client’s balances and aggregates them into a graphic, which displays all the balances at the time that the snapshot was captured, without revealing any private information.

What are the shortcomings?

While proof of reserves offer some financial transparency, there are a few shortcomings to the system. It only shows assets that are on the blockchain, and doesn’t reveal any off-chain activity that could be happening. It is also only a single snapshot, instead of a live, ongoing update on balances. It also doesn’t reveal where balances are coming from, and whether they are borrowed for the purpose of the audit.