What Is Proof of Reserves and Can It Build Back Trust?

The collapse of platforms such as FTX, Celsius, BlockFi, Voyager Digital and Hodlnaut has instilled deep skepticism in centralized custodians — especially those whose don’t directly derive revenue from their custodial services. Those that remain in business and still honor withdrawals need a way to win back trust and avoid a massive user exodus. 

The “proof of reserve” concept has emerged as a popular tool toward this end. But how does it actually work, and can it deliver the consumer trust needed to keep custodial platforms as a market alternative to DeFi?

What is proof of reserves?

Proof of reserves (PoR) is an attempt to provide public transparency to centralized crypto currency reserves through a verifiable auditing practice. It uses cryptographic proofs and public wallet address ownership verification in combination with periodic third party audits to publicly attest that a centralized platform holds enough assets to match user deposits. This cryptographic approach makes it possible for individual users to verify that their account balance is included in the attestation. 

While the solution incorporates elements of blockchain technology, it still requires trust in third party auditors and the accounting practices valuing any off-chain assets.

Why is proof of reserves necessary?

Custodial exchanges provide an important market function — access for institutional and retail investors who are unwilling or unable to take the steps needed to self-custody their assets. While it is clear that proof of reserves cannot deliver the same transparency as non-custodial, blockchain-based platforms, their advocates argue that more transparency is better than nothing.

When combined with a public and legally binding disclosure of liabilities, users can view proof-of-reserve attestations to verify on-chain that the custodian has enough assets to back a third-party audit of deposits. Customers can also easily discover whether assets are being rehypothecated, not backed by a solid basket of assets, or utilized for other high-risk activities that could jeopardize their availability. 

How are audits conducted? 

During an audit, the third-party auditor obtains proof of reserves by taking an anonymized snapshot of user balances. They are typically calculated by hashing a user’s account balance with their unique ID. The auditor then aggregates them into a cryptographic Merkle tree that produces a Merkle root — a cryptographic hash that uniquely represents a combination of all user balances. 

The Merkle tree makes it possible to verify the accuracy of all balances by only cross-examining a few anonymous balances with the verified ones. For example, any user can verify if their true account balance was included in the tree. They would need to:

1. Hash their account balance and unique ID; and
2. Search for it in the Merkle tree. 

A series of these verifications can then be used to prove the accuracy of the whole tree, without examining each individual one.   

The final step is to obtain digital signatures from the custodian proving that they control the on-chain addresses holding the assets. If the balance on the associated digital signatures matches those obtained from the Merkle tree, the auditor can verify that the platform maintains a reserve of all client assets. 

Proof of reserves audit concerns

Proof of reserves can give users a false sense of security. Audits provide an overview of assets held on the platform’s associated addresses without disclosing the company’s liabilities or obligations to customers. So a platform could use their proof of reserves to appear like a self regulating and transparent participant without disclosing their true solvency risk. Ideally, custodians should provide proof-of-reserves reports alongside proof of liabilities. This way, users can confirm the company’s solvency.

In the aftermath of the FTX fallout, many crypto platforms such as Crypto.com announced that they will release a proof-of-reserve auditing solution in the future. In the meantime, Crypto.com published its wallet balances to a dashboard on Nansen.io. This disclosure is one part of this equation, but it doesn’t represent the anonymized balances of users on their platform. 

Other platforms such as Gate.io do have a PoR attestation process that verifies the other part of this equation. Its auditor, Armanino, takes periodic snapshots of anonymized user balances and the exchange’s proven ownership of funds. The critical element to this process is the initial snapshot. If an entity temporarily borrows funds for the snapshot, then they can make it appear that they are solvent without actually having the necessary means to fully cover potential withdrawals. 

Secondly, the addresses containing a platform’s reserves are not always publicly disclosed. So there is no way of verifying that the funds are still present after the audit is complete. Even if exchange addresses are published on Nansan.io, there is no way of verifying if those specific addresses were used to verify account ownership in the audit. And because these snapshots only include user liabilities at a specific moment in time, published addresses can’t be used to verify solvency in real-time. Users are required to trust the auditor’s attestation about the assets in question. 

In Crypto.com’s decision to disclose its wallet addresses, it revealed that 320,000 ETH was sent to Gate.io on Oct. 21, 2022. Crypto.com and Gate.io announced that the transaction was a mistake, and the funds were later returned. Many speculated that these funds were used to top up Gate.io’s books, however, the exchange debunked the notion by asserting their latest snapshot was completed on Oct. 19, 2022, two days prior to the mistaken transfer.  

If platforms could produce a real-time attestation of both account balances, verifiably owned wallet addresses and legally binding liability disclosures, then many of these fears of cross-platform collusion can be put at ease.

Proof-of-reserves companies

In light of the FTX demise, many players in the centralized exchange space and others have quickly established proof-of-reserve initiatives. The specifics of each proof-of-reserves program tend to vary, with many different approaches being adopted.

1. Ledn

Canada-based bitcoin lending platform Ledn implements a proof-of-reserves scheme through Armanino. The program, launched in January 2021, makes Ledn the first lending platform to provide transparency. 

Ledn users can confirm if the firm added their assets to the most recent Ledn audit by using the proof-of-reserves section on their account dashboard or visiting Armanino’s trust explorer for the lending platform. Ledn also publishes a regular announcement on its blog after each proof-of-reserves audit is done biannually.

2. Nexo

Nexo launched in 2018 and offers a platform for users to earn interest on their crypto or draw credit lines using their crypto as collateral. In September 2021, Nexo also introduced a proof-of-reserves program also in partnership with Armanino. Nexo users find the real-time attestation feature on their accounts. Additionally, they can view the company’s PoR on Armanino’s website, with the option to download the account report for the most recent attestation period. 

3. Kraken

Launched in 2011, Kraken is one of the leading cryptocurrency exchanges pioneering proof of reserve audits. The platform launched its PoR program in February 2022 with a commitment to provide semi-annual updates regarding the value of customer assets. 

Kraken implements an “audits” button on user accounts utilizing the Merkle tree functionality. Thus, users can easily verify from their accounts that Kraken included their wallet balances in the most recent PoR audit. Users can also obtain their audit record ID to validate it against a database maintained by Kraken’s auditor — the exchange also uses Armanino. Lastly, users can access technical details from Kraken’s proof-of-reserves page needed to reconstruct a Merkle tree to verify their balances.

4. BitMEX

Cryptocurrency exchange BitMEX introduced a proof-of-reserves-based system in August 2021. The platform is also one of the few to provide visibility into its liabilities. It allows customers to confirm that BitMEX is solvent and always holds more assets than it owes customers.

Pending the release of a frontend feature for users to verify their balance inclusion in ongoing audits, BitMEX currently provides a comprehensive guide for technically-savvy users to audit the exchange’s balances independently. BitMEX also publishes periodic social media updates about the state of its reserves.

5. Gate.io

Gate.io is another cryptocurrency exchange that has adopted proof of reserves. The company published its first audit in August 2020 in partnership with Armanino, with the second only coming in October 2022. 

Users can find the latest audit reports on the Gate.io proof-of-reserves page or Armanino’s website. Users can also verify their balances using a hash ID available on their Gate.io account.

A number of exchanges are working on introducing proof-of-reserves standards into their operations. These include the following:

How to verify a company’s reserves? 

Implementing a proof-of-reserves program makes it easier for anyone to verify a company’s reserves. One of the most straightforward steps is downloading the latest audit or attestation report published by the exchange’s third-party auditor. 

Alternatively, if the custodian uses Armanino as its auditor, users can usually verify the company’s reserves by visiting their Trust Explorer page. On the dashboard for each company, it is possible to verify individual balances or review the current status of the company’s reserves.

If users are technically experienced, they can independently verify reserves by reconstructing the specific Merkle tree node hash provided by the exchange. Another option (currently unique to BitMEX) involves downloading their open-source proof-of-reserve software and running the provided commands on their computer.

Lastly, cryptocurrency data provider Nansen.ai also provides a dashboard displaying the balance of addresses owned by exchanges. Each exchange’s dashboard displays associated addresses, crypto assets, and transaction history.  

Frequently asked questions

What assets can be considered reserves?

Assets considered reserves are those that have a strong liquidity profile. In other words, the exchange and its customers could quickly sell the assets in the case of a crisis. Recall that the collapsed FTX exchange held a significant amount of its reserves in FTT tokens — which had a poor liquidity profile. 

Therefore, the best reserve assets include bitcoin (BTC), ether (ETH), and stablecoins such as tether (USDT), USD coin (USDC), Binance USD (BUSD), and dai (DAI). Although the exchange may hold a portion of its reserves in other cryptocurrencies based on user deposits, a substantial part of the portfolio must include hard, highly liquid assets.

What is a proof-of-reserves attestation?

A proof-of-reserves attestation is a real-time or periodic review of balances held by a centralized cryptocurrency exchange or lending platform. The attestation is usually provided by a third-party accounting firm, with Armanino being the leading auditor for most crypto service providers.

Real-time attestation provides insights updated several times daily. On the other hand, a periodic attestation is published monthly, quarterly, biannually, or at any different timeline specified by the custodian. 

Are auditors necessary to review the reserves? 

Like traditional financial institutions, auditors must review the reserves because they use industry-certified accounting standards and provide third-party affirmation. Users thus can rely on something other than a custodian’s self-assessment, which may be easily skewed or falsified. 

Meanwhile, individual users should also have the option to verify reserves cryptographically. The custodian typically provides all the required documentation and tools for independent verification.

Do P2P exchanges need to publish reserve balances? 

P2P exchanges need to publish reserve balances if they operate in a custodial fashion and hold user assets during a transaction. However, other P2P platforms, such as decentralized exchanges and lending platforms, do not need to publish user balances as these are publicly available on the blockchain. 

Is regulation still required?

Adopting a proof-of-reserves standard is a form of self-regulation that could boost user confidence in centralized platforms and the industry. However, government regulations such as imposing licenses on crypto custodians and mandating advanced security practices may still be required to achieve the highest level of trust. Over time, combining both forms of regulations could make the cryptocurrency industry safer for retail and institutional investors.

Crypto market outlook with proof of reserves

The cryptocurrency industry could immensely benefit from custodians adopting proof-of reserves standards if they fully disclose the risks of this type of self regulation to their users. If the industry succeeds in implementing universal accountability standards, the move could prevent setbacks that often result from the implosion of centralized platforms such as Mt. Gox, Cryptopia, QuadrigaCX and FTX. 

In a world where exchanges and stablecoin issuers must periodically prove their reserves, users will use products that offer the highest degree of fund safety. In the long run, a safer ecosystem would attract more investors and provide a springboard for more institutional capital to flow into the crypto market.

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