What is Proof-of-Reserve: Is Your Crypto Safe? Phemex Academy

As a highly flexible and transparent oracle network model, Proof of Reserve helps accelerate the growth of DeFi by providing collateralization data on a wide array of assets and unlocking cross-chain liquidity. As Chainlink is blockchain-agnostic, Chainlink PoR feeds can be constructed to provide collateralization data on any cross-chain asset settled on any smart contract-enabled blockchain. Tokenized assets that previously required an impractical level of trust in the issuer are now able to utilize Proof of Reserve to https://www.xcritical.com/ provide the transparency required for user adoption.

Why is Proof of Reserves good for crypto?

Ideally, users can be assured that exchanges safely hold their assets through verification of PoR. A proof of reserve crypto exchange could lie outright, and a third-party attestor could still uphold the lie. If the attester is corrupt or incompetent, perhaps by overlooking missing wallets or failing to understand how an exchange had structured customer holdings, the whole purpose of proof of reserve would be undermined. There are no formally accepted rules or procedures that define a Proof of Reserves audit. You should not construe any such information or other material as legal, tax, investment, financial, or other advice.

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These can include fiat currencies such as GBP or commodities like gold, increasing the transparency of an entire category of building blocks within DeFi. To power the TUSD Proof of Reserve reference feed, Chainlink oracles fetch data from The Network Firm, which performs regular reviews of TrustToken’s escrowed bank accounts. When the amount of US dollars held in TrustToken’s reserves deviates beyond a predefined threshold, an update is pushed on-chain to the Proof of Reserve reference feed. DeFi applications can then utilize this data to verify the reserves of TUSD tokens on-demand.

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In this SmartCon 2022 roundtable, industry experts from Armanino, CACHE, Chainlink Labs, and TrueFi discuss how Chainlink Proof of Reserve brings unparalleled transparency to the Web3 space.

In effect, proof-of-reserves brings crypto exchanges closer to the treasuries of decentralized finance protocols, where all funds are matched to cryptocurrency wallets that anyone can trace on-chain at any time. Additionally, DeFi products can be constructed around this data, allowing users to hedge against the fractional reserve activities of traditional off-chain institutions. A Merkle tree is a cryptographic tree in which every “leaf” (node) is labeled with the hash of a block of data.

Asset tokenization projects such as TUSD, PoundToken, and Cache Gold have integrated PoR Secure Mint to employ this standard for tokenized asset transparency, security, and verifiability. Proof-of-Reserves, or short PoR is a publicly shared and verified background check or an independent audit conducted on crypto exchanges by a third-party auditor. For the PoR to work as a true PoS, it’s also crucial for users to be able to check the liabilities themselves against the reserves. While useful, more is needed to re-establish trust in a world where trusted third parties can, all too often, be security holes. Proof of Reserves (PoR) is a method of using cryptographic verification to demonstrate possession of digital assets.

That said, the “liabilities” section of GeckoTerminal is often missing, and exchanges have a way to go before providing absolute transparency without third-party auditors. More than $450 billion vanished from the crypto market following the collapse of TerraUSD in May 2022. While many investments carry the risk of loss (including stocks and bonds), these spectacular collapses arose largely from a failure to maintain proper reserves. Another limitation of PoR is scope since PoR only assures a company’s holdings and liabilities (if done right) at a moment in time, and not other risks. Companies can still be vulnerable to other factors such as bad economic environment, poor internal management, or even hacks. The value of crypto assets can increase or decrease, and you could lose all or a substantial amount of your purchase price.

• First, a snapshot is taken of all eligible users’ Trading, Funding, and Grow accounts, and each user is given a unique anonymous user hash ID.
• If the data passes verification, the “Merkle tree path validation passed” result will be displayed (as shown below).
• These produce efficient data structures called “hash trees” that can be securely verified; these structures, kind of like a map of customers’ funds, work even when the reserves become complicated.
• Chainlink Labs launched another approach in 2020 to help projects across Web2 and Web3 ecosystems prove asset reserves through automated verification.
• They publish the results, with some caveats (which will be unpacked below) to help investors understand a centralized exchange’s state of finances and whether they have enough funds to match customer deposits.
• In this article, we’ll break down what Chainlink Proof of Reserve (PoR) is and how it helps provide stronger security guarantees and more transparency in the cryptocurrency ecosystem.

The platform may also provide cryptographic proof that the balance of all deposit addresses in the Merkle Tree equals the total cryptocurrency they claim to hold. That way, anyone can verify the platform is holding all customer deposits in reserve. For instance, Binance recently released its Merkle Tree-based proof of reserves system for Bitcoin and Ethereum. During the process of PoR, an exchange provides information to demonstrate its ability to cover user withdrawals with assets held in its reserves. The auditor then publishes its findings for the public, and users can confirm their deposits were included in the audit. PoR is typically performed in specific ways to ensure standardization and trust in the system.

Investors can rely on PoR verification to monitor activities in their individual accounts and gain clarity on how the custodian is managing their funds. Therefore, a cryptographic data structure called the Merkle tree (or hash tree) is employed to protect user information. In a Merkle tree, data about each individual depositor (name + balance of deposits) is recorded as “leaves.” Usernames are cryptographically converted into data called hashes to provide a layer of protection.

The idea is that, following the publication of a proof-of-reserves certificate, anyone could follow the money and work out how much crypto an exchange holds. In effect, it is a bona fide verification tool to prevent exchanges from surreptitiously running off with customer deposits. The most common way to verify that customer balances are fully backed in the crypto industry is by constructing a data structure called a Merkle tree (using a snapshot of individual customer balances). Events in November 2022, however, saw more trading platforms work towards having their own proof of reserves, which, depending on the exchange, varied in detail. These included Binance, the world’s largest crypto exchange by trading volume, which released a Merkle Tree-based system for Bitcoin and Ethereum, with OKX, Crypto.com, and ByBit taking a similar approach.

Furthermore, Proof of Reserve feeds can be used beyond the world of DeFi and smart contract applications. For example, they can provide traditional financial institutions with a way to increase trust with customers and counterparties by using Chainlink oracles to publish their audit reports on-chain as an immutable and tamper-proof record. Proof of Reserve traditionally refers to businesses that hold cryptocurrency creating public reports regarding their reserves to prove their solvency to their depositors via an independent audit.

This revealed a strong indication that their accounts were so closely intermingled with those of FTX that if Alameda Research faltered, FTX would likely falter too. People feared that FTX did not have the assets on hand to cover all customer withdrawals. This event triggered an ensuing wave of customer withdrawals that led to a bank run-like effect, ending with the bankruptcy of FTX, likely permanent loss of billions of dollars in user funds, and crash of the crypto market. For crypto asset PoR, this means an auditor verifies that the on-chain assets held by the company are no less than 100% matching customer assets as shown in their balance at the time of the audit. This can help reassure customers that the company is sufficiently liquid and solvent, and that the funds are accessible to the customers should they choose to withdraw. If you’d like to learn more about this use case, read DeFi Circuit Breakers With Chainlink Proof of Reserve and Automation.

All of these checks and balances ensure that a crypto company has the reserve assets that it needs to serve all customers, and that liquidity is maintained no matter the market conditions. Using the summation Merkle tree approach instead of a simple Merkle tree makes sure the user balance for each user account is part of the hash generation input. It also guarantees the user balance is added from the bottom up to the Merkle tree root to record total assets for all users. Instead, we use the full 32 bytes and make sure of one unique ID for every customer (which we compute based on each unique user ID on OKX).

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