Users have several options available to protect their cryptocurrencies – self-storage, exchange wallets, and third-party custodians. Custodial services are required to protect clients' assets by storing the private key on behalf of the owner, preventing unauthorized access. Events such as the FTX collapse have shaken the crypto industry. They made people doubt the integrity of crypto companies.
To regain user trust, other exchanges have introduced the trend of Proof-of-Reserves (PoR), as proof that a business is solvent and liquid enough to continue operating.
What is Proof-of-Reserves
In traditional finance, reserves are company profits kept for use in emergency situations. In the crypto space, a reserve audit is essentially an independent audit performed by a third party to confirm that the entity being audited has sufficient reserves to support investors' balance sheets.
For reliable service providers, passing a PoR audit is an important regulatory step. The audit assures the public that the custodial platform is sufficiently liquid and solvent and clients can withdraw funds at any time.
Proof-of-Reserves also benefits crypto companies because by providing absolute asset backing, they can retain customers and increase trust in their operations.
How does Proof-of-Reserves work?
In general, an audit should assess the solvency of the exchange, and there can only be two results:
Or an exchange is solvent if its assets exceed its liabilities.
Or insolvent in all other cases.
However, this approach is often not enough, for example when the exchange demonstrates partial reserves.
The verification procedure can be divided into three separate stages:
Verification of obligations
Exchange liabilities are the outstanding balances of cryptocurrency that must be paid to clients upon demand. The calculation uses the sum of all funds in client accounts. It is then compared to total reserves. Commitment verification includes steps such as a Merkle tree using a cryptographic hash of the client ID.
Checking the availability of reserves
Cryptocurrencies that exchanges store on the blockchain, controlling private keys, are called reserves. When checking, all balances on crypto addresses are summed up. The exchange can prove it owns them by providing the public key associated with the address and signing it with the private key.
Working with confirmation of reserves
The auditor does not need to analyze the entire blockchain; a set of data available to the public is used. If given the same input values, a deterministic function will always produce the same results. This is a fundamental criterion for any blockchain, as it is difficult to achieve consensus unless transactions result in the same outcome every time they are executed, regardless of who initiates them.
The results of the audit, as well as its certification, that is, confirmation of the reliability of the software used for this, are two key components of proving the solvency of a cryptocurrency exchange.
How is PoR carried out?
The process includes the following steps:
The external auditor takes an anonymized snapshot of the exchange's balances, organizes these balances in the form of a Merkle tree, which has multiple branches, authenticated using hash codes.
The auditor collects individual user balances using the unique signatures of each account holder.
It remains to compare these data to ensure that the former are at least equal to the latter.
Some platforms provide users with the ability to check their own assets in their personal account and use a Merkle tree to verify that they are indeed backed by cryptocurrency on the exchange.
Advantages and disadvantages of confirming reserves
Asset verification proves that the cryptocurrency held by the exchange meets its obligations to users. In particular, you can check whether wrapped tokens, such as Wrapped Bitcoin (WBTC), are actually backed by real bitcoins - in general, there are many suitable situations. DeFi applications receive the information they need to audit WBTC reserves from the Chainlink network of oracles, which check the custodian's BTC balance on the blockchain every 10 minutes.
In addition, Proof-of-Reserves attracts regulatory attention, which is consistent with a broader industry strategy. The goal of eliminating the lack of trust also contributes to the introduction of the product. Users begin to trust custodians again, which helps the latter retain clients.
Proof-of-Reserves also has some disadvantages that should not be overlooked. The critical issue is that the correctness of the audit depends on the competence of the auditor. In addition, there is a risk that the results will be rigged in cooperation with the exchange. The collapsed FTX, let us remind you, also underwent an audit, but this did not help.
Binance exchange audit results
Analytics firm CryptoQuant examined the health of leading crypto exchange Binance and concluded that the exchange is almost fully collateralized and does not exhibit FTX-like behavior.
“At the time of reporting, CryptoQuant's estimate of Binance's BTC holdings was 591,939 BTC. This compares to a liability statement balance of 597,602 BTC. We see that reserves covered 99% of Binance’s liabilities.” And taking into account the assets and debtors of the exchange, the security is 101%.
Binance is not experiencing the same outflow that FTX experienced in the days leading up to the crash. Although withdrawals have increased, they are small compared to the exchange's total reserves. Binance CEO Changpeng CZ Zhao said he even “welcomes the stress test.”
Finally, CryptoQuant points out that Binance is independent of the exchange's native token, BNB, which is fundamentally different from FTX. 88.95% of reserves are net.
Source: https://www.coindesk.com/business/2022/12/15/cryptoquant-on-chain-data-shows-crypto-exchange-binance-isnt-exhibiting-ftx-like-behavior