Summary
Cryptocurrency custodians use Proof of Reserve (PoR) audit reports to self-certify that they fully hold user funds. Binance conducts audits and publishes internal audit reports. Third-party audit institutions use encryption technology to assist in verifying the audit reports, proving that users' funds are safely stored in Binance's reserves. Binance users can also independently verify that individual account balances are included in these audited accounts.
Introduction
Cryptographical proofs powered by blockchain technology promote transparency in financial transactions on cryptocurrency trading platforms. Proof of Reserves (PoR) takes this transparency even further by creating an authorized framework for auditing cryptocurrency custodians.
Although a breakthrough, proof of reserves still needs improvement for the ecosystem to be more transparent and trustworthy.
What is a Proof of Reserve (PoR)?
Proof of Reserves audits are designed to ensure that client funds are fully held by the custodian. Cryptocurrency custody businesses use proof of reserve audits to prove to savers and the public that their deposits match their balances. The audit is conducted by an independent third party to prevent falsification of reserve data.
Proof of reserves is essential for many reasons. First, with proof of reserves, users can verify that balances held on cryptocurrency exchanges are fully asset-backed. Secondly, this certification can urge companies to meet transparency standards, thereby preventing companies from engaging in questionable or illegal financial activities.
Ideally, proof of reserves benefits both users and businesses. This certification minimizes security risks and effectively prevents unscrupulous practitioners from harming the interests of users. At the same time, this certification helps companies improve their credibility and retain users.
Having the ability to audit cryptocurrency trading platforms creates a more transparent cryptocurrency ecosystem. For example, proof of reserves prevents trading platforms from acting as banks and lending stored assets to third parties.
Furthermore, the trading platform shall not misappropriate deposits to invest in other agreements or businesses. In other words, proof of reserves eliminates the risk that a company can leverage client holdings to maximize earnings and other returns.
With proof of reserves, any entity can prove that a cryptocurrency trading platform holds user deposits in full. Therefore, this will naturally dissuade trading platforms from mishandling balances, which would undermine users' trust and affect their continued use of the platform.
What is the purpose of certificate of reserve verification?
During the proof of reserve verification process, the auditor uses cryptography to verify that the balance of each account is included. There are a few key steps to understand how it works.
First, the auditor takes a snapshot of all account balances. The funding data is then converted into a Merkle tree, which is used to structure large amounts of data for more straightforward processing.
User balance data is hashed and stored in "leaves". A set of such "leaves" is then hashed to form a "twig", and a set of "twigs" is hashed to form a "root".
Next, the audit agency can verify the ownership of the user's address in various ways. For example, on the Binance platform, auditors have three ways to identify ownership. The auditor also verifies it when the trading platform runs the information extraction process.
Encrypted information signature: The audit institution provides a piece of exclusive information to the trading platform and uses the associated private key for encrypted signature.
Transfer funds as instructed: The trading platform performs the task of "transfer funds as instructed", that is, the management transfers a specific amount from the public key/address at a specific time and obtains the transaction hash value to verify the transaction in the corresponding blockchain as instructed.
Search addresses in a blockchain explorer: Auditors can also search Ethereum (ETH) and Binance Smart Chain (BSC) (as on Binance Platform) addresses in Etherscan and BscScan respectively to ensure that the address has been marked as belonging The trading platform.
If the balances are confirmed to be consistent through the above methods, the verification of the trading platform reserve fund is completed and it shows that the platform holds all storage assets.
Limitations of reserve certificates and areas for improvement
Cryptocurrency trading platform balances change as user assets are transferred in and out. The problem with a reserve certificate is that the certificate only verifies that the reserve balance is correct during a specific period of time during the audit period. This can have disadvantages because if the problem is exposed too late, the trustee can even take the opportunity to cover up the fact.
It is also important to note that because a third party conducts the audit, this means that the outcome of the audit will depend on the auditor's personal abilities or whether they are influenced by outside interests.
So how can cryptocurrency exchanges improve proof-of-reserve auditing to build and maintain user trust? First, the audit cycle can be shortened to ensure that there are no suspicious financial activities between cycles. The trading platform should also choose a reputable third-party company. The company should not have any financial interest in the trading platform or its affiliates.
Cryptocurrency trading platforms use proof of reserves to increase transparency, which is crucial in times of financial turmoil. The reason is that unlike traditional banking systems that rely solely on trust and communication, blockchain technology uses mathematics and cryptography to better audit financial markets.
Verify personal account has been audited
Users can verify by themselves whether their personal Binance account was included in the last proof of reserve audit report. Just follow the steps below.
Log in to your Binance account and move your cursor to "Wallet". Next, select the Audit Report tab.
All recent audit records containing individual account balances verified through the Reserve Certification process will be displayed here.
Select an audit record for which you want detailed information. Merkle trees can also be downloaded here.
Summarize
Users can access the Proof of Reserves audit report to see if a cryptocurrency custodian holds full reserves of their own and other users’ funds. The audit should curb the mismanagement of user funds on cryptocurrency trading platforms and effectively increase transparency in the cryptocurrency space.
Proof of Reserves is the first step the platform can take to regain and maintain the trust of cryptocurrency users. In addition, Proof of Reserves imposes many requirements on trading platforms, which will hopefully make user funds a priority and give the public confidence that the industry will be more secure and transparent.
Further reading
What are fractional reserves?
A Beginner’s Guide to Security Tokens
What is quantitative easing (QE)?
market cycle psychology
Cryptocurrency Trading Strategy Guide for Beginners