Summary
Crypto custodians use Proof of Reserves (PoR) audits to demonstrate that they keep user funds intact. Binance conducts and publicly publishes internal audits. Third-party auditors help verify it using cryptographic techniques to prove that user funds are safely stored in company reserves. Binance users can also independently verify that their account balances are included in such audits.
Introduction
Blockchain technology-based cryptographic proof facilitates transparency of crypto exchange financial transactions. Proof of Reserves (PoR) further enhances this transparency by creating an official framework for auditing crypto custodians.
However, even though it is a step forward, PoR still needs improvement to make this ecosystem more transparent and trustworthy.
What is Proof of Reserves (PoR)?
PoR audits aim to ensure that the custodian keeps client funds intact. Custody businesses in cryptocurrencies use PoR audits to prove to depositors and the public that deposits match their balances. The audit is carried out by an independent third party to eliminate the possibility of falsification of backup data.
PoR is important for several reasons. Firstly, PoR allows users for example to verify that the balance held on a cryptocurrency exchange has absolute asset reserves. Second, PoR encourages businesses to achieve transparency standards to make it difficult for them to engage in suspicious or illegal financial activities.
Ideally, PoR benefits both users and businesses. PoR protects users by minimizing security risks and protecting them from malicious players. At the same time, PoR helps businesses retain users by increasing their trustworthiness.
The ability to audit crypto exchanges creates a more transparent crypto ecosystem. For example, PoR prevents exchanges from acting as banks that lend deposit assets to third parties.
Likewise, exchanges cannot use deposits to invest in other protocols or businesses. In other words, PoR eliminates the risk of the company maximizing yield and other possible returns from customer asset ownership.
With PoR, any entity can prove that the crypto exchange keeps all of its users' deposits. Therefore, exchanges are encouraged not to mishandle such balances as it may damage user trust and impact their viability.
What happens in PoR verification?
In PoR verification, the auditor verifies the balance inclusion of each account using cryptography. There are several main steps related to how it works.
First, the auditor takes a snapshot of all account balances. Then, the process converts the fund data into a Merkle tree, which is used to structure large amounts of data for easier-to-understand processing.
User balance data is hashed into "leaves". A group of these "leaves" is then hashed to form a "branch", and a group of "branches" is hashed to form a "root".
Next, auditors can use various methods to verify ownership of a user's address. For example, auditors have three ways to identify holdings in Binance. When the extraction process for this information is run by the exchange, it is also verified by auditors.
Cryptographic message signing: An auditor will provide a unique message to the exchange to cryptographically sign using the associated private key.
Instructed fund movements: Exchanges are tasked with carrying out “instructed fund movements”. Management will move a certain amount of public keys/addresses at a certain time and obtain a transactional hash to verify the instructed transaction on the appropriate blockchain.
Address search in blockchain explorer: Auditors can also search (some) ETH and BSC (for Binance) addresses in Etherscan and BscScan respectively to ensure that they have been marked as belonging to the exchange.
If the balance matches the form of the discovery, the exchange has verified the PoR and indicated that all deposited assets are fully deposited.
PoR: Limitations and potential improvements
Crypto exchange balances fluctuate along with users moving in and out of assets. A related problem is that PoR verifies the correctness of reserve balances only at specified audit times. This can be problematic, as problems may arise later and the custodian may even use this opportunity to obscure the facts.
It's also worth noting that third-party businesses perform audits, meaning audit results can depend on the competency of each auditor or whether they are influenced by outside interests.
But how can a crypto exchange improve its PoR audit to build and maintain user trust? The initial step could be to shorten the audit interval to ensure there is no suspicious financial activity between cycles. An exchange may also use reputable third-party companies with no financial interest in it or its related entities.
Crypto exchanges use PoR to offer greater transparency. This is important during times of financial turbulence. Because it uses mathematics and cryptography rather than just trust and communication like traditional banking systems, blockchain technology can offer a better way to audit financial markets.
Verify that your account has been audited
You can also verify your Binance account's inclusion in the last PoR audit yourself. Just follow the instructions below.
Log in to your Binance account, then hover over "Wallet". Next, select the "Audit" tab.
You'll see the most recent audit. In the audit, your account balance is verified by the PoR process.
Select the specific audit you want to get more information. There, you can also download Merkle trees.
Closing
You can access the PoR audit to find out whether the crypto custodian holds the entire reserve of your and other users' funds. Audits are intended to prevent crypto exchanges from mismanaging user funds and help increase transparency in the crypto space.
PoR is the first step in regaining and maintaining the trust of crypto users. Additionally, PoR sets more requirements for exchanges. This is expected to make user funds a priority and make the industry safer and more transparent for everyone.
Further reading
What is Fractional Reserve?
Guide to Security Tokens for Beginners
What Is Quantitative Easing (QE)?
Psychology of Market Cycles
Crypto Trading Strategy Guide for Beginners