Brief content
Cryptocurrency depositories use Proof of Reserves (PoR) audits to show that they fully hold user funds. Binance conducts and publicly publishes internal audits, after which third-party auditors help verify them using cryptographic methods to prove that user funds are securely stored in the company's reserves. Binance users can also check for themselves whether their account balances are included in these audits.
Introduction
Cryptographic confirmations based on blockchain technology contribute to the transparency of financial transactions of crypto exchanges. Proof of Reserves (PoR) further increases transparency by creating an authorized framework for auditing cryptocurrency depositories.
However, despite this progress, PoR still needs improvement to make the ecosystem more transparent and reliable.
What is Proof of Reserve (PoR)?
The PoR audit aims to ensure that depositories are fully holding their clients' funds. Cryptocurrency custodial businesses use PoR audits to prove to depositors and the public that their deposits match their balance sheets. These audits are conducted by independent third parties to prevent falsification of reserve data.
PoR is necessary for several reasons. First, it allows users to verify, for example, that the balances they hold on a cryptocurrency exchange are fully backed by the exchange's assets. Second, it encourages businesses to adhere to transparency standards that make it harder for them to engage in dubious or illegal financial activities.
Ideally, PoR should benefit both users and companies. Auditing protects users by minimizing security risks and protecting against fraudsters. At the same time, POR helps companies retain users by increasing their reliability.
The ability to audit crypto exchanges creates a more transparent crypto ecosystem. For example, PoR does not allow exchanges to act as banks that lend escrow assets to third parties.
Likewise, exchanges cannot use deposits to invest in other protocols or companies. In other words, PoR eliminates the risk that companies will increase revenues and profits at the expense of customer assets.
With PoR, anyone can prove that a crypto exchange holds all of its users' deposits. Therefore, it is certainly better for exchanges not to mishandle these balances, as this will undermine users' trust in them and affect their livelihoods.
What is the essence of PoR verification?
During the PoR audit, the auditor verifies the account balance of each account using cryptography. The process is performed in several steps.
First, the auditor takes a snapshot of all account balances. It then transforms the fund data into a Merkle tree, which is used to structure large amounts of data for easier processing.
User balance data is hashed into a "sheet". A group of these "leaves" is then hashed to form a "branch", and a group of "branches" is hashed to form a "root".
The auditor can then use various methods to verify the identity of the user's address. For example, on Binance, an auditor has three ways to identify ownership. When the process of obtaining this information is carried out by the exchange, it is also checked by auditors.
Cryptographic Message Signing: The auditor provides the exchange with a unique cryptographic signature message using the associated private key(s).
Custodial Funds Movement: An exchange is mandated to perform a "codified funds movement" where management transfers a specified amount from a public key/address at a specific time and receives a transaction hash to verify the transaction as instructed on the respective blockchain.
Address lookup in blockchain explorer: The auditor can also lookup ETH and BSC (in the case of Binance) addresses on Etherscan and BscScan, respectively, to ensure that the addresses are marked as addresses owned by the exchange.
If the balances match these forms of discovery, then the exchange has confirmed the PoR and shown that it holds all deposited assets in the aggregate.
PoR: limitations and potential for improvement
Crypto exchange balances change as users move their assets. The problem with PoR is that the reserve balances are checked for correctness only at the specified audit time. Any problems may be discovered later, and the custodian may even use this opportunity to hide the facts.
It is also important to note that the audit is conducted by third-party companies, which means that the results of the audit may depend on the competence of each auditor or whether they are influenced by outside interests.
But how can a cryptocurrency exchange improve PoR audits to gain and maintain user trust? For starters, it is necessary to shorten the intervals between audits to prevent any suspicious financial activity during these intervals. In addition, the exchange must use a reliable third-party organization without any financial interest in it or its related bodies.
Crypto exchanges use PoR to provide better transparency, which is very important during financial turmoil. Unlike the traditional trust-based banking system, blockchain technology uses a combination of mathematics and cryptography, offering a more sophisticated way to audit the financial market.
How to check that the account has passed the audit
You can also check for yourself whether your Binance account is included in the latest PoR audit. Just follow the instructions below.
Log in to your Binance account and hover over "Wallet". Next, select the Audits tab.
You will see all recent audits where your account balance has been checked by the PoR process.
Select the specific audit for which you would like to receive additional information. In addition, you can download the Merkle tree here.
Results
You can access the PoR audit results and check for yourself whether the cryptocurrency depository is holding the users' funds in full. Audits should prevent cryptocurrency exchanges from misuse of user funds and promote transparency in the crypto space.
PoR is the first step in restoring and maintaining the trust of crypto users. In addition, PoRs set high standards for exchanges, pay special attention to user funds, and make the industry safer and more transparent for everyone.
Related articles:
What is partial reservation?
A Beginner's Guide to Tokenized Securities
What is quantitative easing (QE)?
Psychology of market cycles
A guide for beginners. Cryptocurrency trading strategies