Proof-of-Reserves: Everything to Know

By  Beluga Research November 2, 2023

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Summary

  • In cryptocurrency, proof-of-reserves (PoR) verifies a digital asset's availability by providing transparent evidence of backing and quantity
  • The method of PoR is used in both traditional financial institutions and cryptocurrencies to assure customers of fund security
  • PoR involves cryptographic verification of a custodial service's holdings, allowing independent verification without revealing sensitive user balance information
  • Advantages of PoR include transparency and enhanced trust, but disadvantages include privacy concerns and technical complexity

Overview

In cryptocurrency, proof-of-reserves (PoR) verifies a digital asset's availability by providing transparent evidence of backing and quantity. PoR is a transparency and security measure used by financial institutions, such as banks and cryptocurrency exchanges, to demonstrate that they hold the assets they claim to have.

It involves providing cryptographic evidence, typically through the use of blockchain technology, that verifies the existence and authenticity of reserves. This proof helps to build trust with customers and stakeholders by ensuring that an institution's liabilities are fully backed by assets, reducing the risk of insolvency, fraud or mismanagement. PoR is particularly relevant in the cryptocurrency industry to confirm the solvency of exchanges and custodial services holding digital assets.

A Brief History

As mentioned above, PoR is not exclusive to cryptocurrency, as traditional financial institutions have long maintained reserves to assure customers of fund security. In the cryptocurrency realm, the need for such assurances became evident after security breaches and fraudulent activities on exchanges.

The first implementation of PoR in cryptocurrency dates back to 2014, with the introduction of proof-of-solvency by Bitcoin developer Greg Maxwell. Various iterations and improvements have since been proposed and implemented.

Proof-of-Reserves: Everything to Know

PoR involves cryptographic verification of a custodial service's holdings. It allows independent verification of claimed assets without revealing sensitive user balance information.

The process begins with the custodial service generating a cryptographic commitment, binding them to not spend or move the assets without authorization. This commitment is based on a cryptographic hash function, making any alteration detectable.

Next, the custodial service provides proof of the cryptographic commitment, demonstrating the validity and integrity. The proof can be publicly shared for verification.

Simultaneously, the custodial service must provide evidence of liabilities, such as user account balances and withdrawals. This information maintains privacy while allowing auditors to confirm claims align with actual liabilities.

Finally, the cryptographic commitment and evidence of liabilities are combined to create a comprehensive PoR. This proof can be verified by users, auditors or regulators to ensure accurate representation of assets and liabilities.

Getting Started

To understand PoR, it is essential to grasp the basics of cryptocurrencies. Cryptocurrencies are digital or virtual currencies that use cryptographic techniques to secure transactions and control the creation of new units. Unlike traditional currencies issued by central banks, cryptocurrencies are usually decentralized and operate on blockchain networks.

When people trade cryptocurrencies on exchanges or entrust digital assets to custodial services, they rely on these platforms to safely store and manage these holdings. However, there have been instances wherein exchanges or custodians faced insolvency or engaged in fraud, resulting in losses for users. PoR aims to address this issue by providing a transparent way to verify the solvency of such platforms.

Unique Aspects

PoR involves verifying an exchange's or custodian's holdings through a cryptographic proof. This process allows users to independently verify if the platform holds the claimed amount of assets. By providing transparency, PoR enhances trust and reduces the risk of fraud or mismanagement.

One common method for PoR is publishing balance sheets or audit reports. Exchanges or custodians disclose liabilities and assets, including the cryptocurrencies they hold for users, and independent auditors can then verify these disclosures and confirm the accuracy of the reported holdings.

Another approach to PoR uses cryptographic proofs. Exchanges or custodians generate cryptographic commitments that represent holdings without revealing specific details. These commitments are then published on a public blockchain, allowing users to verify the existence and integrity of the reported balances.

Cryptographic commitments can take various forms, such as "Merkle trees" or "zero-knowledge proofs" (ZK-proofs). Merkle trees organize commitments into a hierarchical structure, making verification efficient, while ZK-proofs allow verifying a statement without revealing additional information beyond this truth.

The choice of PoR method depends on the specific requirements and constraints of the platform. Both balance sheet audits and cryptographic proofs offer different trade-offs in terms of transparency, efficiency and privacy.

Advantages

  • Transparency - PoR enables users to independently verify a platform's claimed reserves, building trust and ensuring the platform has the necessary reserves to cover user deposits.
  • Auditable - Users can audit a platform's reserves to ensure the claimed amount of assets is held and to prevent misuse or mishandling, increasing accountability and reducing fraud risk.
  • Trustworthy Exchanges - Implementing PoR enhances the reputation of exchanges, attracting more users and demonstrating transparency and accountability.
  • Protection Against Insolvency - Regular verification of reserves provides confidence to users that personal funds are properly accounted for and segregated, reducing the risk of losing them in case of bankruptcy.
  • Deterrent for Fraud - Fraudulent activities are deterred by PoR by auditing and verifying reserves, creating a safer environment for cryptocurrency transactions.

Disadvantages

  • Privacy Concerns - Verifying reserves may raise privacy concerns, as certain information about the platform's holdings needs to be disclosed, although it typically does not reveal individual user details.
  • Technical Complexity - Implementing PoR can be technically complex, especially for platforms with multiple cryptocurrencies and complex accounting systems, requiring robust auditing procedures and blockchain integration.
  • Cost and Resources - Maintaining PoR is costly, requiring dedicated resources for auditing, reporting, technological infrastructure and regulatory compliance. Smaller platforms may struggle with resource allocation.
  • Limited Scope - PoR focuses on asset backing and does not guarantee overall platform security. Other vulnerabilities like hacking or insider attacks still exist, so users should consider it as part of broader security measures.
  • Regulatory Challenges - Implementing PoR may require compliance with specific regulatory requirements, which vary across jurisdictions and pose legal challenges for platforms operating in multiple countries.