PoR: What is Proof of Reserves and Why It Matters for Crypto Exchanges
If you are a crypto user, you may have heard of the term “proof of reserves” (PoR) before. But what does it mean and why is it important for crypto exchanges? In this article, we will explain the concept of PoR, how it works, and how it can help build trust and transparency in the crypto industry.
What is Proof of Reserves?
Proof of reserves is a way of verifying that a centralized crypto exchange has enough assets on the blockchain to cover the deposits of its users. It uses cryptographic proofs and public wallet address ownership verification, along with regular third-party audits, to publicly demonstrate that the exchange has a 1:1 ratio of assets to liabilities, or even more.
This means that for every crypto unit that a user deposits on the exchange, the exchange has at least one crypto unit in its reserve, and can honor the withdrawal requests of its users at any time. This also means that the exchange does not engage in fractional reserve banking, which is a common practice in the traditional financial system, where banks lend out more money than they actually have in their vaults.
How Does Proof of Reserves Work?
There are different methods and technologies that can be used to implement PoR, but one of the most advanced and secure ones is called zk-STARK, which stands for Zero-Knowledge Scalable Transparent Argument of Knowledge. This is a type of zero-knowledge proof, which is a way of proving something without revealing any information about it.
For example, using zk-STARK, a crypto exchange can prove that it has a certain amount of assets on a blockchain at a certain time, without disclosing the exact amount, value, or addresses involved. This way, the exchange can protect the privacy of its users, while also proving the solvency of its platform.
To do this, the exchange takes a snapshot of each user’s account balance, and then inputs these data into a spreadsheet and an encrypted “Merkle tree” system, which creates a tamper-proof audit record that can be used to verify the accuracy of the balance data. The exchange then sets three rules or “constraints” that the user balances must satisfy, and if all three constraints are validated, then the exchange’s reserves are proven to be true. The three constraints are:
Balance sum constraint: The total amount of assets that the exchange holds is equal to the sum of all user balances.
Non-negativity constraint: Each user’s total balance is greater than zero, meaning that their assets include their liabilities, and that their net worth is positive. This is crucial for maintaining the exchange’s liquidity and ability to pay.
Inclusion constraint: Each user’s total balance is included in the calculation and verification process.
The exchange’s PoR system is open-source, and anyone can check and use it on GitHub.
Why is Proof of Reserves Important?
Proof of reserves is important for several reasons. First, it enhances the transparency and accountability of crypto exchanges, which are often criticized for being opaque and unregulated. By proving their reserves, exchanges can show that they are not manipulating the market, inflating their volumes, or running away with their users’ funds.
Second, it increases the confidence and security of crypto users, who can verify that their funds are backed by real assets and not just numbers on a screen. By using PoR, users can avoid the risk of losing their money in case of a hack, a bankruptcy, or a fraud by the exchange.
Third, it contributes to the health and sustainability of the crypto ecosystem, which relies on trust and cooperation among its participants. Proof of reserves is a key factor for building trust between exchanges and regulators, as well as between exchanges and users. It also sets a higher standard for the crypto industry, and demonstrates the commitment of exchanges to promote the growth and development of the crypto space.
Conclusion
Proof of reserves is a concept that tries to provide public transparency for centralized crypto reserves. It uses cryptographic proofs and public wallet address ownership verification, and combines them with periodic third-party audits to publicly prove that centralized platforms have enough assets to match user deposits, while also having the ability to pay. This cryptographic method allows individual users to verify that their account balances are included in the proof. Proof of reserves is a key component of the crypto ecosystem, as it helps establish trust and transparency in the crypto industry.