Centralized and decentralized institutions play varying roles in the crypto ecosystem. With decentralized exchanges, users are in complete control of their funds. On the other hand, with centralized exchanges, users lack total control as they keep funds with the exchange. But how can crypto users ensure that their funds have not been tampered with even when they are stored with a centralized exchange? The simple answer is through Proof of Reserves (PoR).

A proof of reserve is an audit conducted by a third-party company on a financial company or crypto exchange to verify that the value of assets on its books matches that held in its reserves. The third-party auditor is responsible for verifying the claims made by the financial institution or exchange. Auditing results are usually published publicly and made accessible to users.

How Does Proof of Reserve Auditing Work?

In the crypto ecosystem, centralized exchanges store users’ funds. The amount of funds stored by an exchange should always be equal to or more than the net value of assets deposited by users. To confirm this, an exchange typically invites a third-party auditing company to verify its claims.

The role of the auditing company or firm is to find potential loopholes in the balance sheet of an exchange or to verify the accuracy of the exchange’s claims. One such auditing organization responsible for checking the financial health of a crypto exchange is Armanino LLP. Armanino is a leading auditing firm based in the United States. Gate.io and many other famous crypto exchanges use Armanino for auditing. To accurately audit an exchange’s proof of reserves, the Merkle tree technique is usually implemented.

Armanino and Proof-of Reserve

Armanino is an accounting and auditing firm founded in 1953. The company has its headquarters in the US and is one of the largest independent accounting and auditing firms in the States.

Armanino became the first auditing company to be integrated with Trust Explorer for on-chain auditing. Thus, users can verify an exchange’s proof of reserve in real-time, making Armanino’s auditing model 100% transparent.

Currently, Armanino services 7000+ clients in more than 100 nations globally. In the past year, Armanino LLP received more than 25 performance awards in its industry. Undoubtedly, the longevity of Armanino and its high reputation have spurred leading crypto exchanges like Gate.io to adopt its auditing services.

The Role of a Merkle Tree in Proof of Reserve Auditing

A Merkle tree is a cryptographic hash that uniquely represents a comprehensive collection of smaller bits of on-chain data. In other words, it is a cryptographic way of tiny grouping bits of data accurately and without compromising privacy. Just like a literal tree has leaves, branches, and roots, a Merkle tree has smaller components - the leaves or nodes, branches, and Merkle root.

With the use of Merkle trees, users’ balances can be confirmed. Here’s how it works:

• The auditing firm conducting the proof of reserves extracts the record of balances held via a Merkle tree.
• A Merkle root is procured. This collates the balances of users’ assets.
• The users’ balances are then verified on the blockchain, where the crypto tokens are stored. The cryptocurrency exchange provides digital signatures to confirm ownership of the assets.
• The records of the exchange’s balances are then matched with those found on the public ledger. The values should be consistent.
• In coalition with the exchange, the auditing company sets up systems for individual users to confirm if the tokens in their wallets were verified. This makes it even more transparent.
• Should the data be altered, the Merkle root will also reflect the alteration.

Benefits of Proof of Reserve Auditing

Although the steps taken for successful auditing are comprehensive, it benefits customers and the crypto exchange. Here are some benefits of executing a proof of reserve audit:

• Proof of reserve audits builds trust in the minds of crypto users. One of the core reasons for creating cryptocurrencies is to promote transparency in the financial ecosystem. When exchanges adopt a standard auditing model, it makes it possible for users to trust the centralized entity.
• Proof of reserve audits helps to prevent misuse of funds. The transparency spurred by this systematic way of verifying the asset holdings of a company keeps crypto trading companies on their toes. In the crypto ecosystem, there have been a handful of cases where custodians have misused funds. This may likely have been avoided with proof of reserves auditing.
• It could indirectly increase adoption. Proof of reserves is a regulatory framework for crypto exchanges that could attract more skeptical users to the ecosystem.

Limitations of Proof of Reserve Auditing

Although Proof of reserve auditing promotes transparency, it still has some limitations. Here are some of the limitations:

• When conducted by an inexperienced auditor, loopholes in the crypto exchange’s balance sheet could be omitted or even overlooked.
• The Proof of reserves does not guarantee sole ownership of verified private keys. This means that two or more organizations could collaborate to share the same reserve. Although, this is very rare in the crypto ecosystem, as many centralized exchanges are competitors.
• Even if fund movement and wallet interaction can be monitored, the Proof of reserves process can not reveal whether funds were borrowed to pass the auditing process.

The Best Reserve Assets for Crypto Exchanges

Gate.io holds its reserve in Bitcoin and Ether. These are the largest cryptocurrencies by popularity and market share. More importantly, BTC and ETH are highly liquid or can easily be sold compared to the many other cryptocurrencies.

Reserve assets should have a high liquidity profile. This would make it easy for users to sell their assets in case of black swan events. Aside from Bitcoin and Ether, USDT, USDC, and DAI could also serve as reserve assets.

Exchanges could also hold smaller cap altcoins in their reserves, but it is recommended that these be held in small amounts to avoid incurring huge losses when there is an exit rush.

Gate.io’s Proof of Reserve

Source: Gate.io Proof-of-Reserves Assessment Report

Gate.io is one of the largest cryptocurrency exchanges globally and became the first mainstream exchange to submit a PoR audit. In May 2020, Armanino LLP audited Gate.io’s reserves and found Gate.io’s assets to surpass its liabilities by 4%. Thus, Gate.io held 104% BTC of its total client deposits, giving the exchange a healthy financial score.

The most recent audit of Gate.io’s reserves conducted by Armanino was done in October 2022. At a BTC block height of 759290, Gate.io had an asset collateralization ratio of 107.79% for Bitcoin. At an ETH block height of 15778435, Gate.io had an asset collateralization ratio of 104.45%.

The audit results from May 2020 and October 2022 reveal that the exchange has excess assets in store. Thus, Gate.io guarantees its users 100% access to funds even when there is a withdrawal rush. The crypto exchange has a surplus of assets in its holdings to pay all users at the same time.

The full report of audits conducted by Armanino, the third-party auditing company, can be found on the company’s and Gate.io’s official websites. The assessment report was also published on GitHub and can be accessed by everyone.

How to Verify the Inclusion of your Account for the Audit

You can confirm whether the Merkle tree data derived during the auditing process has been tampered with. This could be done using your login details. Here are the steps to verify if your Gate.io account was audited.

• Step 1: Visit Gate.io’s Proof of Reserves page.
• Step 2: Scroll down to the “Verify my account” section and click on the login button to log in.
• Step 3: Your Hash ID is displayed once successfully logged in. Copy the Hash ID, and click on the Verify button.
• Step 4: Enter the copied Hash ID in the space provided to verify your snapshot.
• Step 5: Verify where your account is on the Merkle leaf node.

Image Source: Gate.io

Note that it is possible for your data to be omitted if your account was inactive during the audit period. You’ll also have no data if you opened an account after the Proof of reserve auditing had been concluded.

Closing Thoughts

The periodic review of balances held by a financial institution or trading company has many benefits, especially for crypto users. Rather than relying on the attestations of a crypto exchange, proof of reserve auditing enables customers to verify the financial status and reports of the exchange.

Further, with the implementation of Merkle trees, users can verify reserves cryptographically, thereby boosting transparency. Although proof of reserve attestations do not completely restrict exchanges from tampering with users’ funds, it reveals an exchange’s financial situation and claims. It could also help users identify potential red flags, if any, and help users make the right decision regarding which exchange should hold custody of their funds.