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Proof of Reserves: Concept and Purpose

Proof of Reserves is an official document or digital proof used to verify an exchange’s claim of holding reserves. These proofs confirm that the exchange has enough assets to cover its liabilities, providing users with a snapshot of its financial health.

Basic Mechanism of Proof of Reserves

Typically, Proof of Reserves involves the audit of a third-party entity. This entity evaluates the exchange’s on-chain and off-chain assets, from simple proofs to more complex cryptographic proofs like the Merkel Tree. Users can use their own generated Merkel hash to verify their asset holdings, ensuring a 1:1 ratio of funds and allowing third-party auditing firms to verify.

Purpose of Proof of Reserves

Proof of Reserves is a verification method aimed at demonstrating that an exchange has the ability to redeem users’ digital assets at any time. It shows that the exchange has sufficient liquidity and matches the assets users store. It also provides proof similar to an audit report, ensuring the exchange can indeed redeem digital assets.

User Verification and Safeguards

Most importantly, users can independently verify the central custodian’s ability to repay and ensure liquidity, ensuring the ability to fulfill withdrawal requests when needed. Proof verification also helps prevent custodians from misusing user deposit assets, such as using them for obtaining loans or making other investments.

Transparency and Protection

The goal of Proof of Reserves is to provide transparency and protection to users, enabling investors to rely on proof of reserves to monitor activities in their individual accounts and understand how the custodian manages funds.

Proof of Reserves and Exchange Liquidity Issues

To maintain transparency and solvency, cryptocurrency exchanges often provide proof of reserves. The liquidity crisis experienced by exchanges like FTX has led to increased demand for transparency in the industry. Proof of reserves serves as evidence that customer deposits are securely held and can be withdrawn at any time, while also safeguarding user assets against mismanagement and fraudulent activities.

This initiative marks an important step towards self-regulating centralized cryptocurrency exchanges, aiming to establish trust among users and regulatory institutions. By showcasing financial integrity and responsible operations, exchanges convey a clear message to users and regulatory bodies about their commitment to enhancing security and transparency levels.

Market Demand for Exchange Proof of Reserves

The market demands that exchanges provide proof of reserves, driven by past events that have eroded trust in exchanges. These events include issues such as mismanagement of customer funds, misappropriation of customer deposits, and insufficient reserves to support customer balance withdrawals. Notably, the collapse of FTX triggered panic throughout the cryptocurrency industry, causing investors to lose confidence and resulting in a significant outflow of funds, directly impacting trading volumes and spot prices in the crypto market.

To address this crisis of trust, exchanges have started offering proof of reserves to demonstrate fund transparency and further protect investor rights. The FTX incident revealed issues with the mismanagement of customer funds, such as mixing customer funds with institutional and proprietary funds, as well as transferring a significant portion of customer deposits to its subsidiary, Alameda Research, leading to insufficient reserves to support customer balance withdrawals. These actions severely compromised investor interests, prompting strong demands for regulatory oversight and transparency of funds.

To address these issues, legislators have proposed bills requiring exchanges to provide proof of reserves. These bills aim to ensure proper management of customer funds by exchanges and enhance the transparency of reserves to foster investor trust. Proof of reserves is considered a best practice in the industry to verify whether an institution holds sufficient reserve funds to protect customer deposits. Under these bills, exchanges must undergo regular third-party audits and submit inspection results to regulatory bodies, increasing transparency and imposing fines on exchanges that fail the review. The goals of these bills are to enhance trust in the digital asset market by strengthening transparency and regulatory requirements and protecting investor rights.

How Proof of Reserves is Implemented

Different exchanges may employ different technologies to create proof of reserves, but there are also some common methods for proof of reserves:

Conventional Auditing

Prepared by internal auditors of the exchange, it evaluates and examines the financial condition and operational status of the exchange. These auditors are usually internal exchange employees who review internal controls, financial statements, and business operations to ensure accuracy and compliance.

Blockchain Verification

Proof of reserves is an updated and technically more complex method that uses cryptographic proofs to demonstrate that the exchange controls wallets holding the reserved funds without revealing sensitive information. Exchanges can use blockchain technology to verify their reserve funds by publicly disclosing the reserve fund addresses on the blockchain, allowing users to verify if the exchange’s assets match their claimed reserves. Gate.io’s algorithmic audit is updated monthly. (Gate.io Blockchain Self-Verification Tutorial)

Real-Time Dashboards

Some exchanges have implemented real-time dashboards that dynamically update reserve status, allowing users to continuously monitor the exchange’s reserves. (Gate.io has a Real-Time Dashboard where users can check the changes in Gate.io’s reserves anytime.)

Third-Party Audits

Exchanges can hire independent third-party auditors or accounting firms to audit their reserves. These auditors or firms typically have no conflicts of interest with the exchange. Exchanges can regularly engage accounting firms to independently verify the exchange’s assets and liabilities, audit its operations and assets, and publish audit reports to ensure the exchange has sufficient reserve funds to cover user deposits.

These methods aim to ensure that exchanges have enough reserve funds to protect user assets and increase transparency and trustworthiness. By creating proof of reserves, exchanges can demonstrate the health of their financial condition to users and increase trust in the exchange.

Comparison of Exchange Reserve Technologies

The strengthening regulation of auditing firms by the US Securities and Exchange Commission (SEC) has led to the cancellation of audit services for cryptocurrency institutions by some firms such as Mazars, Armanino, and Prager Metis CPAs LLC. External audit firms typically only audit reserve reports and not the internal controls and financial conditions of exchanges, and some traditional Web2 auditors lack expertise in blockchain analysis, so centralized cryptocurrency exchanges have had to adopt more native methods to prove their reserve assets.

Gate.io has been using Merkle Trees for reserve proof since May 2020 in response to this background. With technological advancements, starting in 2023, Gate.io has adopted more advanced verification methods, combining Merkle Trees with zkSNARKs technology. Combining these two technologies aims to balance the need for transparency and privacy protection, and enhance the effectiveness of proof of reserves.

This process reflects the impact of strengthened regulation on audit firms, prompting exchanges to adopt more innovative and native technologies to meet the dual requirements of transparency and privacy protection.

Exchange Proof-of-Reserve Technologies

Cryptocurrency exchanges utilize various reserve technologies, including Merkle Tree, zk-STARK, and zk-SNARKs, each with its own advantages and disadvantages.

Merkle Tree

A Merkle Tree is a data structure used to verify data integrity and is commonly used in the process of proving reserves. It was proposed by computer scientist Ralph Merkle in 1979. A Merkle Tree efficiently organizes large data sets by compressing the entire data set into a single root hash or Merkle root. Proof-of-Reserve, based on the structure of a Merkle Tree, involves hashing large data sets. This approach allows auditors to aggregate the account balance data of all users into a single Merkle root, without revealing the account balances of individual users. Merkle Trees efficiently verify the integrity of large amounts of data and protect user privacy. However, Merkle Tree cannot solve negative balance issues and may have security risks.

zk-SNARKs

zk-SNARKs allows one party to prove to another party that they possess certain information without revealing the specific details of the information. For Proof-of-Reserve, zk-SNARKs can be used to verify the validity of transactions and the balance of user funds without disclosing specific amounts, values, or addresses. The advantages of zk-SNARKs are that they provide higher privacy protection while ensuring the validity of proof of reserves. zk-SNARKs is a concise, non-interactive zero-knowledge proof technology that can verify a user’s knowledge of original values while protecting user privacy. However, the drawback is that it may require more computational resources and technical knowledge for implementation and verification, and it requires an initial trusted setup, which may have security risks.

zk-STARK

Using zero-knowledge proofs, zk-STARKs can verify the correctness of exchange proof of reserves without disclosing specific asset details. This means that exchanges can prove the adequacy of their reserves while protecting user privacy. This technology is based on mathematical proofs and provides strong security guarantees. By using zk-STARKs, the validity and consistency of transactions can be ensured without revealing the details of the transactions. It can also compress a large amount of transaction data and verify its validity with a smaller proof size. This can greatly improve transaction throughput and reduce transaction costs. However, generating and verifying zk-STARKs zero-knowledge proofs require significant computational resources, making the computation cost of zk-STARKs relatively high. This may result in longer processing times and higher computational overhead. zk-STARK technology has significant advantages in existing exchange proof of reserve as it provides higher privacy protection and security. However, it also faces challenges such as computational complexity and technical complexity.

How Exchanges Ensure User Rights

The following data is as of December 13, 2023.

Impact of Proof of Reserves on the Industry’s Development

First, Proof of Reserves enhances transparency and trust in the operation of funds. By allowing users to verify the transfer of their assets, it increases trust and reliance between investors and the trading platform. This timely and accurate proof demonstrates the technical capabilities and asset management abilities of centralized exchanges, further strengthening user loyalty to the platform.

Second, Proof of Reserves helps improve the industry’s reputation. Negative events like the FTX incident still linger within the industry, and more transparent operations contribute to a positive image, encouraging more newcomers to join the crypto industry.

Third, Proof of Reserves contributes to compliance and regulation. In traditional industries, asset transparency and disclosure are crucial to ensuring compliance. With increasingly transparent proofs of reserves, trading platforms are more likely to meet regulatory standards, thereby raising the overall compliance level of the industry.

Conclusion

In summary, Proof of Reserves is crucial for increasing transparency and establishing user trust by verifying that exchanges have sufficient reserve funds to support user deposits and ensure their financial health. This mechanism not only enhances investor confidence, attracting institutional investments and fostering market growth but also demonstrates the commitment of exchanges to regulatory compliance and customer protection.

While there is still room for improvement in Proof of Reserves, its potential is significant in fostering trust, maintaining stability, and gradually becoming an industry standard. However, investors should remain cautious when utilizing Proof of Reserves and consider other factors to evaluate the reliability and security of an exchange.