Proof-of-Reserves Audits: A Shield Against Uncertainty in Crypto Custody

    As digital assets gain prominence among institutional and retail investors, the importance of secure custody solutions has risen in tandem. In this evolving landscape, investors are presented with various custody options, including self-custody, exchange wallets, and third-party custodians. However, recent events, such as the collapse of FTX and the liquidation of Three Arrows Capital, have sparked concerns about the reliability of crypto custodians. To address these concerns and ensure financial soundness, the concept of proof-of-reserves (PoR) audits has emerged. This article explores the intricacies of PoR audits, their significance, the auditing process, and how users can verify them.

    Understanding Proof-of-Reserves

    In the crypto space, a proof of reserves is an independent audit conducted by a third party to confirm that a custodial entity has ample reserves to support its depositors’ balances. Unlike traditional finance, where reserves are profits set aside for unforeseen circumstances, crypto proof-of-reserves audits provide transparency about the availability of funds held by custodians. It acts as a critical step in the regulatory process for digital asset service providers, assuring customers and the public that the custodian is solvent, liquid, and capable of honoring withdrawals.

    How Proof-of-Reserves Audits Work

    The PoR audit involves a meticulous auditing process conducted by a third-party auditor. Here’s an overview of the key steps:

    1. Proof of Liabilities:
      • The audit begins by assessing the exchange’s liabilities, which are the outstanding cryptocurrency balances owed to its clients. This involves creating a Merkle tree using cryptographic hashes of customer identities and calculating the hash of the fraction factor. The resulting hash values contribute to proving liabilities.
    2. Proof of Reserves:
      • The assets held by the exchange on the blockchain are considered reserves. The exchange proves ownership of these assets by providing the public key linked to cryptocurrency addresses and signing it with the private key. This process includes signing a nonce for additional security. The proof of reserves outputs the sum and hash of the address balances.
    3. Proof of Solvency:
      • The final audit result is a binary outcome — true if reserves exceed liabilities, and false otherwise. An attestation serves as a signature for the executed program and platform measurements, ensuring the audit was conducted in a trustworthy environment.

    Conducting Proof-of-Reserves Audits

    The PoR auditing process typically involves the following steps:

    1. Snapshot Collection:
      • An external auditor captures an anonymized snapshot of the institution’s balances, organizing them into a Merkle tree with authenticated branches.
    2. User Contribution:
      • Individual user contributions are collected using unique signatures for each account holder.
    3. Authentication:
      • The auditor authenticates whether customers’ reported balances match those obtained from the Merkle tree, ensuring full-reserve basis holdings.
    4. Verification by Users:
      • After the PoR audit, users can independently verify their transactions by accessing platforms like Binance, checking audit dates, and confirming the audit type, assets covered, Record ID, and included asset balances.

    Benefits of Proof-of-Reserves Audits

    1. Asset Verification:
      • PoR audits verify that on-chain holdings of cryptocurrencies match users’ balances, ensuring transparency and honesty.
    2. Regulatory Compliance:
      • PoR audits are crucial for regulatory compliance, providing a self-regulating approach that aligns with industry strategies.
    3. User Trust and Retention:
      • Users gain transparency and confidence in custodians, leading to increased trust and client retention.
    4. Independent Verification:
      • Users can independently verify the transparency of PoR audits through Merkle tree hashing, reducing the likelihood of fraudulent practices.

    Limitations of Proof-of-Reserves

    While PoR audits offer significant advantages, they are not without limitations:

    1. Dependence on Auditor Competence:
      • The correctness of a PoR audit relies on the competence of the auditor, and a fraudulent result may occur with collaboration between the auditor and the custodian.
    2. Temporal Validity:
      • The legitimacy of a PoR audit is only valid during the time of the audit, and subsequent events, such as loss of private keys or users’ funds, can impact its accuracy.
    3. Borrowing to Pass Audit:
      • PoR audits cannot determine if the custodian borrowed funds to pass the audit, raising concerns about the true financial health of the entity.

    Conclusion: Safeguarding Trust in Crypto Custody

    Proof-of-reserves audits play a pivotal role in instilling trust and transparency in the realm of digital asset custody. As the crypto industry matures, the adoption of PoR audits is likely to become a standard practice, providing investors with the assurance that custodians are managing their assets responsibly. While there are limitations, the benefits of PoR audits, including asset verification, regulatory compliance, and user trust, position them as a valuable tool in securing the future of digital asset custody. As the ecosystem continues to evolve, the integration of PoR audits reflects a commitment to building a robust and trustworthy financial infrastructure for the growing community of digital asset investors.

    Stay in the Loop

    Get the daily email from CryptoNews that makes reading the news actually enjoyable. Join our mailing list to stay in the loop to stay informed, for free.

    Latest stories

    - Advertisement - spot_img

    You might also like...