Proof of Reserves (PoR) is an audit that aims to prove that a custodian holds all its clients' funds securely. In the field of cryptocurrencies, PoR is vital for ensuring that all funds on an exchange are fully backed by actual assets. This type of audit is typically conducted by independent third parties to prevent any potential data falsification by the custodian undergoing the audit.
Let’s go through a typical PoR verification process. First, an auditor takes a snapshot of all account balances. Then, they use it to create a data structure known as a Merkle tree, which helps efficiently organize and verify large sets of data. Each user's balance is converted into a data point, or "leaf," in this tree. A group of “leaves” can then be hashed to form “branches”, and “branches” hashed to form the “root”. The auditor can then use various cryptographic methods to verify that each user's balance is correctly included and backed.
That’s how PoR audits allow users to confirm that the balances they see in their accounts on an exchange are not just numbers but are actually backed by real assets. This promotes transparency and can increase trust in centralized exchanges (CEXs). In addition, these audits discourage the platforms from engaging in risky financial practices, such as using user deposits for internal investment or lending. Essentially, PoR ensures that exchanges operate more like vaults rather than banks, holding deposits securely without reallocating them elsewhere.
Despite its benefits, the PoR system has limitations. Since these audits provide a snapshot in time, they can only confirm that the reserves were accurate at the moment of the audit. This means that there is no guarantee that the reserves have not been tampered with immediately after an audit. Furthermore, the effectiveness of a PoR audit can depend on the competence of the third-party auditor and their independence from the audited exchange.
Learn more: What Is Proof of Reserves and How it Works on Binance