What is proof of reserves in crypto?

Proof of reserves, often shortened to PoR, is a way for a crypto exchange or custodian to show that it holds enough assets to cover what it owes customers. The firm compares the crypto it controls with the total of all customer balances at one moment. If the reserves equal or exceed the balances, the platform appears to be fully backed.

The practice spread after the 2022 collapse of FTX, when customers discovered the exchange could not meet withdrawals.

What does proof of reserves mean in crypto?

A proof of reserves has two halves. The first is the assets: the exchange shows the wallet addresses it controls, so anyone can see the balances on the blockchain. The second is customer balances: the exchange adds up what each user is owed.

The result is often given as a reserve ratio. A ratio of 100% means the exchange held one coin for every coin customers had on deposit when the snapshot was taken.

How does a Merkle tree prove your balance is included?

A Merkle tree is a way of combining many pieces of data into a single short code, using hashes. Each customer balance is hashed, then pairs of hashes are combined again and again until one value is left, called the Merkle root.

The exchange publishes the root. A customer can take their own entry and the few hashes next to it and recompute the root. If it matches, their balance was part of the total. Changing any one balance would change the root, so the exchange cannot quietly leave someone out without it showing.

How does proof of reserves work at Binance and Kraken?

Binance launched a proof of reserves page for its bitcoin holdings on November 25, 2022, using a Merkle tree and reporting a reserve ratio of 101%, TechCrunch reported. In February 2023 it added zk-SNARKs, a type of zero-knowledge proof that lets the totals be checked without revealing individual users' data, and released the code as open source, according to The Block.

Kraken uses an independent accounting firm, which takes an anonymized snapshot of client balances and builds a Merkle tree from it. Clients can check their inclusion in their account or with code samples Kraken publishes. Kraken's page notes that the review covers assets and does not prove funds were not borrowed against.

What does proof of reserves not show?

In March 2023 the US Public Company Accounting Oversight Board (PCAOB), which oversees auditors of public companies, warned investors to be very careful with these reports. Its staff made several points, according to the law firm DLA Piper.

• It is not an audit. The work is not done under auditing standards.
• Liabilities are usually missing. A report may not cover the firm's debts or whether its assets have been lent out or borrowed.
• It is a snapshot. Funds could be moved in just before the count and moved out after.
• No view of controls. It says nothing about how well the firm is run.

Proof of reserves is a useful signal, but it does not guarantee a platform can pay everyone back. The guide to custodial and non-custodial wallets explains the trade-offs of leaving crypto on an exchange.

No check can remove all risk of loss when assets are held by a third party.