Proof-of-Reserves Are Not Good Enough, Says Industry

In response to these clear deficiencies, many exchanges have taken steps to increase transparency and trust amongst their users. Proof-of-reserves is one such measure, with many leading exchanges now implementing this process. In simple terms, proof-of-reserve is a process by which an exchange verifies that it has sufficient reserves (in this case, fiat and cryptocurrency) to back its customers’ balances. 

Proof of Reserve hit the headlines in recent weeks following the FTX collapse. In a Nov. 8 tweet, before the exchange filed for bankruptcy, CZ pledged to implement proof-of-reserve to provide “full transparency.” On Friday, November 25th, Binance published a new site to explain its proof-of-reserves system. Currently, Binance has a reserve ratio of 101%. In theory, this should mean Binance has enough to cover its user’s deposits.

What is Proof-of-Reserve?

Proof-of-reserve is not a new concept in the financial world. A similar method is already used by banks around the globe to prove to their customers that they have sufficient funds to cover their deposits. 

In a crypto context, proof-of-reserve is a method used to verify that the fiat and cryptocurrency assets held by an exchange are sufficient to cover the funds owed to its customers. This is done by generating a cryptographic hash of the amount held. Which is then published on the exchange’s website alongside a link to a verified third-party audit report. In addition to providing transparency, this also offers a degree of protection against exchange employees misappropriating funds. Since the audit report verifies that the published data is accurate and the hash matches the funds held, the probability of an exchange committing fraud is reduced. 

How Does Proof-of-Reserve Work?

The first step is for the exchange to create a cryptographic hash of the number of funds they have on hand. They then publish that hash alongside the number of funds held on their website. The accompanying link leads to a third-party audit report, which verifies that the published hash matches the funds held by the exchange. The hash is generated using a computer program that randomly selects a number between 0 and 100,000,000. 

The exchange then takes this number and adds it to the number of funds held. Creating a new hash that can be published on their site. Now, if an exchange employee were to misappropriate funds, they would have to guess the number that would be added to the funds held. This would be incredibly difficult to do and would raise serious red flags among the exchange’s employees. Since the hash is publicly available, any discrepancy between the published hash and the funds held would be highly suspicious.

Source: beincrypto.com