POR: Proof of Reserves

To ensure centralized exchanges hold the client account balances they claim to. An independent audit is conducted by a third party to verify the exchange’s reserves.

The auditor takes a snapshot of account balances at a point in time and then aggregates them into a merkle tree to preserve client privacy and security.

Using the merkle tree the auditor derives a merkle root. The merkle root is a roadmap for the merkle tree that allows users to navigate to individual account balances.

To complement this process the auditor will typically verify the exchange controls the blockchain addresses associated with the assets clients hold. Once control of addresses is confirmed the last step is to verify the balance of the addresses is greater than or equal too the merkle tree value. Demonstrating the assets held in client accounts are fully backed by readily available reserves tied to specific wallets the exchange controls.

Kraken, the first exchange to implement the proof of reserves protocol, gives clients the chance to verify their holdings directly. By linking their account specific data to the information stored in the merkle root.

If the data in the root cannot be verified. Than its clear the audit process was compromised and balances are potentially at risk.

The biggest disadvantage of proof of reserve is its a point in time snapshot. Given the intensive nature of the process it would be challenging to the point of infeasible to implement on a real time basis.

Meaning, exchange clients can only be confident an exchange was insolvent, and hope with a long enough track record of responsible operations remains solvent long term.

Further Reading Proof of Reserves

Proof of Reserves: Could It Have Avoided the FTX Meltdown?