Proof-of-Reserve Audit is an auditing process that verifies that a crypto exchange has the exact amount of assets it claims to have. It has become a powerful tool for consumers and custodians. Below is everything you need to know about this audit.
Many centralized traditional financial institutions have been ensured by the government to release periodic financial reports which declare their assets. Most of the time, these institutions release quarterly reports, annual reports, and the following year’s projections. This ensures that customers’ funds are not mismanaged or invested into risky investments by the organization. However, no governmental law binds decentralized financial institutions like crypto exchanges to submit such reports. How can customers then be assured that their fund is safe, well-spent, and not mismanaged? The solution to this is the Proof-of-Reserve (PoR) audit. It gives customers financial assurance in decentralized companies. To ensure maximum transparency, only an external auditor can award a proof-of-reserve pass.
Proof-of-Reserve: Audit Committed to Transparency
The Proof-of-Reserve (PoR) is an independent third-party audit that ensures that a decentralized institution has the number of assets it claims to possess. This process utilizes a simple mathematical data structure known as Merkle Tree. A Merkle Tree allows the auditor to condense all clients’ balances together, displaying the total asset owned by the decentralized body.
Without the Proof-of-Reserve, DeFi groups would have been at liberty to secretly use customers’ deposits to invest in risky sectors. PoR ensures that crypto lenders do not lend more than their collateral, so the firm can pay the lenders in case of any mishap.
Proof-of-Reserve serves as a public report of the financial activities going on in a decentralized firm. Interestingly, customers can check if their accounts were included during the PoR process. The verification process prevents customers from hearing tragic stories whenever they decide to withdraw their funds. Basically, PoR helps customers confirm that crypto exchanges are still solvent. Newbies must ensure that their preferred exchange has a committed Proof-of-Reserve audit and an isolated cold wallet that keeps users’ assets.
Origin of Proof-of-Reserve Audit
Armanino LLP, the 19th largest firm in the United States, was the first provider of transparency in the decentralized firms. Armanino LLP is the leading transparency firm used by blockchain firms. The company manages stablecoin issues and other wealth management platforms. Currently, Armanino has over 7,000 clients. The American Institute has approved the business solution firm of Certified Public Accountants to carry out these activities.
In 2020, Gate.io became the first exchange for running proof-of-reserve on its platforms in collaboration with the leading US auditing firm. The following year, Canada-based Bitcoin (BTC) lending platform Ledn also performed its proof-of-reserve in partnership with Armanino LLP. Other crypto companies like Nexo, Kraken, and Bitmex have implemented the proof-of-reserves on their platform. Many other exchanges are actively working on adding proof-of-reserve to their operations following FTX’s insolvency. These exchanges include Binance, Crypto.com, Kucoin, Poloniex, Bitget, Huobi, and OKX.
How does the Proof-of-Reserves Audit Work?
As earlier stated, the Proof-of-Reserve audit is using the Merkle Tree. The Merkle Tree is an encrypted key that verifies all reserves assets an exchange owns. It functions like a tamper-proof method such that any slight change in the actual value of the reserve assets will change the generated hash. The sensitivity of the hash-based data structure prevents fraud and manipulations. This method of operation is similar to the Bitcoin network and blockchain technology. An exchange cannot carry out its own audit; only an independent audit firm like Armanino can run an audit. The next section shows how auditors use the Merkle Tree to provide transparency in crypto exchanges.
Merkle Tree Principle
Merkle Tree serves as the backbone of the Proof-of-Reserve Audit. The process is conducted only by an external auditor. The auditor begins the process by taking a snapshot of all customer’s balances on the exchanges. All gathered balances are organized into a Merkle Tree. After this, the auditor can obtain a Merkle root, often called the hash of all hashes. A Merkle root is a single 64-character string that encapsulates all the customers’ balances. The auditor proceeds to compare the exchange’s digital signature to the user’s balance in the Merkle tree. The result must show that all user assets are equal to all users’ trading funds in reserve. Authentic results serve as the proof-of-reserve. Users can use the Merkle root and their unique ID to confirm if their accounts were included in the Proof of Reserves. PoR proves the originality of all transactions carried out on the platform. A slight tweak in the value of a user’s account balance affects the whole Markle Tree, showing 100% transparency.
Benefits of Proof-of-Reserve Audit
The decentralized space appears to be riskier than traditional financial organizations. The cryptosystem has been designed to be flawless. However, it is pertinent to have some checks and balances in place against manipulations. The government often saves many private financial institutions from going bankrupt. The 2008 financial crisis was not an exception, as governments and central banks saved financial institutions from insolvency. Unfortunately, crypto firms cannot benefit from such government incentives. Therefore, crypto exchanges and lending platforms must undergo a proof-of-reserve audit. PR boosts trust and confidence in a decentralized firm. It reduces investment risk, enhances transparency, and prevents system failures. Proof-of-Reserve Audit also serves as a regulatory measure in the crypto industry. It is highly beneficial to all participants: the user, the exchange, and the government.
Limitations of PoR
PoR is the solution to crypto exchanges’ transparency and antidote to risky investments. However, the audit also poses some threats, which cannot be overlooked. In particular, Proof-of-Reserve (PoR) audit can expose the crypto exchange to attackers, as the process cannot guarantee the exclusive ownership of the private keys involved.
In addition, PoR cannot detect if the funds have been borrowed to pass the audit. Similarly, the loss of private keys and stolen funds can affect the authenticity of the proof-of-reserve audit. The auditor and auditee may conspire to produce a false audit result. However, they must ensure transparency on both sides. Finally, an auditor must be experienced and independent.
Notably, the above-listed limitations can be avoided by partnering with popular and reliable audit firms only.
Bottom Line
Proof-of-Reserve (PoR) Audit has become a powerful tool for consumers and custodians. While consumers use it to audit firms, the custodian gains the trust of the auditor once the audit is passed. The powerful Merkle Tree tool is expected to undergo future improvements to curb a few challenges. This is one of the developing innovations in the crypto world that increases the trust in this ecosystem. It will also go a long way in mitigating the notion that the crypto world is just another dark web.