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When assessing a crypto asset, it’s essential for you to do your research and due diligence to make the best possible judgement, as any purchases shall be your sole responsibility. Simply put, a Merkle tree is a data structure constructed by repeatedly proof of reserve hashing a set of data (i.e., two or more pieces of data). Binance moved to quell concerns over its state of finances by drafting the South African arm of the international audit, tax, and advisory firm Mazars to prepare an additional proof of reserve report. In this article, we’ll break down what Chainlink Proof of Reserve (PoR) is and how it helps provide stronger security guarantees and more transparency in the cryptocurrency ecosystem.
- Merkle trees allow large data structures to be pieced together in an efficient, secure, and externally verifiable way.
- With the growth of DeFi comes an increasing demand for new collateral types that extend beyond native on-chain assets, including cross-chain tokens, fiat-backed stablecoins, tokenized real-world assets, and more.
- These auditors confirm that the financial state of a company is presented accurately and honestly.
- By Saturday evening, Domain Group had recorded a preliminary auction clearance rate of 59 per cent from 890 reported results, while 206 auctions were withdrawn.
What is Proof of Reserves & How Does It Work?
Decentralized finance (DeFi) provides an alternative by offering highly transparent, trust-minimized financial products that are powered by deterministic smart contracts and cryptographic truth. With the growth of DeFi comes an increasing demand for new collateral types that extend beyond native on-chain assets, including cross-chain tokens, fiat-backed stablecoins, tokenized real-world assets, and more. Although proof of reserves offers assurance that a crypto company has the assets in place to cover its liabilities, https://www.xcritical.com/ it is only a single snapshot in time, not a live accounting of balances over time. It also only shows the on-chain assets of the custodian; it does not track where those assets come from (i.e., whether the assets were borrowed for the purposes of the audit). Coinbase addresses these concerns by reporting its assets to regulators in compliance with being a publicly traded company in the United States.
Concerns About Proof of Reserves (PoR)
Chainlink Labs launched another approach in 2020 to help projects across Web2 and Web3 ecosystems prove asset reserves through automated verification. By connecting to an exchange’s API, vault addresses, and proof-of-reserve smart contracts, it automatically and independently determines if its reserves are equal to or greater than its deposits. The crypto industry clearly needs a better way to prove the safety of customer deposits independent of external parties to maintain its decentralized approach while complying with financial regulations. But until recently, there was little urgency in deploying widespread solutions to increase trust among customers and users. However, November 2022 saw the most remarkable example of centralized exchange insolvency. Sam Bankman-Fried’s FTX cryptocurrency exchange famously crumbled after Alameda Research’s (FTX’s sister trading firm) balance sheet was leaked to the media.
How Does the Merkle Tree Proof-of-Reserve Work?
Some exchanges and crypto lending platforms, including Kraken, Nexo, BitMEX, and Gate.io, moved to launch their proof of reserves before the implosion of FTX. TUSD uses Chainlink PoR in an additional way—to add even more enhanced security and transparency to the stablecoin minting process. Chainlink Proof of Reserve Secure Mint enables stablecoin issuers to programmatically require reserves to be greater than or equal to the supply being minted. By providing cryptographic guarantees that new tokens minted are backed by reserves, PoR Secure Mint takes tokenized asset and stablecoin security to the next level, helping to prevent infinite mint attacks.
Why is Proof of Reserves important?
Once Chainlink PoR determines that wrapped tokens are undercollateralized, Chainlink Automation can be used to halt the minting, redeeming, and burning of wrapped tokens. CoinGecko provides an easy way to access proof-of-reserves data across multiple exchanges. When visiting the exchanges page, you can see a column titled “Reserves Data” that shows if an exchange provides proof-of-reserves data and if there are third-party audits. After clicking on an exchange, you can visit the “Exchange Reserves” tab for a breakdown.
Using cryptographic proofs, the PoR protocol verifies the validity of user balances and transactions. We are specialists in building digital products that require blockchain implementation. A simple example–if an exchange tries to tamper with the records to reflect that it has $12,000,000,001 in reserves when it actually has $12,000,000,000, the hash changes completely. As a hash-based data structure, it is hypersensitive to the smallest change and can thus be used to prevent data fraud and manipulation. Proof-of-reserves remains an evolving concept in the crypto industry, but there are a few early attempts at implementation.
Every node that isn’t a leaf is called a branch and is labeled with the hash of the labels of its child nodes. Merkle trees allow large data structures to be pieced together in an efficient, secure, and externally verifiable way. That makes Merkel trees ideal for our purpose of offering a quick way for our millions of users to verify our reserves for themselves. Some argue that because “PoR” implies only accounting for assets in reserve, it does not account for an exchange’s liabilities—specifically, user deposits. Specifically, providing a Proof of Assets without a Proof of Liabilities may only reveal part of the picture.
The goal of providing proof of reserves is to offer financial transparency about a crypto company’s balance sheet, especially in regard to customers’ funds. A third-party audit gives consumers confidence that the crypto company they are using has sufficient liquidity to handle day-to-day operations, and more importantly, customer withdrawals. Proof of reserves is completed by a third-party auditor that creates a snapshot of all of the company’s balances to show transparent “proof” that the crypto company has enough assets to cover its liabilities at any given time. This gives customers confidence that the crypto company is not at risk of a liquidity crisis, and that customers can withdraw their funds at any time. It is a way for a CEX (centralized exchange e.g. Binance, Crypto.com, Coinbase) to provide transparency by revealing in public that they hold in their reserves enough assets to match user deposits.
As traditional banks and asset managers expand their services to include digital assets, proof-of-reserves will feature more prominently as an industry gold standard for credibility and trust. When the penultimate two nodes are summed, it creates a final node in the tree called the Merkle root. The Merkle root represents the sums of all users and balances, used to verify a large data set with just one piece of information. An auditor takes the summed balance in the Merkle root and compares it against the exchange’s proven holdings.
This is a significant problem if you are a customer of a crypto exchange and have entrusted the company with your coins, only to learn later that the exchange had squandered all the money ferried through its platform. In the context of PoR, applying a Merkle tree allows the auditor to aggregate the data of all customers’ account balances into a single Merkle root without publicly exposing the account balance of any individual customer, thereby preserving privacy. Industry leaders use Chainlink Proof of Reserve for its unmatched security, reliability, and compatibility. Integrate the most reliable proof of reserves solution today for automated verifications that provide unparalleled transparency to your users.
Proof-of-reserve ensures that a custodian of wrapped tokens like WBTC (wrapped bitcoin), actually has the bitcoins in reserve, or that stablecoin issuers like Circle actually has the USD to back all the USDC it issues. This creates a “branch”, which is the sum of the two users’ hashes + sums of their balances. On the next level, two branches are combined—their hashes and balances again added together—to create another branch.
Proof of Reserves (PoR) verifies digital asset collateralization held by crypto businesses, helping bring greater transparency to depositors via public reserves reporting or independent audits. The cryptocurrency industry has become a playground for the dishonest, as evidenced by the actions of the executives and owners of the crypto exchange FTX, which collapsed in November 2022 after widespread fraudulent practices were exposed. FTX did not hold assets in reserve for its customers, or employ third-party auditors to vet its financial practices, easily fooling its customers that all was well within the once-popular exchange.
Binance’s CEO, Changpeng Zhao, tweeted that his exchange would begin to implement proof-of-reserves. Smart contract developers can integrate Chainlink Proof of Reserve as a circuit breaker to help ensure unexpected fractional reserve activity from issuers does not result in cascading user losses if unbacked tokens are minted. Introduce automated verifications into your decentralized application to decrease risk and increase efficiency through oracle-triggered circuit breakers. Chainlink Proof of Reserve enables the reliable and timely monitoring of reserve assets using #ProofNotPromises.
Thus, PoR should always include wallet addresses to enable the tracking of fund movements. The collapse of TerraUSD and FTX underscores the need for a reliable way to prove crypto platforms properly manage customer deposits. PoR is thought to reduce audit tampering by documenting all on-chain activities, including monitoring wallets to track asset movements.