Michelle Legge
By Michelle LeggeHead of Crypto Tax Education
Updated Jan 24, 2024
This article has been fact checked and reviewed as per our editorial policy.

Proof of Reserves: The Beginners Guide

Proof of reserves are the talk of the town in crypto currently - with exchanges clamoring to release their proof of reserves in the wake of the FTX Group collapse to attempt to restore investor trust. But what exactly are proof of reserves and why does it matter more than ever? Learn everything you need to know in our proof of reserves guide.

What are Proof of Reserves?

  • An audit of an exchange’s balance sheet

  • Conducted by a third party

  • Verifies that a custodian holds the assets it claims to

  • Results are published in a report

Proof of Reserves (PoR) is a method of verifying that a cryptocurrency exchange has a 1:1 backing across all digital assets that are held there.

This can be done by the exchange either publishing a “proof of reserves” report to detail the amount of cryptocurrency they hold or by proving ownership of wallets on-chain via an audit or “Merkel Tree”. Usually, exchanges hold most user funds in cold storage wallets, with hot wallets for more immediate liquidity.

Proof of Reserves is an integral part of the crypto space, as the phrase “not your keys, not your crypto” means unless you hold your own private keys, an exchange could be loaning out your deposits in order to earn yield or “rehypothecate” deposited funds.

Why are Proof of Reserves important?

Say an exchange is facing a “bank run”, if they do not have the appropriate funds or 1:1 backing of the digital assets deposited, liquidity issues may arise, causing depositors to wait long periods of time to get their deposits back - if at all.

Proof of Reserves can help to provide some assurance to users of exchanges that their funds are secure; however, this doesn’t prevent issues from arising in the event of a hack or attack.

While Proof of Reserves is not a perfect solution, it is likely to force greater transparency within the space, with many exchanges now moving to show PoR or having their wallets audited by independent parties.

What is a Proof of Reserves audit?

A Proof of Reserves audit sees all deposits on an exchange rigorously vetted to ascertain if the ownership of the wallets sits under the exchange and if the funds add up 1:1 to user deposits. Cryptocurrency exchanges may publish Proof of Reserve audit results periodically (weekly, monthly, quarterly) or have real-time PoR available on their website.

It is important to note that “snapshots” or audits of holdings by exchanges may be sufficient to prove solvency at a point in time; however, having real-time access to Proof of Reserves is superior as any users or members of the public can ensure that funds indeed are held and custodied correctly by an exchange.

Chainlink is a decentralized oracle network built on Ethereum. It is used to facilitate the transfer of data from “real world” off-chain sources to on-chain smart contracts, such as price feeds of tokens and other information such as weather, sports scores, and more.

Exchanges can also use Chainlink Proof of Reserves in order to provide security around the guarantees that they cannot mint more tokens than assets stored in reserves. Chainlink Proof of Reserves are also used by DeFi protocols to transparently show how much is deposited, borrowed, and staked at any point in time.

What is a Merkle Tree?

In simple terms, a Merkle tree (or a “hash tree”) is a data structure that allows for efficient and secure data verification. In the cryptocurrency space, it acts as a way to verify the validity of user balances and transactions, combining cryptographic hashes of small balances and encapsulating them into one.

The digital signatures produced by a Merkle tree can be verified by an independent auditor or users of an exchange, with proof of ownership over on-chain wallet addresses demonstrating balances that match 1:1 user deposits or exceed these amounts.

Merkle trees can form an important part of Proof of Reserves, as they allow for secure, efficient, and provable verification of balances.

Infographic: Koinly explains what is a merkel tree

Which exchanges have Proof of Reserves?

Many exchanges do have Proof of Reserves - and following the FTX collapse, others are working towards having it over the coming weeks or months.

Here’s a list of some of the top crypto exchanges and what kind of Proof of Reserves they currently have:

Infographic: Koinly lists cryptocurrency exchanges with proof of reserves

How do I see my exchange’s Proof of Reserves?

Depending on what exchange you hold your crypto on, you can check what type of Proof of Reserves they have, as well as how to find more information on their websites below.

Proof of Reserves and exchange collapses

2022 has seen the collapse of many high-profile exchanges and CeFi borrow/lending yield platforms, including:

  • FTX

  • Celsius

  • BlockFi

  • Voyager

  • Genesis

  • Liquid Exchange

At the core of each platform’s downfall was their inability to repay user deposits due to ‘liquidity issues’ which were the result of crypto equivalents of bank runs - with thousands of users blocked from being able to withdraw funds. The recent spate of collapses has spurred on the need for PoR and other transparency measures.

The FTX collapse

In the case of FTX - the story is still developing, large-scale misappropriation of funds to various linked entities, including Alameda Research, has thus far resulted in losses in billions of dollars. Bankruptcy proceedings have begun in the US and will continue over the coming weeks and months.

Compared to DeFi platforms - which show how much value a protocol holds at any point in time, funds held on centralized exchanges are usually less transparent. As deposits are held across a combination of various wallets that may or may not be disclosed, users of exchanges may find it hard to see whether their exchange is holding user deposits 1:1 or not.

So how can the crypto industry move forward transparently and win back users’ trust? Can “Proof of Reserves” play a role in this transparent future? What is it, and why has it got the entire crypto community talking?

Stay informed! Read next FTX US Collapse: What it means for your taxes

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