What Is Proof of Reserves (PoR) And Why Does It Matter?

The recent turbulence in the crypto sector has placed its users in a state of disbelief and skepticism toward centralized custodians. This acted as a catalyst for most centralized exchanges and custodians to make it their top priority to rebuild their users’ trust with Proof of Reserves.

This article will explain what Proof of Reserves is, how it works, as well as if it can help to reestablish trust in centralized custodians.

Proof of Reserves is public proof that crypto exchanges or custodians hold the customers' assets on a full 1:1 reserve basis on the platform.

Exchanges use cryptographic proofs and public wallet address ownership verification, as well as periodic third-party audits, to show the public that their holdings match user deposits.

Since they are using cryptographic proofs, This cryptographic approach makes it possible for individual users to verify that their account balance is included in the attestation.

Why Does Proof of Reserves (PoR) Matter?

Proof of reserves is vital for a number of reasons, namely:

• First, it helps to build trust and transparency between the exchange and its customers. By providing Proof of Reserves, the exchange is showing its customers that it is not engaging in any fraudulent or deceptive practices, and that it is holding onto the customer's funds in a safe and secure manner. This procedure will help build the custodian’s trustworthiness.
• Second, Proof of Reserves can help to ensure that the exchange complies with regulatory requirements, particularly in jurisdictions where there are specific rules or guidelines governing the storage of cryptocurrency. By providing Proof of Reserves, the exchange can demonstrate that it is holding onto its customers' funds on a full reserve basis, and is not engaging in any activities that could be considered illegal or unethical.

The process of conducting a Proof of Reserves audit for a crypto exchange typically involves a few key steps, namely:

Compiling: First, the exchange will compile a list of all of the cryptocurrency that it is holding, including the total amount of each type of cryptocurrency and the individual addresses or wallets where the funds are being stored.

Hashing: Next, the exchange will use a cryptographic hash function to create a unique "fingerprint" for each piece of data in the list. This fingerprint, known as a "hash," can be used to verify the integrity of the data without revealing the data itself.

Organizing: Once the hashes have been generated, the exchange will organize them into a data structure known as a Merkle tree. This tree allows for the efficient verification of large data sets, and enables the exchange to provide a compact proof of its reserves.

Auditing: To conduct the audit, the exchange will provide the auditor with the root of the Merkle tree, as well as a number of "branches" that the auditor can use to verify the integrity of the data. The auditor can then use these branches to recreate the Merkle tree and verify that the root matches the one provided by the exchange. This process can help to ensure that the exchange is holding the amount of cryptocurrency that it claims to be holding.

Overall, the process of conducting a Proof of Reserves audit for a crypto exchange is designed to provide a high level of assurance to the exchange's customers that their funds are being held securely.

What Is a Merkle Tree, and Why Is It Used?

Crypto exchanges use Merkle trees for their Proof of Reserves for several reasons. A Merkle tree is a tree-like data structure that uses cryptographic hashing to allow for the efficient verification of large sets of data. This is particularly useful in the context of cryptocurrency, where the amount of data that needs to be processed can be quite large.

Named after Ralph Merkle, the Merkle tree is a data structure used for different forms of verification. If we imagine a Merkle tree as a real tree, each leaf node would represent a hash of a block of data, while a branch node is a hash of its children-leaf nodes. Even the most minuscule changes to the balances affect the root, making it not match the original Merkle tree structure, meaning that any form of tampering is obvious.

One of the key benefits of using a Merkle tree for Proof of Reserves is that it allows the exchange to provide a compact proof of the data it needs to show. This is because a Merkle tree allows for the efficient verification of large sets of data without having to provide the entire set of data itself. Instead, the exchange can provide a small "proof" that consists of a few critical pieces of information, which can then be used to verify the entire set of data.

Overall, the use of Merkle trees for Proof of Reserves is an efficient and effective way for crypto exchanges to provide assurance to their customers that they are holding the amount of cryptocurrency that they claim to be holding. By using this data structure, exchanges can provide a compact proof of their reserves, and can also enable efficient verification of this proof.

This can help to build trust and transparency between the exchange and its customers, and can also support the overall growth and development of the cryptocurrency market.

There are a few potential limitations to using Proof of Reserves for a crypto exchange.

One potential limitation is that Proof of Reserves is not a foolproof method of ensuring the security of an exchange's reserves. While it can provide a high level of assurance to customers that the exchange is holding the amount of cryptocurrency that it claims to be holding, Proof of Reserves does not include the liabilities of the custodian.

Another potential limitation of the Proof of Reserves is its time sensitivity. Since a Merkle tree generates proof for a specific time-stamp, it only proves the coverage of user funds at that particular moment in time. Numerous custodians are, however, combating this limitation by vowing to conduct audits on a weekly, monthly, or quarterly basis.

Additionally, Proof of Reserves is not a regulatory requirement in all jurisdictions. It may not be recognized as a reliable method of ensuring the security of an exchange's reserves by all regulators. This means that an exchange that provides Proof of Reserves may still be subject to penalties or other legal action if it is found to be engaging in activities that are illegal or unethical.

As the People’s Exchange, the safety and security of users’ funds are KuCoin’s top priority. As part of our dedication to transparency and strengthening the trust in the industry, we have already taken action towards providing users with complete insight into our financial matters.

KuCoin has already published an overview of our major token holdings, with the snapshot taking place on 11.11.2022.

We partnered with the international accounting firm Mazars for a third-party audit of our Proof of Reserves (PoR). The official KuCoin Proof of Reserves report is now publicly available. All users can now verify their asset holdings by following the instructions on our PoR page.

The verification provides our customers with a report showing that all user assets are fully collateralized, along with details on main, trade, margin, robot, and contract accounts for Bitcoin (BTC) and Ether (ETH), as well as for the stablecoins Tether (USDT) and USD Coin (USDC).

Verify your KuCoin asset holdings on our Proof of Reserves page.

Proof of Reserves has quickly become an essential practice for the centralized custodian to build trust and transparency with their customers. Regaining customers’ trust in this time is crucial for crypto exchanges to survive and thrive in the long run.

Additionally, Proof of Reserves sets new standards for crypto entities to protect their users, which is clearly a benefit to the users themselves. With more centralized custodians taking this approach, it's certainly a bold step forward toward a safer and stronger crypto industry.