What is a Proof of Reserves Audit, and Why is this Important?

A Proof of Reserves (PoR) Audit provides clients with an excellent opportunity to ensure that their digital asset service provider meets all required accountability standards. Proof of Reserves Audit is an audit conducted by a third-party auditor that takes a snapshot of all available balances and combines them into a unique Merkle tree.

With the growth of the cryptocurrency industry, PoR is an excellent verification technique to ensure security and transparency in the crypto space. 

This public cryptographically consistent reports show that digital asset service providers hold enough digital assets on the balance sheets to offset different customer liabilities. The hash tree allows you to safely and efficiently check the contents of a large data structure. So, what is a proof of reserves audit?

What is the Proof of Reserves Audit?

So what is a reserves audit, and why is it required? Proof of Reserve, or PoR for short, is an excellent way for crypto asset users to know that all real assets back the balances they hold on exchanges. This process uses a particular innovative cryptographic accounting procedure based on a unique Merkle tree. As it is known, this data structure s designed with privacy in mind.

Reserve confirmations are transparent audit processes used by crypto companies to provide an honest account of a given company’s reserves. An independent auditor can access cryptographic documents representing the total balance of the client assets. Such checks help prevent a liquidity crunch if customers withdraw cash and ensure full account transparency.

In this way, clients can be sure that the company is protected from a liquidity crisis and can withdraw money anytime convenient. Proof of Reserve uses secure Merkle trees that aggregate customer total balances without sharing personal data.

A Merkle tree in Blockchain 

A Merkle tree is a special data structure used in computer applications. In cryptocurrencies, Merkle trees provide more secure and efficient encryption of blockchain data. They are also called “binary hash trees.”

Ethereum as a unique Merkle Tree

Ethereum is based on a modified version of the Merkle Tree, which is why it is called Patricia’s Merkle Tree. Each block in the Ethereum blockchain does not consist of one binary tree (as in Bitcoin) but three Merkle trees. Each of the three roots has its purpose.

How are PoR Audits Conducted?

The auditor obtains PoR to analyze client balances anonymously. The settlement amount is usually determined using a unique account identifier. This data is combined into a particular cryptographic Merkle tree.

As you know, the Merkle root is a cryptographic hash that represents unique combinations of the total balance of users. The Merkle tree allows you to check the exact balance by checking an anonymous number of balances with verified ones.

Proof of Reserves (PoR) as a Safeguard against Crisis

The FTX crisis that caused the bankruptcy started in October 2022 when evidence of reserves was seized. The collapse of the Celsius platform, Voyager digital, FTX, BlockFi, and Hodlnaut has created distrust on the part of users. In improving the situation, attention was paid to Proof of Reserve, which began to gain popularity. Proof of reserves is a great way to ensure the financial safety of clients.

Concerns about Confirming Reserves

Proof of reserves gives investors confidence that crypto assets have all the right assets to recoup the risks. However, this check reflects only the current situation with the real account of the balance. The problem is that this audit shows precisely the assets of the custodians in the chain. It cannot track where these assets came from. This mechanism is, of course, capable of providing evidence of the insolvency of the crypto firm. However, the review is not as complete as possible because there are some questions that the Proof of reserves cannot answer. 

Should all Crypto Exchanges publish Reserve Balances?

Crypto exchanges are cryptocurrency companies with the highest trading volume, the highest traffic, and the highest value of customer deposits. There is no regulation requiring confirmation of reserves, but it is likely to appear very shortly. Thus it will most likely be mandatory soon.

Conclusion about Proof of Reserves Audit

Since the fall of FTX, various Proof of Reserves tools have quickly emerged, each offering investors a way to track the financial performance of their institutions or assets regarding collective funds owned by their various users. Despite the presence of some drawbacks, Proof of Reserves plays a massive role in ensuring the safety of users’ digital assets.

Given the emerging regulatory framework in the digital asset management sector, Proof of solvency, transparency, reporting, and audits covering decentralized markets can be critical for users of these products, services, and platforms. Proof of Reserve uses blockchain technology to verify a company’s network assets publicly.

Crypto companies track reserves on the site or publish the results of a reserve check. Crypto industry experts are sure that an independent audit of Proof of Reserves will gain more and more popularity. 

FAQ

What is evidence of a Proof of Reserves Audit?

PoR combines cryptographic verification with periodic audits to validate centralized fund accounts. Proof of reserve is a verifiable procedure allowing you to increase the transparency of the centralized management of cryptocurrency reserves.

What is reserved in practical auditing?

Reserve amounts are amounts of money for profit. They cannot be used to increase or decrease the value of assets or offset losses known when the financial statements are issued.

What are the three types of reserves?

– Income and capital reserves – the classification is carried out by the nature of the profit.
– General reserves – those that are usually created without any specific purpose.
– Specific reserves are created for specific purposes.

Why should a third-party auditor be preferred?

An organization’s third-party audit is conducted independently of the customer and supplier relationship. This person is free from any conflict of interest and can express an unbiased opinion.