What is Proof of Reserves?
This lesson will focus on the definition and basic principles of Proof of Reserves.
In centralized exchanges (CEXs), each user’s assets are recorded through the ledger in the platform database. It is difficult for users to confirm whether their assets have been transferred and whether the exchange has sufficient assets to cover the assets deposited by users. Therefore, the exchange needs to prove that it has sufficient reserve assets to be 100% redeemed when the user withdraws them, which requires the value of the exchange’s reserved assets to be higher than the value of the assets deposited by the user. This proof of publicly available assets is called Proof of Reserves.
Why do We Need Proof of Reserves?
After the user deposits the assets into the exchange, the assets under the custody of the exchange are liabilities to the user. For example, after user A deposits the assets into the exchange, let’s say 10 ETH, the exchange’s balance should show an additional 10 ETH in assets and an increase in liabilities of 10 ETH because these assets belong to the user, who can withdraw them at any time. The total assets of the exchange would be assets (10 ETH) - liabilities (10 ETH) = 0.
There are tens of thousands of users on an exchange, who have deposited hundreds of millions of assets. If only a small part is misappropriated, users can still withdraw as usual. For example, if the platform has 10,000 ETH and misappropriates 1,000 ETH, user A would not have a problem withdrawing 10 ETH. However, a liquidity crisis can occur when there is a significant demand for funds and a large number of customers withdraw their funds at the same time (this scenario of mass withdrawals is often referred to as a “bank run”), and the shortfall of misappropriated funds cannot be replenished.
When a liquidity crisis occurs, the later you withdraw, the more likely it is that you will not be able to retrieve your assets. Therefore, everyone wants to withdraw or liquidate their assets as soon as possible to avoid being the slowest and triggering a death spiral. For example, after FTX was disclosed to have misappropriated funds, a large number of users withdrew money from FTX and began to sell and short their token FTT, causing a drastic drop in the prices of projects invested by FTX and assets in the associated ecosystem. FTX’s held assets also faced devaluation, making it unable to repay user assets. In the end, they had no choice but to declare bankruptcy, resulting in tragic losses for countless users and investors.
The Proof of Reserves can largely avoid the liquidity crisis mentioned above. It makes the asset situation of CEXs more transparent and proves that CEXs have the funds to fully repay all user debts.
Basic Principles
Proof of Reserves is a reliable auditing procedure that verifies assets held by exchanges through cryptographic proofs, public wallet ownership checks, and repeated audits. It enables custodians to provide transparent proof that on-chain reserves are real, indicating that the total amount of tokens held by the platform and at their discretion is greater than or equal to the total amount of token assets of all users.
Generally speaking, each token will be verified separately, such as BTC, ETH, LTC, etc. For a certain token, divide the number of it held by the address owned by the platform by the sum of the number of it held in all user addresses, and then you will get the reserve ratio of a certain token. A reserve ratio greater than 100% means that the exchange has sufficient solvency for the token. As shown in the image below, Gate.io has listed a total of nearly 100 tokens’ reserve ratio.
In addition to the reserve ratio of a single token, it is also important to understand the concept of total reserve ratio, which means the total assets held by the exchange or the total assets deposited by users. This data is mainly used to measure the exchange’s overall solvency of the exchange.
Conclusion
Now we can understand the basic concept of Proof of Reserves and its importance to centralized exchanges (CEXs). We have also discussed how Proof of Reserves can help prevent liquidity crises and maintain the financial transparency of exchanges. This philosophy is essential to establish trust between exchanges and users.
You may also consider whether crypto exchanges can be directly audited by accounting firms like traditional financial companies, and how we can use crypto to audit reserves. These topics will be discussed in further depth in the following lesson.
What is Proof of Reserves?
This lesson will focus on the definition and basic principles of Proof of Reserves.
In centralized exchanges (CEXs), each user’s assets are recorded through the ledger in the platform database. It is difficult for users to confirm whether their assets have been transferred and whether the exchange has sufficient assets to cover the assets deposited by users. Therefore, the exchange needs to prove that it has sufficient reserve assets to be 100% redeemed when the user withdraws them, which requires the value of the exchange’s reserved assets to be higher than the value of the assets deposited by the user. This proof of publicly available assets is called Proof of Reserves.
Why do We Need Proof of Reserves?
After the user deposits the assets into the exchange, the assets under the custody of the exchange are liabilities to the user. For example, after user A deposits the assets into the exchange, let’s say 10 ETH, the exchange’s balance should show an additional 10 ETH in assets and an increase in liabilities of 10 ETH because these assets belong to the user, who can withdraw them at any time. The total assets of the exchange would be assets (10 ETH) - liabilities (10 ETH) = 0.
There are tens of thousands of users on an exchange, who have deposited hundreds of millions of assets. If only a small part is misappropriated, users can still withdraw as usual. For example, if the platform has 10,000 ETH and misappropriates 1,000 ETH, user A would not have a problem withdrawing 10 ETH. However, a liquidity crisis can occur when there is a significant demand for funds and a large number of customers withdraw their funds at the same time (this scenario of mass withdrawals is often referred to as a “bank run”), and the shortfall of misappropriated funds cannot be replenished.
When a liquidity crisis occurs, the later you withdraw, the more likely it is that you will not be able to retrieve your assets. Therefore, everyone wants to withdraw or liquidate their assets as soon as possible to avoid being the slowest and triggering a death spiral. For example, after FTX was disclosed to have misappropriated funds, a large number of users withdrew money from FTX and began to sell and short their token FTT, causing a drastic drop in the prices of projects invested by FTX and assets in the associated ecosystem. FTX’s held assets also faced devaluation, making it unable to repay user assets. In the end, they had no choice but to declare bankruptcy, resulting in tragic losses for countless users and investors.
The Proof of Reserves can largely avoid the liquidity crisis mentioned above. It makes the asset situation of CEXs more transparent and proves that CEXs have the funds to fully repay all user debts.
Basic Principles
Proof of Reserves is a reliable auditing procedure that verifies assets held by exchanges through cryptographic proofs, public wallet ownership checks, and repeated audits. It enables custodians to provide transparent proof that on-chain reserves are real, indicating that the total amount of tokens held by the platform and at their discretion is greater than or equal to the total amount of token assets of all users.
Generally speaking, each token will be verified separately, such as BTC, ETH, LTC, etc. For a certain token, divide the number of it held by the address owned by the platform by the sum of the number of it held in all user addresses, and then you will get the reserve ratio of a certain token. A reserve ratio greater than 100% means that the exchange has sufficient solvency for the token. As shown in the image below, Gate.io has listed a total of nearly 100 tokens’ reserve ratio.
In addition to the reserve ratio of a single token, it is also important to understand the concept of total reserve ratio, which means the total assets held by the exchange or the total assets deposited by users. This data is mainly used to measure the exchange’s overall solvency of the exchange.
Conclusion
Now we can understand the basic concept of Proof of Reserves and its importance to centralized exchanges (CEXs). We have also discussed how Proof of Reserves can help prevent liquidity crises and maintain the financial transparency of exchanges. This philosophy is essential to establish trust between exchanges and users.
You may also consider whether crypto exchanges can be directly audited by accounting firms like traditional financial companies, and how we can use crypto to audit reserves. These topics will be discussed in further depth in the following lesson.