Better Than Yesterday With BSCStation #7: Proof-of-Reserve

The past few weeks have been more turbulent than usual, even by crypto standards. Scars from the Luna, Celsius, and 3AC crashes had yet to completely heal when we faced the threat of another crypto exchange, FTX, going down due to sketchy finances and rumors of insolvency.

To remedy the situation, Binance CEO Changpeng Zhao (CZ) announced a new audit system that uses Merkle trees and allows for a transparent verification of user holdings. This initiative is called the proof-of-reserve fund, and it has quickly garnered the support of investors and high-profile personalities from within the industry.

Let's dive in with BSCStation and figure out what Proof-of-Reserve is and how it works.

What is Proof-of-Reserve

A Proof of Reserve (PoR) is an independent audit conducted by a third party to ensure that a custodian (such as a centralized crypto exchange) actually has, in its ownership, the assets it says it has.

Currently, most centralized exchanges and other CeFi crypto platforms, like lenders and custodians, keep their asset data in private, proprietary databases. As such, they can claim that their users’ funds are safe with them, but these claims are difficult to verify.

With a Proof of Reserve, customers don’t just have to take their word for it but have an indisputable assurance of that claim, going back to the core tenet of crypto–“don’t trust, verify.”

Why you should care about PoR

Proof-of-reserve ensures that crypto custodians, exchanges and lenders do not engage in secretive financial transactions that put their customers’ funds at risk.

Proof-of-reserve ensures that a crypto lender does not loan out more money than the collateral it holds, so that its lenders can be compensated in full if anything happens.

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.

Proof-of-reserve ensures that a crypto exchange:

✅ Is not secretly insolvent

✅ Will not secretly park your coins in a third party that may be insolvent

✅ Is actually in ownership of your trading funds/assets–which means you can withdraw them anytime you want

How Proof-of-Reserve work

​​What makes Proof of Reserve work is something called a “Merkle Tree” (also called “hash tree”). A Merkle Tree provides a cryptographically secured (i.e. tamper-proof) method of verification of assets on reserve.

As a hash-based data structure, it is hypersensitive to the smallest change and can thus be used to prevent data fraud and manipulation.

💠 The independent auditor first takes a snapshot of all the user balances held on a crypto exchange and organizes it into a Merkle Tree.

💠 This gigantic data set is run through a cryptographic hash function–a computer algorithm that scrambles up data and spits it out as just one single, 64-character string

💠 The auditor gathers the exchange’s digital signatures that show the total balances it has, and verifies that it matches user balances represented in the Merkle tree. This shows that all user assets are  and therefore that all users’ trading funds are held in the exchange’s reserve (hence the term “proof-of-reserve.”)

💠 The user can subsequently verify that his assets were accounted for in the Proof of Reserves audit using a unique record ID and comparing it with the Merkle root.

💠 If there was any change to his asset balance, no matter how small, or it is a fake balance, it would result in a change that cascades up the tree to the Merkle root and changes the value completely.

As such, the Merkle Tree is a single value that proves the integrity of all of the transactions by making even the smallest tampering obvious. 

A 3-Point Checklist To Ensure You Are Using A Safe & Secure Crypto Exchange

💠 Your crypto exchange has, or is committed to, Proof-of-Reserve audits.

💠 Your crypto exchange uses cold wallet systems that keep users’ funds isolated

💠 Bonus: your crypto exchange focuses only on creating great user trading experiences instead of platform tokens that are subject to volatility, which then puts your own assets at risk.

Conclusion

The Merkle Tree Proof-of-Reserve provides an assurance by enabling quick, easy verification of a large volume of data, for the purpose of transparency and customer assurance.

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.

About BSCStation

BSCStation - The fully decentralized protocol for launching new ideas. An all-in-one Incubation Hub with a full-stack Defi platform across all main blockchain networks. We provide exclusive services including IDO/INO Launchpad, Yield farming, NFT Auction, Marketplace, and BSCSwap

BSCStation operates on top of all the main blockchain networks and is designed to offer maximum value to consumers and institutions.

BSCStation platform uses the Sharing Economy Model for the purpose of profit-sharing, helping users to access DeFi platforms in the easiest, safest, and most cost-effective way. BSCStation is the most convenient bridge to connect users and application products on all main blockchain networks.

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Disclaimer: Cryptocurrency investment is subject to high market risk. BSCStation is not responsible for any of your trading losses. The statements made in this article are for educational purposes only and should not be considered financial advice or investment recommendation.