Chainlink is a decentralized network of oracles built on the Ethereum blockchain. Chainlink uses PoR to confirm its financial solvency. Through third-party auditing, they ensure that their clients are well-informed in regard to the actual status of their funds and assets.
Proof of Reserves: Discovering the Main Purpose of PoR
14 Feb, 2023
Crypto is hot right now. Everyone knows that. However, not everybody is aware of the fact that the crypto custody option market is experiencing analogous growth.
What Are Proof of Reserves?
Let’s begin with the definition of PoR and set out some key information. In regular banking or business, reserves are the revenue a firm sets aside as a reserve in case of a potential loss. They get audited from time to time to ensure solvency.
In crypto, there is a similar kind of review known as Proof of Reserves (PoR). It is defined as a fully independent audit carried out by an outside party to confirm that the project/firm/entity that is being examined has sufficient reserve funds to support the balances of all depositors.
With PoR, an exchange or a crypto custodian can prove to the public that they have enough funds to swap, withdraw, or convert at any given point in time. With the increased trust it brings from the public, a company that successfully undergoes a PoR audit can quickly attract new clients. The positive impact is beyond that because it also helps retain current clients along with other shifts. It might not result in exponential growth right away, but it certainly lays the foundation for this kind of boost.
What Is Proof of Reserves and How It Works
The second step in understanding how Proof of Reserves works is to make sure you have a basic grasp of the process itself. It is not really complicated, since this kind of audit, in most cases, can only go two ways: either there is sufficient solvency, or there isn’t. The audited exchange either has enough funds to meet long-term debts and other cryptocurrency obligations, or it does not.
The only exception to the above is fractional-reserve banking. With this system, only a portion of the crypto funds is kept as a reserve, and the rest is lent to borrowers.
Main Steps of the Process
To make it easier for you, let’s break the process down into three steps:
Step 1: Proof of liabilities. In accounting, a liability is a future financial obligation to other entities or people based on past transactions or events. So, liabilities here are presented in the form of the outstanding crypto balances owed to the users. In this step, financial health is calculated based on the sum of all client balances, fraction factor hash, and the root of a Hash/Merkle tree.
Step 2: Proof of reserves. This is where the sum of all account balances is calculated. The audit program that they run during this step is very nifty – it does not have to examine the entire blockchain; it utilizes a time- and resource-saving precompiler instead.
Step 3: Proof of solvency. The final step involves confirming that all software was run in an environment with a sufficient level of trustworthiness. At the end of the audit, you will be presented with two options – either liabilities (future financial obligations) exceed liabilities, or they don’t. If they do, then the audited platform is in bad shape and poses high risks to users, shareholders, and the company itself.
Carrying Out a Proof of Reserves Audit
The first thing to establish is that it is always a third party that carries out the audit. When auditing a platform, you can’t have ties with them: not directly or indirectly. Here are the steps that an auditor takes during the process:
A third-party auditor or auditing company takes a snapshot of the platform’s balances. All depersonalized, of course. The balances are then fitted into a hash tree containing key custodial data.
Individual contributions from clients are gathered. It is done using their unique signatures.
The final step is confirming that the cryptocurrency assets of the clients are in full-reserve status, meaning that indicated crypto balances are, at the very least, equal to those fetched from the hash tree data.
Upsides of Conducting This Type of Audit
You now know what PoR entails and how it is carried out. Now, it is high time for you to learn about the main advantages of this audit method. Audited companies will enjoy the following benefits:
Simple method of restoring faith. Even if an exchange’s reputation took a hit, most users are willing to look the other way if everything is in order on the financial side of things.
Opportunities to improve. An audit can expose issues with your recordkeeping systems or any other internal issues that have the potential to affect the business adversely and should be addressed in time. When you fix them, you are on the path to improving quality for customers.
The biggest benefits to users include:
Great way to confirm your cryptocurrency assets are safe. Mismanagement of funds is a huge issue in the field of digital money. PoR audit confirms that the funds aren’t being used to generate additional profit for the company.
Easier to choose a platform to entrust your money to. With a reliable PoR practice, the exchange will look more attractive, so it will be easier for you to make a final decision.
Ability to monitor actual records of your crypto transactions. Not only that but it can be done in a quick and convenient way.
Frequently Asked Questions
The Merkle tree was named after Ralph Merkle. Some people call it a hash tree. It is a tool that makes it possible to consolidate huge amounts of data into a single hash. This hash (Merkle root or hash root) acts as a crypto seal that provides a summary of all the data inputted. Related to PoR, a hash tree represents the sum of all user balances.
Proof of reserves is a cryptographic proof used to achieve verifiability in a blockchain environment. It is an audit that takes place on a specific platform and is carried out by third parties. The main goal is to verify that there are enough reserves to at least cover the sum of all balances.