What is Proof of Reserves?

What are Reserves?

In traditional banking, reserves are funds that banks set aside to ensure that customers can withdraw their money when needed. Most banks use a fractional reserve system, where only a small portion of customer deposits are held in reserve, with the rest loaned out to earn returns. This model, however, has its risks; if too many customers withdraw at once, a bank may lack the funds to cover all withdrawals, leading to a bank run.

A full-reserve model, in contrast, means a bank or financial service provider keeps 100% of customer deposits on hand, enabling clients to withdraw their funds at any time without fear of a liquidity crisis.

What is Proof of Reserves (PoR)?

Proof of Reserves (PoR) is a transparency measure that allows financial institutions, particularly in the Bitcoin and crypto sectors, to prove they hold sufficient assets to cover all customer deposits. For Bitcoin-related companies, PoR has become a crucial tool for assuring customers of solvency and transparency, especially given the public nature of the Bitcoin blockchain.

Through PoR, companies publicly demonstrate that they are financially prepared to honor customer withdrawals, building trust and accountability.

How does Proof of Reserves work?

For a successful PoR, a company must prove it has enough assets (reserves) to cover its liabilities (customer deposits). This process generally involves two steps:

1. Proof of Assets: The institution publicly shares a list of all its wallet addresses, allowing anyone to view and verify its Bitcoin holdings. To ensure that these addresses belong to the institution, it might also conduct a verification process, such as signing a message to prove ownership.
2. Proof of Liabilities: Liabilities represent the total of all customer deposits. To make it possible for every customer to verify his balance, Merkle Trees are used. They keep the balance private and make sure the customer can only check his own balance.

By comparing assets to liabilities, an institution’s reserve ratio is determined. A ratio of 100% or more confirms full reserves, while a higher ratio indicates the institution holds extra assets beyond its obligations.

What are the Limitations of Proof of Reserves?

While PoR enhances transparency, it has certain limitations:

• Snapshot Nature: PoRs are usually conducted periodically, so customers only see a “snapshot” of the company’s reserves at that time. This doesn’t guarantee reserves will always be adequate in real time.
• User Verification Requirement: For PoRs using Merkle trees, user participation is essential. If users don’t verify their balances, hidden liabilities could go undetected.
• Additional Liabilities: A PoR only covers customer balances and does not account for other institutional liabilities, like loans or debts. In the case of insolvency, users may not always be the first to receive funds.

Final Thoughts

• Reserves ensure liquidity, providing assurance that customers can withdraw funds when needed.
• Proof of Reserves (PoR) enables companies to publicly prove they have sufficient assets to cover all client deposits
• Limitations of PoR include its reliance on periodic snapshots, user participation for liability verification, and its focus on customer liabilities without considering other debts.