Liquidity risks associated with cryptocurrency exchange services

What are Proof of Reserves?

"A Proof of Reserves (PoR) is an independent audit conducted by a third party which seeks to ensure that a custodian holds the assets it claims to on behalf of its clients. This auditor takes an anonymized snapshot of all balances held and aggregates them into a Merkle tree — a privacy-friendly data structure that encapsulates all client balances.

From there, the auditor obtains a Merkle root: a cryptographic fingerprint that uniquely identifies the combination of these balances at the time when the snapshot was created."

Source: Kraken

"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:

  • Will not secretly park your coins in a third party
  • Is actually in custody of your trading funds/assets–which means you can withdraw them anytime you want"

Source: Phemex, last revised 9 Nov 2022

FinReg business tip

Following the collapse of FTX, cryptocurrency exchanges are looking to demonstrate transparency and credibility to its users with Proof of Reserves. As a user, this is one way for you to assess the safety and security of your chosen exchange and - by extension - your crypto assets. However, a PoR should not be a your consideration for security.