What are Proof-of-Reserves?

Proof-of-Reserves?(PoR) provides an audit of customer funds within an exchange. The audit is conducted via Merkle Trees and has become an essential part of the operation of an exchange.

Following November 2022 and the FTX collapse, cryptocurrency exchanges rushed to provide proof that customer funds were safe. It is essential customer assets are kept entirely separate from business funds and each customer has their funds backed 1:1.

The collapse of FTX left customers in limbo. There was little clarity on which exchanges were legitimate and which were not. In light of this, exchanges began to conduct internal audits with?PoR?and provide the relevant information to demonstrate a strict and appropriate operation.

Merkle Trees

A?Merkle tree?facilitates high-speed data transmission and collation in a decentralised process. A Merkle tree is a hash-based mathematical structure that organises data into blocks that can be linked back to the previous data input. Due to this, they are beneficial for data provenance and transparency.

A Merkle tree is also known as a hash tree which has branches that pass on data throughout the system. Transactions pass up the tree structure via Leaf Nodes, each of which has its own unique hash before being compiled to form a singular hash in a Non-Leaf Node. These Non-Leaf Nodes then create the Merkle Root, which groups sets of transactions under one hash.

Transactions start at the bottom of the Merkle tree solo before forming the two group hashes in the node segments.

Leaf Nodes represent the transaction ID or the hash of a transaction. Even when the transactions are paired together, each transaction still has its own hash, such as the one viewable on Etherscan.

Non-Leaf Nodes are the result of pairing Leaf Nodes together. As each transaction hash is located within the Leaf Nodes, the Non-Leaf Nodes simply represent the grouping of transactions. Due to the formation of Non-Leaf Nodes, there is half the amount of Leaf nodes as the Merkle tree’s objective is to compile transactions into blocks.

The Merkle Root is the epicentre of the system. It acts as the locator for all pieces of information via the Leaf Nodes. The Merkle Root ensures the Non-Leaf hashes are grouped to form a root hash at the top of the system.

Due to the Merkle tree’s efficient design, transaction verifications can be completed promptly and transparently.

Utility in Proof of Reserve

Merkle trees used for?Proof of Reserve?audits are variations of a typical?Merkle tree. Users who want to verify their account balance request the information to be pulled from the tree. The system does this by directing the request from the Merkle Root downwards to the Leaf Nodes, which hold the individual transactions.

The Merkle tree uses two critical data pieces to determine each user’s account balance: Balance Data and Hash Data.

Users can self-confirm their data for exchanges that have fully integrated Merkle trees. It can show users exactly where their hash data is stored in all stages of the Merkle Proof.

Adopting Merkle trees allows exchanges to be transparent and for users to know their funds are safe and are not being mismanaged or comingled. This is imperative as the one thing the industry requires moving forward is trust.

Without Merkle trees, PoR would not be possible. It has become an integral role and system within cryptocurrency. But it isn't just exchanges that Merkle trees are helpful for; any peer-to-peer blockchain can use them for data grouping and organisation in a transparent, decentralised manner.

For example, Merkle trees are utilised within the Bitcoin Network as the trees play a role within each block as every transaction has a unique hash, but they are also placed within blocks with the Merkle tree placing each hash in the header. Merkle trees are also used in Bitcoin mining as it allows miners to hash the header instead of each transaction in the block. Merkle trees are also active within the Ethereum blockchain via Etherscan, which allows anyone to view any transactions publicly and see the status and transactional data.

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