What is a Proof of Reserves? How does it ensure asset security and transparency?

Whether it's traditional banks or cryptocurrency exchanges, the most concerning issue for users is whether they can withdraw funds at any time. Let's take a look at the deposit reserve system adopted by traditional banks and the 100% reserve proof in the cryptocurrency industry, and explain in detail how these two systems ensure user withdrawals.

Fractional Reserve System and Run on the Bank

The reserve requirement refers to the cash reserves that financial institutions must hold to ensure customers can withdraw funds. The reserve ratio is the proportion of this amount to the total deposits. For example, if Alice deposits $1,000 in the bank, and the current reserve ratio is 10%, the bank can use $900 of Alice's deposit for loans or financial investments, keeping the remaining $100 as reserves to ensure that Alice's withdrawal is not refused due to insufficient cash.

Assuming there are 10,000 users like Alice depositing $1,000, a 10% reserve ratio would allow 1,000 users to withdraw simultaneously. Since large-scale withdrawals occurring in a short period are relatively rare, a reasonable reserve ratio can usually operate normally.

A run occurs when a large number of depositors withdraw funds from a financial institution simultaneously due to market panic or concerns that the bank may go bankrupt. When the bank runs out of cash, it faces the risk of bankruptcy. Therefore, during a run, banks may suspend withdrawals or seek government assistance. Many countries, including the United States, Russia, and the United Kingdom, have historically experienced runs.

100% reserve proof in the Crypto Assets industry

Some exchanges mistakenly believe they can use deposits at will like traditional banks, which has led to the misuse of user assets in the industry we see today.

When a run on the bank occurs, even with deposit insurance, there is no guarantee that customers can withdraw their funds immediately. Major traditional banks may go bankrupt during a bank run. Similarly, crypto assets exchanges cannot rely on a fractional reserve system to protect user funds' safety. Only financial institutions with a 100% reserve ratio can cope when a large number of users withdraw deposits simultaneously.

To ensure the safety of user funds, cryptocurrency exchanges should maintain a 100% reserve and hold actual asset reserves for the withdrawal of funds such as BTC/ETH/USDT. A 100% reserve proof refers to the evidence that the exchange maintains a 100% reserve ratio, and that proof is transparent and verifiable.

How to use Merkle trees and signature verification for proof of reserves?

100% reserve proof requires three steps:

1. Disclose the total amount of assets deposited by all users in the exchange;
2. Disclose the number of assets available for withdrawal from the exchange;
3. Compare the total deposits of users with the total assets of the exchange to verify the reserve ratio.

The commonly used auditing method in the first step is the Merkle tree. The Merkle tree is a hash-based data structure. As shown in the figure below, the hash nodes at the bottom contain the user's account name and balance data. For example, user1 has 1.023 BTC and 1.131 ETH. The parent node can be calculated based on this data as Hash(user1). The Hash(user201 on the sibling nodes along the path can be used to calculate Hash)user12(, and then the root node can be calculated accordingly as Hash)user1234(.

The Merkle tree

If the Merkle tree omits or alters user1's data, all parent node calculation results, including Hash)user1( and Hash)user12(, will change. The final value of the root node Hash)user1234( will differ from what the exchange publishes. Users will immediately notice that the exchange has tampered with the data. This user self-verification model can effectively prevent the exchange from fabricating user total asset data.

For the second step, use asymmetric encryption algorithms for signature verification. It is well-known that Crypto Assets addresses are generated by algorithms through the encryption process from private keys to public keys. Therefore, the exchange can encrypt messages using the private key to generate signatures, and users can decrypt the original message using the signature and address (public key). In this way, it can be verified that the exchange holds the private key of that address.

address的私钥

Merkle trees and signature verification processes are based on irreversible algorithms, which can effectively ensure the authenticity of the data. After verifying the authenticity of the user's total assets and the assets held by the exchange, these two data points can be compared. When the assets held by the exchange are greater than or equal to the user's total assets, it proves that the exchange maintains a 100% reserve ratio.

The reason for 100% reserve proof

Proof of reserves can help improve transparency, benefiting both the industry and users )$SATS **$CTSI **