FTX’s collapse elicited growing calls for centralized exchanges (CEXs) and custodial crypto services to prove that they actually hold the customer funds and aren’t deploying them elsewhere. One way they can do this is by providing Proof of Reserves. 

This article will explain what Proof of Reserves (PoR) in crypto are, how they work, and their importance in the sector.

What Is Proof of Reserves?

PoR is the practice of determining a centralized exchange’s financial soundness. It’s a deliberate effort by a CEX to prove the assets it claims to hold on its customers’ behalf and reassure customers of its solvency.

Typically, the CEX engages an auditor to conduct an unbiased review of its resources. The auditor will list the exchange’s assets and liabilities and determine the difference. A positive result proves that it can adequately cover customer balances.

PoR analysis is crucial in building trust between customers and the exchange.

How Do Proof of Reserves in Crypto Work?

PoR in crypto can be conducted in any of the following three ways:

Public Wallet Scrutiny

The first is allowing users and regulators to access the CEX’s wallets. It does so by signing a transaction to prove ownership of the private keys to its crypto wallets. This way, the interested parties can view its balances to see if they match its claims.

A benefit of this method is that it is straightforward. Additionally, users can detect any irregular falls in the balances, which could point to possible fraud. 

The downside is that a CEX’s wallet balances don’t give much information regarding its management of customer funds. Again, they don’t show the exchange’s liabilities, a critical component of determining any firm’s solvency.

Instituting Independent Audits

Exchanges may also choose to engage an impartial third party to audit its reserves. The auditor begins by documenting all of the customers’ balances. They also list the CEX’s assets and any debt(s) they may owe. 

The auditor will then add the customer funds to the exchange’s assets and subtract the liabilities from this new figure. A positive difference will prove that the CEX is a going concern.

Besides ascertaining the CEX’s financial soundness, the auditor also determines if it has followed proper bookkeeping procedures. This is important as it helps identify irregularities. 

While such audits prevent record tampering, they aren’t without their downsides. For example, they lack real-time authenticity. These reports can only be valid at the audit time and may be overtaken by events in a highly dynamic sector such as crypto. 

The Merkle Tree Approach

The third option entails using Merkle trees to carry out a PoR audit. These hierarchical data structures validate block transactions and customer holdings without revealing their balances. Central to these is the Merkle root, a hash that uniquely identifies any transaction block.

To do this audit, the CEX first creates a Merkle tree that’s a snapshot of its financial position at that time. It does that by aggregating all the assets and liabilities within its hold. It then provides the customers with the Merkle root hash. 

Likewise, it will give them their leaf hashes and cryptographic functions related to their wallet balances. Any customer can work out the Merkle root using the given Merkle proofs. A match in the hashes proves that a given transaction, in this case, their account balance, is part of the provided data.

Why Do Proof of Reserves Matter in Crypto?

PoR helps users ensure the security and trustworthiness of CEXs and other custodial crypto services. 

Without these audits, customers struggle to determine if an exchange holds the assets it claims to have. This can create loopholes for the platforms to engage in risky activities or fraudulent behavior. 

The reviews mitigate that risk by enabling an audit of crypto exchange holdings. They do so by having third parties examine their on-chain balances. 

Moreover, PoR checks promote stability within the cryptocurrency industry. Through them, exchanges can demonstrate that they are operating transparently. The audits help attract new users to the industry, encouraging wider adoption of digital assets.

Benefits and Limitations of PoR

PoR audits offer benefits and limitations. Here’s a look at the pros and cons.


  • Enhances transparency and accountability: CEX users get an inside view of the exchange’s or crypto custodian’s financial standing to verify that they hold the claimed assets.
  • Boosts trust: Crypto investors are more likely to trade with exchanges open about their financial health. 
  • Reduces risk of fraud: Frequent PoR analysis helps deter fraud to the customers’ benefit. Genuine CEXs will, therefore, pull all the stops to safeguard their images, including protecting customer funds.
  • Promotes market confidence: PoR reviews help dissuade FUD as an assurance that customer funds have adequate backing encourages increased investor confidence. 


  • Technical complexity: Adopting and maintaining a sound PoR system can be technically challenging and expensive, which could be an issue for budding exchanges with limited funding.
  • Limited scope: Any PoR audit is time-specific. There are no assurances, therefore, that the CEX will remain a going concern. Additionally, real-time verification might be difficult due to the dynamism of the crypto market.
  • Focus on reserve: While justifying an exchange’s asset holding, PoR checks don’t address its liquidity. They may not accurately measure how readily customers can access their deposits.
  • Potential for manipulation: CEXs can use unconventional means to pad their figures. They may also collude with unscrupulous auditors to give the wrong impression about their solvency. 

The Bottom Line

Proof of reserves audits are essential for building trust, transparency, and security in the crypto ecosystem.

While they have their limitations, they provide a valuable mechanism for verifying the solvency of cryptocurrency exchanges and custodians. Users should carefully consider the PoR practices of an exchange before depositing funds.