Proof-Of-Reserves Audits: Explaining Tool's Best Features

Proof-Of-Reserves Audits: Explaining Tool's Best Features

In the wake of major exchange failures like FTX, Proof-of-Reserves (PoR) audits have emerged as a crucial solution for enhancing transparency and security in the cryptocurrency industry. Using Merkle trees and zero-knowledge proofs, PoR audits verify that an exchange holds sufficient assets to cover customer deposits—providing users with greater confidence in platform solvency.

While PoR shares similarities with traditional banking regulations, it still faces challenges in verifying liabilities and maintaining real-time accuracy. This article explores how PoR audits work, their advantages, and their evolving role in reinforcing trust within the crypto ecosystem.

Understanding Proof-of-Reserves (PoR) Audits

As the cryptocurrency industry evolves, Proof-of-Reserves (PoR) audits have become a vital tool for ensuring transparency. These audits help verify that crypto exchanges and custodians hold enough assets to cover user deposits, reducing the risk of insolvency and restoring trust among investors. By leveraging cryptographic proofs, Merkle trees, and on-chain verification methods, PoR functions similarly to capital adequacy requirements in traditional finance.

In traditional banking, financial institutions are required to maintain capital reserves to absorb potential losses and ensure operational stability. The 2008 financial crisis underscored the need for such safeguards, prompting regulatory bodies to introduce stricter financial oversight measures like Basel III, which enforces:

• Common Equity Tier 1 (CET1) – Ensuring banks hold a minimum level of capital to withstand financial shocks.
• Leverage Ratio – Limiting excessive risk-taking by controlling how much a bank can leverage its capital.
• Liquidity Coverage Ratio (LCR) – Ensuring banks have sufficient liquid assets to manage short-term financial stress.
• Net Stable Funding Ratio (NSFR) – Encouraging long-term financial stability by requiring banks to use reliable funding sources.

Inspired by these traditional financial safeguards, PoR audits bring a similar level of accountability to the crypto industry. Unlike traditional banking, however, PoR audits rely on blockchain-based verifications, offering real-time transparency instead of periodic regulatory reviews.

Through cryptographic audits, exchanges can demonstrate their solvency by proving they hold the assets they claim. Some PoR audits report reserves in dollar equivalents, while others display holdings in major cryptocurrencies such as Bitcoin (BTC) and Ethereum (ETH). Regardless of the format, PoR audits offer users a crucial layer of confidence in the security of their funds.

How Proof-of-Reserves Audits Work

Proof-of-Reserves (PoR) audits use advanced cryptographic techniques to verify that crypto exchanges and custodians hold enough assets to cover user deposits. However, while they confirm asset reserves, they do not account for hidden liabilities, meaning they do not provide a full picture of an exchange’s solvency.

The PoR process generally follows these steps:

1. Asset Verification – Exchanges disclose wallet addresses or use cryptographic proofs like Merkle trees to confirm holdings without revealing sensitive information.
2. Merkle Tree Authentication – User balances are hashed and aggregated into a single Merkle root, allowing both auditors and users to independently verify reserves.
3. Third-Party Auditing – External auditors assess whether the reported reserves match the exchange’s actual holdings.
4. Customer Liability Verification – Ensuring that total deposits do not exceed available reserves, reinforcing trust in an exchange’s financial stability.

The Evolution of PoR: Zero-Knowledge Proofs (ZK-Proofs)

While Merkle tree-based audits improve transparency, they have limitations—they cannot confirm whether an exchange has hidden liabilities. To solve this, Zero-Knowledge (ZK) proofs are being explored as a more private and secure alternative.

ZK-proofs enable exchanges to mathematically verify they are fully backed without exposing individual account balances or wallet addresses. This enhanced PoR method would allow platforms to prove that their reserves exceed liabilities, moving the industry toward a Proof-of-Solvency standard.

Although ZK-proof-based PoR systems are still in early adoption, several blockchain projects and exchanges are actively experimenting with them. If widely implemented, they could prevent misleading reserve claims, like those seen in the FTX collapse, and strengthen long-term trust in crypto exchanges.

By combining Merkle trees with ZK-proofs, the industry could establish a more robust and transparent audit framework, ensuring not only that reserves exist, but also that exchanges do not carry undisclosed debts—a critical step in making crypto platforms more secure for users.

Limitations of the Proof-of-Reserves Approach

While Proof-of-Reserves (PoR) audits provide greater transparency by confirming that crypto exchanges hold sufficient assets, they also have significant shortcomings that can create a false sense of security for investors. These limitations highlight the need for more comprehensive financial audits in the crypto industry.

1. Exclusion of Liabilities

One of the biggest flaws in PoR audits is that they only verify an exchange’s assets without accounting for its liabilities. This means that while an exchange may appear to have adequate reserves, it could still be deeply in debt due to hidden loans, outstanding obligations, or leveraged trading positions.

A prime example is FTX, which misled users by showcasing its assets while concealing the massive liabilities it owed to creditors and customers. Without a simultaneous Proof-of-Liabilities (PoL) audit, an exchange can present a strong financial position while actually being at risk of insolvency. A truly effective audit system must incorporate both assets and liabilities for a complete picture of financial health.

2. Snapshot Audits and Ongoing Solvency Risks

Another critical limitation of PoR audits is that they only provide a one-time snapshot of an exchange’s financial position at a specific moment. However, this does not guarantee ongoing solvency, as an exchange could pass an audit today but deplete reserves tomorrow through fund withdrawals, riskier lending practices, or hidden liabilities.

For instance, Binance faced criticism in December 2022 when it released its first PoR audit, as the report only reflected a single point in time rather than providing continuous monitoring. In traditional finance, banks undergo regular regulatory oversight, stress tests, and liquidity checks, ensuring ongoing solvency—a standard that crypto exchanges currently lack.

Although some firms, like Nexo, introduced real-time PoR tracking in 2021, the initiative was discontinued in 2024 due to auditor limitations. This underscores the difficulty of maintaining consistent financial transparency in the crypto industry.

3. Dependence on Third-Party Auditors

PoR audits heavily rely on third-party auditors, meaning their accuracy and effectiveness depend on the credibility and independence of the auditing firms conducting them. Some exchanges have even opted for internal audits, raising concerns about objectivity and transparency.

A notable example is Mazars Group, which provided PoR reports for Binance and Crypto.com in 2022 before abruptly ceasing all crypto audit services due to concerns over process reliability. This incident highlighted the lack of standardized, independent auditing frameworks in the crypto space, emphasizing the need for stronger regulatory oversight and more reliable financial reporting practices.

The Need for a More Comprehensive Audit System

To truly enhance financial transparency, the crypto industry must move beyond basic PoR audits and develop a more robust system that includes:

• Proof-of-Liabilities (PoL) audits to prevent misleading financial statements.
• Real-time reserve tracking to ensure exchanges remain solvent between audits.
• Independent, standardized auditing frameworks to increase credibility and trust.

Without these improvements, PoR audits risk becoming little more than a public relations tool, rather than an effective method of ensuring financial stability in crypto exchanges.

Final Thoughts

While Proof-of-Reserves (PoR) audits have become an essential tool for improving transparency and trust in cryptocurrency exchanges, they are not without flaws. These audits confirm that an exchange holds assets but fail to account for liabilities, meaning they cannot guarantee solvency. Additionally, PoR audits are often one-time snapshots, leaving room for financial manipulation between audit periods.

For PoR audits to be truly effective, the crypto industry must adopt more comprehensive financial assessments, including Proof-of-Liabilities (PoL) audits, real-time tracking, and independent oversight. By integrating these improvements, crypto platforms can offer stronger financial transparency, ensuring greater security for investors and users alike.

As the industry evolves, more reliable auditing frameworks will be crucial in shaping a safer, more accountable crypto ecosystem.