Cryptocurrency exchange Binance has launched a new website that explains its Proof of Reserves system.
Why is it needed?
The popular crypto exchange FTX collapsed two weeks ago due to a liquidity crisis. As a result, the exchange stopped processing client and investor withdrawals. As FTX’s collapse led to a lot of distrust in the cryptocurrency community, crypto exchanges, including Binance, began offering more information about how they handle people’s funds.
What is Proof of Reserves?
Proof of Reserves is one of the ways in which Binance offers transparency to users. It refers to an independent audit conducted by a third party to verify the assets that are held in users’ custody.
Proof of Reserves shows that Binance has funds that cover “all of our users’ assets 1:1, as well as some reserves,” the company’s website says. Reserves are cryptocurrencies or other types of assets that offer liquidity. It tells users that the company can sell its assets to cover withdrawals if needed, regardless of market conditions. It also shows that Binance has slightly more controlled bitcoins in its wallets than the amount deposited by users.
Binance clarified that these figures do not include corporate holdings, which are stored in a separate blockchain. Binance also claims to have zero debt in its capital structure and a reserve fund for emergencies.
How does it work?
To show evidence of users’ assets, Binance uses a Merkle tree (also known as a hash tree) that allows people to verify the assets they hold on the platform. The verification is done by a third-party auditor. The auditor takes an anonymized snapshot of all customer balances and combines them into a graph that shows all balances at the time the snapshot was created, without revealing any personal information.
What are the drawbacks?
While Proof of Reserves provides some financial transparency, there are a few drawbacks to the system. It only shows assets that are on the blockchain and does not disclose any off-network activity that may be occurring. Besides, it is just a single snapshot, not an ongoing update of balances. Moreover, it does not disclose where the balances are coming from or whether they are borrowed for auditing purposes.
