Proof of reserve is the process of verifying that the assets that customers hold on the exchange are the same as the assets the exchange holds in its reserves. While people started to pay more attention to Proof of Reserve after the FTX collapse, even before that, this was the most popular method for investors to make sure that their funds were stored properly and not spent by the exchange. It’s also a great tool for exchanges to prove that they are not spending users' funds and are able to satisfy the withdrawal requests with their liquidity. Otherwise, they might suffer the same fate as FTX.

Proof of Reserves can be calculated and published by exchanges themselves, but for more transparency, these are done by third parties. This makes sure that exchanges don’t lie about their holdings and gives people concrete evidence that exchanges have enough liquidity in their reserves that they can satisfy the withdrawal needs, even if everyone decides to withdraw at the same time. 

This is a win-win situation for both exchanges and customers and helps to create a partnership that’s based on truth rather than promises. With this, exchanges can prove that they are storing everything users deposit on their platform and don’t spend it recklessly as FTX did. And customers are assured that their funds are kept safe and in case they want to cash out, they will not run into any problems.

When storing cryptocurrencies, we have many different options that give us safety and full control over our funds. Non-custodial hot wallets, like MetaMask, and cold wallets, like Ledger, all give us an opportunity to store our cryptocurrencies so no one has access to them. But despite this, the majority of people still prefer to store their assets in custodial wallets provided by crypto exchanges. These wallets are highly protected by exchanges themselves and also bring comfort to users. When you store your assets on an exchange's wallet, you are able to easily trade with them and also give these tokens other utilities such as staking or providing liquidity. But with last year's collapse of the FTX, a lot of people started to question if it’s the best decision to keep funds on these exchanges. Because of this, Proof of Reserve audits have become a go-to strategy for these exchanges to prove that they are storing users' funds in a safe place and are not spending or lending anything out. But how are these audits conducted?

The audit starts with a third-party auditor looking at the total amount of deposits made by customers. Also called liabilities that exchanges owe to customers. After this, the exchange will provide a digital signature to the crypto wallets that hold these funds and then it’s time to compare these two numbers. The auditor will compare these two numbers and make sure that reserves at the very least match the liabilities, meaning that the exchange has the ability to satisfy withdrawal requests from everyone. 

While this is enough to confirm that the exchange has enough funds, some exchanges go even further in order to build better trust with their customers. When this audit is being conducted they build a table that contains information about every customer and with this information, audits can confirm that no user has been left out. Users themselves are also provided with the pathway to their place on the table, and with this users can also make sure that their funds were counted towards this Proof of Reserve. 

While discussing the Proof of Reserves, we also need to touch on liquidity. While these two share similarities and are connected with each other, there are still differences between them. Proof of Reserves verifies that the exchange is keeping every user's fund and is not spending it, but these reserves can be diverted toward liquidity. Liquidity is the ability of the exchange to provide a smooth and fast trading experience. 

Liquidity is very important in crypto trading. When trading cryptocurrencies, there are traders who are making multiple trades throughout the day and there are those who hold their cryptocurrencies for long periods of time. But irrespective of which type of trader it is, every trader values the speed of the market and how fast their trades are executed. Liquidity is what provides this execution speed and market flow and it is in direct correlation with reserves. 

Exchanges usually use these reserves as a sort of liquidity and move the funds around in order to make sure that every trader is satisfied with their trading experience. But reserves are not the only thing that contribute towards liquidity and in fact, if the exchange provides the liquidity only from reserves deposited by users, it’s not a good sign. Most exchanges will have other additional funds that are counted towards liquidity and these funds are acquired through different means.

Some exchanges provide liquidity themselves, meaning that they go out and spend their own money to get some cryptocurrencies and put these funds towards liquidity. There are also exchanges that give users the option to provide liquidity on which these users then earn monthly returns. 

Proof of Reserves has become one of the most important factors that determine crypto exchange status. When we are choosing which exchange to use, it’s a very good practice to check if the exchange in question has a proof of reserves publicly in place. You can do so by going to websites such as CoinMarketCap and checking the exchanges section. There you will be able to see which exchanges have proof of reserves and you can even see these reserves yourself.

But we also need to mention that if an exchange has proof of reserves, it does not automatically guarantee that your funds will be safe. When proof of reserves is released, we can see that this exchange actually holds these funds at that given moment. We can also periodically check if these funds are still there, how much was added or removed, and what coins are in reserve at any given time. But this does not stop exchanges from suddenly transferring these funds somewhere else or spending them. While it’s illegal to do so, taking a look at FTX we can see that’s not something that will stop exchanges from doing so. Because of this, proof of reserves is not a guarantee of your safety, but a simple tool that can be used to constantly assess and monitor the situation.