Sign UpWhat Is Merkle Tree and Proof of Reserves?
BlockchainBeginner
2024-10-29
Many well-known centralized exchanges have announced to publicly provide their Merkle Tree reserves in an effort to promote further transparency since the previous FTX collapse, which had snowball effects that reverberated throughout the entire crypto industry. To reaffirm its dedication to openness and security, Toobit has released the latest proof of reserves and boasts a total asset of $10,619,691 at the beginning of October.
What is Proof of Reserves?
Proof of Reserves tackles the issue of asset transparency for exchange-held assets. It is an essential method of verification to make sure that cryptocurrency is backed by tangible assets. Merkle trees are a type of data structure used in the Proof of Reserves algorithm to securely encrypt blockchain data.
What is a Merkle Tree?
A common binary tree structure called a Merkle Tree (hash tree) consists of a root node, a number of intermediate nodes, and several child nodes.
Working Principle :
Let's take a look at how a Merkle Tree works before going into how a Proof of Reserves audit works.
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A data structure is like a tree with a root node and child nodes. Nodes and all data processing are hierarchical.
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Front and rear node verification is necessary while delivering data results layer by layer from bottom to top.
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It converts the block contents into a hash value using the hash algorithm. The hash value also changes as the block contents do.
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The Merkle root stores the hashes of every child node whereas the child nodes can be added indefinitely if the data expands rapidly.
Using the Merkle tree, a logical and interconnected data structure was created. Each child node’s data modification will immediately result in a changed root hash. We can verify that the data hasn’t been changed or tampered with by comparing this root hash with the one supplied by the source.
Now, let’s deep dive into how Proof of Reserves work
A Proof of Reserves audit indicates that an exchange is collaborating with a third-party crypto auditor to ensure that it has assets on its balance sheet and that customer holdings are balanced. This is to ensure that customer funds are not misappropriated and that the cryptos held are backed by real assets. These third-party reports are reconciled cryptographically, ensuring privacy and security.
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A Merkle tree is created by the third party using the information on all of the retained balances.
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The balances of all the accounts used are then added together and uniquely identified by a Merkle root that is then obtained.
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The exchange’s digital signatures are used to verify these balances on public blockchains where assets are stored.
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The balance information and asset information on public blockchains are validated. These figures should be in balance to ensure consistency.
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Additionally, systems will be set up so that clients may verify the validity of the assets they own.
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The Merkle root will be affected by any data changes, which might indicate suspected asset manipulation.
The Benefits of Proof of Reserves
It is crucial to have checks and balances in a decentralized environment like crypto, where systems are ideally built not to have a single point of failure. Traditional financial firms have also experienced bankruptcy in some cases.
However, governments bailed out these institutions in the majority of situations. The benefit of having government institutions bail them out in the event of bankruptcy is not available to crypto organizations.
Thus, the "Proof of Reserve” approach combines the finest aspects of both asset management transparency and client asset privacy.
Proof of Reserves Limitations
Transparency in audits and money verification is assured by proof of reserve. It does, however, have a few drawbacks.
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Proof of Reserve can demonstrate control over on-chain data and the money that is being kept, but it is unable to establish the exclusive possession of a private key.
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There is a chance that the auditor and the auditee will work together. However, both parties are accountable for ensuring openness.
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Loss of keys and missing money might reveal discrepancies in the verification process, and the Proof of Reserves procedure cannot reveal whether an exchange has borrowed money to pass an audit.
Conclusion
Market confidence in the crypto space is constantly restored by programs like the Proof of Reserves. Even while it has its own unique set of execution difficulties, it’s unquestionably a strategy that is for the greater benefit. Although improvements in the future may approach even better, it is a crucial starting point for safeguarding investors' assets.
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