Blockstream — a leading Bitcoin development company — recently introduced a new standard for the cryptocurrency exchange industry for proving Bitcoin balances to third-party auditors that improve upon the currently fragmented in-house models.
Called ‘Proof of Reserves’ (PoR), the standard is open-source, and a BIP proposal has already been submitted to the Bitcoin developer mailing list. The standard is designed to make the auditing process much more efficient and compatible for exchanges to build trust with their users while offering users and third-parties more effective methods for validating Bitcoin balances.
How Proof of Reserves Works
The PoR method was initially conceived by the Blockstream team while they were looking to provide an auditability feature for their Liquid sidechain project. Historically, the lack of standardization in proving balances of exchanges has led to independent, in-house initiatives by exchanges, creating both problems for the exchanges and users.
Proving reserves currently requires exchanges to demonstrate ownership of funds by moving them between wallet addresses, presenting attack vectors that may compromise the secure storage of funds. Similarly, the disparate techniques for proving reserves requires users and third-parties to input extensive technical effort to understand how the auditing process for specific exchanges work.
Blockstream’s PoR standard would enable exchanges to prove ownership of bitcoins by creating a transaction that spends all of the exchange’s Bitcoin UTXOs, but cleverly adds in a single invalid input, and consequently, the network would reject the transaction. The exchange would not have to generate a live transaction that actually exchanges funds to a new address — reducing attack vectors.
The standard can run through a CLI application and can be trivially verified by any third-party.
However, a problem that Blockstream is still addressing is the fact that using the PoR method would expose all of the exchange’s Bitcoin UTXOs, which could reveal too much financial information. Blockstream notes that using the Confidential Transactions in Liquid, exchanges would be able to mask the list of UTXOs retained by them. Additionally, they have already begun working on several methods for enhancing the privacy of the process as well.
Blockstream is expecting to roll out PoR as a feature for Liquid participants and will provide technical support for using the tool.
Standardized practices are increasingly emphasized in the cryptocurrency market as the industry transitions to more regulatory oversight and transparency. Blockstream’s proposal for PoR presents a significant step in that direction and will be pertinent to watch as it develops among participants using their Liquid sidechain.