Like any other currency, cryptocurrency is subject to fraud and theft. Unlike fiat currency, however, cryptocurrency is not regulated by a central government or financial institution. This makes it particularly vulnerable to bad actors who may try to take advantage of investors.
One way that crypto exchanges can protect themselves—and their investors—from fraud is by having proof of reserves. Proof of reserves is a way of demonstrating that an exchange actually has the amount of cryptocurrency it says it does in its wallets. This boosts investor confidence and helps to prevent fraud and theft. Let's take a closer look at how proof of reserves works and why it's so important.
How Proof of Reserves Works
There are two main ways that crypto exchanges can demonstrate proof of reserves: 1) by providing public addresses for all customer funds, and 2) by publishing regular audits conducted by third-party firms.
The first method, providing public addresses for customer funds, gives investors the ability to check the balance of an exchange's wallets at any time. This transparency builds trust between the exchange and its customers, as it ensures that the exchange is not holding more or less cryptocurrency than it says it is.
The second method, publishing regular audits conducted by third-party firms, is even more ironclad. These audits verify that the exchange actually has the amount of cryptocurrency in its wallets that it claims to have. These audits are typically conducted quarterly or semi-annually, and they help to further build trust between exchanges and their customers.
Cryptocurrency exchanges need to be transparent in order to gain and maintain investor trust. One way they can do this is by providing proof of reserves. Proof of reserves is a way of demonstrating that an exchange has the amount of cryptocurrency in its wallets that it claims to have—no more, no less. This protects investors from fraud and theft, and it helps exchanges build trust with their customers.