Proof of Liabilities

Proof of liabilities is the half of a solvency claim that states what a custodian owes its customers, and it is the half that decides whether a reserves figure means anything. Holdings alone prove nothing: an exchange can show a large on-chain balance and still be insolvent if it owes more, so the reserve number is only interpretable against a total of customer claims. The usual construction commits every customer balance into a Merkle tree and publishes the root, so each customer can check that their own balance was included in the total without seeing anyone else's, while the total itself is what the reserves are compared against. Its weaknesses are the ones to hold in mind. The commitment can omit accounts unless every customer checks; borrowings, obligations to other counterparties and off-balance-sheet arrangements are not customer balances and may not be in the tree at all; and the whole exercise is a snapshot at one moment, verified only if someone independent checked both sides.