The recent failure of FTX, one of the biggest and most reputable cryptocurrency exchanges in the market, has sparked discussion about the need to establish criteria for demonstrating solvency in centralized exchanges.
Numerous centralized cryptocurrency exchanges have voluntarily released their Proof-of-Reserves in an effort to regain public confidence and continue to be a popular choice in the market since the news of FTX’s bankruptcy broke.
Custodial exchanges disclose publicly viewable proof of their on-chain reserves using the Proof-of-Reserves protocol. The goal is to show that the assets kept on deposits correspond to user balances, demonstrating the exchange’s viability.
Exchanges rely on a system that adds client balances and publishes the information anonymously through so-called Merkle proofs to match on-chain assets with liabilities. Users of the exchange can use this approach to check that their balance is represented in the liabilities data set.
By publishing the list of customer balances using cryptography, the Merkle tree method prevents privacy leakage. This is accomplished by digitally signing or hashing each piece of added data.
The ideal situation would be to have several continuing attestations under the supervision of an on-chain auditor in order to ensure the solvency and credibility of an exchange.
The auditor would create a Merkle root tree using an anonymous snapshot of all the additional exchange balances. The next step would be to use the corresponding transaction hash to compare each user’s balance to the data in the Merkle tree.
An extensive article on how centralized exchanges can use Merkle trees to demonstrate their solvency was recently written by Vitalik Buterin, one of the co-founders of Ethereum. It can be read here.
The aforementioned example demonstrates how account holders can compare their balances to the total amount of liabilities held by an exchange. Account Holder 001 in this instance simply needs the details in the red box to confirm that his balance is included in the exchange’s liabilities (1,400).
To increase transparency, Phemex, a well-known cryptocurrency exchange, also embraced the Proof-of-Reserves standard. Through its platform, users can check the exchange’s liabilities in addition to its Proof-of-Reserves. For trading balances for ETH, BTC, USDC, USDT, and USD, Phemex supports on-chain balance inquiries.
The aforementioned model ensures a certain level of privacy as different users are given access to different parts of the tree, though it is far from ideal since it depends on trust in a third-party auditor.
Most crucially, the likelihood that the exchange won’t defraud by concealing liabilities increases the more depositors who check their holdings using the Merkle tree structure.
If there is one thing the industry can learn from the failure of FTX, it is that implementing a proof of reserves system across all custodian exchanges will attract more users since it will promote transparency.
Another benefit is that any potential bad actors who refuse to demonstrate their solvency will be kept off the field. Something that could lessen the scrutiny of regulators and policymakers and be perceived as a sign of maturity in our industry.
However, enhancing exchange security and transparency shouldn’t be at the expense of abandoning self-custody. We should keep emphasizing how crucial it is to eliminate third-party risk by educating consumers about the best ways to maintain their private keys. If you don’t ultimately have control over what should be your own crypto, what use is it to use cryptography? The next article has more information on these procedures.
