Proof-of-Reserves is Becoming The Standard For Exchanges. How Can Greater Transparency Go Hand in Hand with Regulations?

21 November 2022

When CoinDesk released the balance sheet of Alameda Research, a trading firm with ties to the FTX cryptocurrency exchange, no one could have predicted that it would lead to a chain of events that has been called cryptocurrency’s ‘Lehman moment,’ reminiscent of the 2008 subprime mortgage crisis that caused the collapse of the Lehman Brothers financial firm.

The collapse of a major centralized cryptocurrency exchange caused panic in markets already seeing a bearish turn of events, and the total value locked on major blockchains began dipping as users started moving their assets off-chain. Major chains like Ethereum saw an estimated dip of 25% within the week, and the Solana chain has dipped 66% since the collapse of FTX. Institutions were also affected with companies like hedge fund Galois Capital and Hong-Kong based platform Hbit Limited being unable to withdraw their funds from FTX, and retail traders were not spared from the pause in withdrawals as well.

In the wake of widespread user mistrust and panic in the cryptocurrency market, centralized exchanges have been turning to a concept called Proof-of-Reserves to regain the trust of their audiences and put a pause to rumors about their insolvency due the fallout.

What is Proof-of-Reserves and how is it conducted?

Proof-of-Reserves is a concept that aims to audit the asset holdings of centralized exchanges in a transparent and verifiable manner. The audit process uses a Merkle tree data structure that can integrate a large amount of data with multiple hash functions into a single hash, while verifying the integrity of the data in a fast and efficient manner. Through this process, independent third parties can audit the asset holdings to provide fair checks and balances on centralized exchanges.

To conduct a Proof-of-Reserves audit, external auditors will first take a snapshot of the exchange’s balances and run it through the Merkle tree to obtain a single hash function from the Merkle root, which has identified and summed the balances in the snapshot. Next, the auditor will pick a few selected data and compare it to the output from the Merkle root. The results should balance out if it matches, and any mismatch means that the data has been tampered with.

But the concept is not a perfect solution for greater transparency. While it does allow independent audits, the process cannot verify the user who holds the private key to the particular asset wallet. Moreover, Proof-of-Reserves is not able to prove if the funds have been topped up with borrowed loans to make up the balance. Both Huobi and had come under fire for allegedly making use of this loophole when the exchanges released their snapshots.

What is a Merkle tree and a Merkle root?

Simply put, Merkle trees are mathematical data structures used in cryptography and are an essential part of blockchain technology. To put its importance into perspective, Bitcoin uses a Merkle tree structure as well, while Ethereum uses a modified version called a Merkle Patricia tree.

Why is it called a tree? Well imagine an actual tree, but it is inverted with leaves at the bottom, branches in the middle, and its roots at the top. Each ‘leaf’ contains a hash function of a block, and two ‘leaves’ are hashed together to produce one hash function which forms the ‘branch’. Two of those functions are hashed together again to produce one, and the process repeats until only one function remains at the top which forms the ‘root’.

What is the benefit of going through the Merkle tree process? It compresses the information so that it takes up a small amount of disk space on the chain, and the block data can be verified accurately without having to download the entire block size, which speeds up block verification significantly.

Why are centralized exchanges turning to Proof-of-Reserves to regain customer trust?

The collapse of FTX stemmed from the opacity of Alameda Research’s balance sheet, and the fear and panic that arose as investors were surprised by the large quantity of $FTT tokens it held, along with its perceived illiquidity. Furthermore, FTX’s CEO Sam-Bankman Fried was a major supporter of the proposed U.S. bill known as the Digital Commodities Consumer Protection Act (DCCPA) which is expected to enact more regulations on cryptocurrencies.

The fact that one of the most popular crypto exchanges went against the best practices and regulations they were championing meant the trust and faith in centralized exchanges had been broken, and crypto traders also feared that the fallout would lead to a domino effect of more cryptocurrency platforms toppling as well. Their fears were realized as platforms like BlockFi and Liquid exchange started pausing asset withdrawals soon after the collapse of FTX.

To rebuild trust with their platform users while trying to halt market rumors, centralized exchanges are turning to Proof-of-Reserves to improve transparency on their asset reserves and show that they are not insolvent. Binance has taken the lead by releasing their wallet address to the public while promising a Proof-of-Reserves audit soon, and other exchanges like OKX, Kucoin, Deribit, and Bitfinex have followed suit.

Where do we stand on the idea of Proof-of-Reserves?

The implementation of Proof-of-Reserves is a step in the right direction for centralized exchanges. In the end, what their customers want are greater transparency and trustworthy information records before depositing their assets. This is in line with our belief in self-reporting and being transparent about one’s processes and practices.

We embed our beliefs through the range of enterprise solutions we offer to other businesses. This includes implementing immutable persisting of captured data with PreventiveChain, utilizing provenance tracking to capture every data’s point of origin with ApprovalChain, and creating compliant smart contracts on ChattelChain. Through enterprise solutions that align with existing laws, we can help businesses be compliant as the blockchain and cryptocurrency space becomes increasingly regulated.


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