A shellshocked cryptocurrency industry is still reeling from the collapse of the shuttered exchange FTX ‘s crypto empire and the subsequent contagion incoming, which could set back trust in the industry by years.
The havoc wreaked on the symbiotic crypto ecosystem — FTX and Alameda Research invested heavily in many leading projects, while many venture capital funds invested heavily in FTX — is outdone in financial destruction only by the scores of regular people who, in all likelihood, may never get their deposits back.
In addition to this, FTX-backed projects like layer-1 chains Solana (SOL), Aptos (APT) and Near Protocol (NEAR) have seen dramatic drops in their market cap, as investor fear spread like wildfire that these projects will not survive without the help of their fallen patrons.
As the drama plays out, many are looking for a villain, in this case FTX founder Sam Bankman-Fried (SBF). However, even if SBF spends time behind bars, it’s unlikely to prevent the next crypto disaster. The more pressing conversation is about what the industry needs to do next.
Proof of Reserves: The Answer?
One proposed solution to centralized exchange ( CEX) failures is called “ proof of reserves,” which refers to a set of standards for demonstrating solvency. The idea is not entirely new, but it has gained prominence in recent weeks. Binance founder Changpeng Zhao (CZ) jump-started the conversation by announcing it would be implemented on his exchange. The move was met with similar declarations from exchanges such as KuCoin, OKX, Crypto.com, Gate.io, Bitfinex, and Huobi; however, it’s unclear what methods will be used in each case.
This week, leading market data aggregator CoinMarketCap also announced that it would verify exchanges’ reserves with a new tracker icon.
So, what does proof of reserves actually entail? And will it be enough to prevent the next FTX?
What is Proof of Reserves?
While banks in the traditional finance world are allowed to hold fractional reserves, they are also FDIC-insured, meaning account holders are guaranteed to recoup a certain portion of their funds in the case of bank insolvency. Unfortunately, in crypto, there is yet no such backstop, which highlights the need for exchanges to have assets in excess of their deposits and other liabilities.
Proof of reserves refers to cryptographic techniques used to verify exchange holdings as well as the locations of their funds. This can be done through multiple means, but the main method under discussion involves Merkle trees.
These create a computationally efficient data structure known as a “hash tree,” which is essentially a map of the funds in the shape of a Christmas tree. The data can then be used by third-party auditors to quickly assess its integrity and the financial health of a given exchange.
Since the system still relies on third-party audits, which are typically conducted on a schedule with weeks-long gaps, the proposals relying on Merkle trees could be said to be a step short of offering users real-time data on exchange holdings and the whereabouts of their crypto. However, the solution is still far more comprehensive than what is available on most exchanges today.
A big issue for custodians is how to deliver proof of reserves whilst preserving user and data privacy and asset security. A solution was presented by Ethereum leading man Vitalik Buterin, who proffered in a post-FTX blog post titled “Having a safe CEX: proof of solvency and beyond” that ZK-Snarks could the answer to help exchanges prove they’re solvent, without revealing sensitive information in the process.
Buterin proposed that Merkle trees or KZG commitments be used in combination with ZK-Snark technology to “greatly simplify and improve privacy in proof-of-liabilities protocols.”
Third parties can use a ZK-SNARK to prove that all balances in the Merkle tree are non-negative and equal to the claimed value. By adding a layer of hashing for privacy, the Merkle branch (or KZG proof) given to each user would not reveal any information about other users’ balances.
Proof of liabilities
ZK-SNARK technology can also be applied to negative balances for “proof of liabilities”. For example, in a system where individual users are leverage trading and have negative balances, it is OK if it can be validated that they have enough other assets to cover the funds with some collateralization margin.
Vitalik believes that in the long term, this type of “ZK proof of liabilities” could not only be used to verify customer deposits at exchanges, but also more broadly for crypto lending in general.
What are the downsides of proof of reserves?
The problem with a solution based on disclosing asset holdings is that they are only half the picture. To fully understand the state of a business, it’s also necessary to have a sense of its liabilities. At least so far, no exchanges have fully committed to making their liabilities public.
Using Merkle trees to implement proof of reserves is fundamentally an approach to analyzing blockchain data. Given the scale of many crypto exchanges and their diversified assets — FTX had over 130 affiliated companies — any serious assessment of the health of these entities will need to employ multiple methods.
The solutions in play at the moment all involve the continued analysis of Merkle trees by auditors, on timelines ranging from a few weeks to about a month. While CZ has said these audits will also be available to Binance users on third-party platforms, in the fast-moving reality of crypto, what is really needed would be data that users can view in real-time.
In addition to questions of trust in audits, it remains unclear whether the specialized skills required to perform this new variety are abundantly available right now.
It’s important to keep in mind that proof of reserves is the cryptocurrency industry’s attempt at self-regulation in order to restore user confidence and stave off a regulatory invasion. Will it be enough? At least for the moment, there are still significant holes in the net it would cast. In the long term, clear regulation and customer protection is needed to ensure that a situation similar to FTX never happens again.
That said, the full evolution of this approach has not yet run its course. There may be innovations that make proof of reserves the failsafe solution that crypto needs. It’s a conversation that really ought to be further along, but it’s also fair to say it’s only just begun.