With the FTX collapse unfolding snowball effects that is sending ripples across the entire crypto industry, many prominent centralized exchanges such as Binance, Gate.io, KuCoin, Poloniex, MEXC Global, Bitget, Huobi, OKX, Deribit, Giottus and Bybit have all announced to publicly providing their Merkle Tree reserve certificates in an effort to encourage further transparency. In today’s article we are focussing on what is proof of reserve, their benefits, weakness and can it actually boost the public confidence.
The Merkle tree proof of reserve, named after its investor Ralph Merkle, is a cryptographic tool at the heart of all blockchain technology. It is touted as an attempt to boost the public confidence towards centralized exchanges and to douse their fears. Ideally it uses public wallet ownership with third party audits to prove that the centralized exchange has adequate assets to match their customer deposits. This enables the users to verify that their account balance is included in the attested proof shown by the exchange.
These balances are held by the exchanges in the form of merkle tree. This tree usually has a root that sums up the balances held across the accounts and gives an overview through which unique identification is possible. Consistency is of utmost importance here as any change in data will indicate that the assets have been altered in the merkle root.
<source: Google>
In order to authenticate the proof of reserve, the audit firm randomly chooses an anonymised snapshot of user balances. Each account comes with its own unique ID which is hashed before calculations. The auditor then goes on to bundle them into a merkle tree that produces the merkle root which represents the sum of all user balances.
Using this method, a user can verify if their account balances are included in the tree. A series of such random checks will lead to prove the authenticity of the merkle tree.
Many exchanges have publicly stated that this is an important step in building fundamental trust in the industry, and at the same time, it is also an important means to ensure the transparency of user assets. DeFiLlama has listed out the top exchanges with their clean TVL (funds excluding their own token), liabilities auditor, last audit date and link to wallets, which we believe will be updated once the exchanges are ready with their proof of reserve audits.
Link: CEX Transparency
Recently Crypto.com published its wallet balances on a dashboard in Nansen.io, that lists their assets and net worth, which is one part of the forming the merkle tree. Gate.io has implemented a proof of registration process conducted through Armanino, their third-party auditor to perform their proof of reserve proceedings. Kraken has been using Armanino to do these audits periodically (biannually) and are publishing their reports here.
The idea of proof of reserve helps towards establishing the transparency of an exchange. Typically, a public company could be bailed out in case of a bankruptcy by the government, which is essentially not the case for crypto firms. Hence the proof of reserve practice could instill confidence to the users of the exchange.
However, the critical aspect of this process is the initial snapshot and if an exchange borrows funds temporarily before the snapshot, then it could be viewed as if they are solvent and can cover the withdrawals of user funds. There are also widespread concerns over the expertise in conducting the audit. If the audit firm fails to understand how the customer assets are structured by the exchange, the whole purpose of proof of reserve would not prove to be fruitful. In coming years, we could see different advancements to the proof of reserve method such as real-time attestation of both account balances, verifiably owned wallet addresses as suggested by Blockworks which could aid in building a strong foundation of trust between exchanges and investors.
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Disclaimer: This article was authored by Giottus Crypto Exchange as a part of a paid partnership with The News Minute. Crypto-asset or cryptocurrency investments are subject to market risks such as volatility and have no guaranteed returns. Please do your own research before investing and seek independent legal/financial advice if you are unsure about the investments.