Proof-of-reserves – Can reserve audits prevent another FTX-like moment

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Although crypto exchanges are actively publishing proof-of-reserves audits to increase transparency, experts believe it will take more to regain investor confidence. Analysis After the FTX collapse, which was caused by the now-bankrupt cryptocurrency exchange funneling funds to mitigate its own risks and causing it to crash, crypto exchanges devised a transparency solution called “proof-of-reserves”. Binance CEO Changpeng Zhao recently supported this practice. It allows exchanges to provide transparency to users despite not having clear regulations. Banks rely on fractional reserves. This is not the case for crypto exchanges. @Binance will soon begin to do proof-of reserve. Transparency.– CZ Binance, @cz_binance, November 8, 2022
Proof of reserves (PoR), an independent audit by a third party, is a way to verify that a custodian has the assets it claims it owns for its clients. An anonymous snapshot of all balances is taken by the auditor and merged into a Merkle tree. A Merkle is a cryptographic commit scheme in which each “leaf” or node is identified with a data block’s encryption hash. They are used to verify data that has been sent, stored, or handled between computers. Although the concept was first used in 1979, it has been widely used in peer-to-peer blockchain networks. The auditor then obtains a Merkleroot, a cryptographic fingerprint that uniquely identifies which combination of these balances were created at the time the snapshot was taken. This digital signature is used by the crypto exchange to prove ownership of the on-chain addresses with publicly verifyable balances. The auditor then compares and verifies whether these balances match the client balances in the Merkle tree. This is a crucial step towards a more transparent crypto community. Centralized exchanges can record the liabilities of each account and provide specific assets. Public anonymity would be maintained by them publishing the information with a tag that only account holders can see. Co-founder of decentralized venture capital firm DAO Maker Hassan Sheikh said that PoR provides a clear summation and comparison of due liabilities to assets. He explained that exchanges could not fake liabilities if they have good PoR practices. “If liabilities are ever falsified, users can raise a red flag. Even if only 1% of users bother to verify, it would be impossible for any CEX to bypass the smaller accounts. The CEX could only verify the larger accounts, and would be able to skip a small number of smaller accounts before being caught. While a proof of reserve audit is still an effective way to monitor crypto exchanges, it is not sufficient. He suggested that investors consider other options, such as having a separate cash reserve, asset-backed token, or both, along with a proof of reserves certificate. The only way to solve the problem is total transparency. Users should trust crypto exchanges that are transparent. Many centralized exchanges have begun to accept PoR audit data. However, the problem of crypto platforms moving funds immediately after the audit snapshot was taken is still a concern. After releasing its PoR audit, Crypto.com transferred 280,000 Ether to Gate.io. This fueled rumors about crypto exchanges possibly faking reserve audits. Many in the crypto community claimed that exchanges were borrowing assets to show a healthy book. However, the transfer to Gate.io address was a mistake. This fueled rumors about crypto exchanges possibly faking their reserve audits. We worked closely with Gate team, and the funds were returned to our cold storage. Crypto.com (@kris) November 13, 2022
While some exchanges provide detailed breakdowns of their reserve during a PoR audit, others simply respond quickly claiming that they are in the black. Nexo simply provided a one-page snapshot stating that they have more assets than customer deposits (around $3.2 billion). Philipp Zimmerer, core contributor to decentralized finance protocol Spool.fi told Cointelegraph that the main problem is that there are no rules regarding what constitutes a proper PoR audit. This means that the process will vary between exchanges. He explained that even if the procedure is implemented in the best-faith interpretation, proof of reserves cannot prove exclusive ownership or detect funds that were borrowed to influence the audit’s outcome. The practice is generally only as trustworthy as the exchange or the auditors, and will never be 100% proof of anything. He also noted that showing assets without showing liability is useless. “Trusted” only those that are fully regulated and on-shore bank license holders who undergo regular, comprehensive audits from known and unrelated firms. He cited Coinbase as an example. Coinbase makes its assets and liabilities publicly available. Zimmerer also mentioned Kraken, an exchange that is registered in the United States that conducts regular audits. The results of these audits are published and disseminated to the public. However, in order to gain trust and improve transparency, it will be wise to examine the overall balance sheet, monitor the liabilities, and have transparency around capital reserves. It’s not only the company’s reserves that are important, but also its exposure. FTX had more than 130 companies where they had disposed of the income and liabilities. The same happened with WeWork, and other corporate land blowups. Rust stated that “Proof of reserve” is the first step. A great proof of liabilities would be necessary, and is a must-have edition in light of FTX. A proof of consolidation or incorporation across related companies is also required. We must educate the market and community about these tools as well as the benefits. Users need to understand why decentralization is so important to not only the crypto ecosystem, but also the future financial and Web3 markets.” Don Guillaume, Gate.io’s head of PR and communications, stated that regulation was the best way to keep track of crypto exchanges. We’ve seen positive steps taken by regulators around the globe over the past few years to ensure that crypto exchanges and all companies operating in the cryptocurrency industry are regulated and comply with the law. Experts believe that proof of reserves cannot be relied on alone, even though key market players offer transparency to regain public trust.