- The collapse of FTX has spurred other crypto firms to try to increase trust by promising more transparency.
- Binance and several other rivals have promoted proof of reserves as a solution.
- Experts aren’t so sure proof of reserves is enough to restore confidence in crypto exchanges.
The collapse of FTX has heightened scrutiny into cryptocurrency firms’ ability to pay up when customers panic, and industry leaders have touted “proof of reserves” as a way to boost confidence.
But experts aren’t sure that it’s sufficient as the FTX bankruptcy has uncovered an array of counterparty risks that crisscross the sector.
Binance, which is the world’s largest crypto exchange by trading volume, has vowed to conduct a proof of reserves, as have several other exchanges. Binance CEO Changpeng Zhao has said it would foster “full transparency” between exchanges and their clients.
What is proof of reserves?
A third party conducts a proof of reserves, which essentially seeks to confirm that stated holdings are actually there. It could show in detail where a customer’s assets are and where they’ve been.
But while proof of reserves could show customers that their money is still sitting in their accounts and hasn’t been lent out, that doesn’t account for the full picture.
The problem, experts say, is that clients often won’t be privy to key risks, as proof of reserves only serves as a brief snapshot that can be misleading.
Here’s the catch with proof of reserves
“Proof of reserves has emerged as a cunning way to save crypto, but it has two major flaws,” Martin Hiesboeck, head of blockchain and crypto research at Uphold, told Insider.
First, it shows balances at one specific point in time but doesn’t account for any in-and-out movement of assets that would produce a momentary balance.
For example, Hiesboeck pointed to a recent incident with Crypto.com, which said earlier this month it accidentally transferred $400 million worth of cryptocurrencies to a different exchange before recovering it. Some skeptics said such transfers could bolster proof of reserves.
Second, a glaring gap in proof of reserves is the absence of liabilities, which make the assets look misleading, according to Hiesboeck.
“Have you ever seen a company balance sheet not including the liabilities? The picture would be incomplete,” he said.
In addition, proof of reserves is still limited in its ability to say whether customer funds have been commingled with company funds or whether there are any off-balance-sheet liabilities, according to Ahmed Ismail, CEO of liquidity aggregator Fluid.
Instead, firms should seek to guarantee user funds and deposits, similar to the way retail bank deposits are guaranteed in traditional finance, he said.
Merkle tree proof of reserves
Another possible solution that’s been touted is a Merkle tree proof of reserves, which work in real time. A Merkle tree is a data structure that encodes blockchain transactions more securely, tracking assets from their origin to their destination.
But while it promises “tamper-proof” security, exchanges can still just as easily put client money in danger by lending to riskier borrowers.
“Even such tracking won’t prevent the exchanges/custodian solutions from giving the funds to unvetted borrowers who might be unable to repay the loan,” said Rishabh Gupta, director of operations at TDeFi. “For such incidents, governance comes into action that will ensure the proper usage of funds.”