More Crypto Exchanges are Verifying Reserves, is Proof of Reserves the Solution?

In the wake of the FTX collapse, which happened because the now-defunct cryptocurrency exchange used customer money to cover its risks, cryptocurrency exchanges came up with proof-of-reserves to clarify transactions.

Without clear rules, Binance CEO Changpeng Zhao recently pushed for a practice that gives exchanges a way to show users that they are more honest. A Proof of Reserves (PoR) audit verifies that a custodian has the client funds it claims to have. The auditor takes a snapshot of all accounts and arranges together a Merkle tree to protect users’ privacy. Once the snapshot has been taken, the auditor will have a Merkle root, a cryptographic fingerprint specific to the sum of these accounts as of the snapshot’s creation time.

The auditor then compiles the digital signatures generated by the cryptocurrency exchange as evidence of who has the on-chain addresses that have balances that can be validated publicly. The final step of the audit is to verify whether or not these amounts are greater than or equal to the customer balances displayed in the Merkle tree. In that case, the client’s assets are held with a full reserve.

Binance Holdings Ltd. and OKX are just two examples of cryptocurrency exchanges that have turned to third-party auditors in recent months for a proof of reserves report, an increasingly popular form of attestation that can demonstrate the company’s solvency and ability to meet its debt obligations. Since most exchanges are privately owned, they don’t have to follow the rules of the Securities and Exchange Commission (SEC) about filing financial reports and having them audited.

The collapse of FTX, which had loaned billions of dollars from its clients to an affiliate, Alameda Research, and then blocked its consumers from accessing their funds, has prompted widespread worries about the financial stability of crypto platforms. Additionally, FTX went the extra mile by having its books audited by Armanino LLP and Prager Metis CPAs LLC for the previous two years, which is not something businesses in the industry typically do.

Is proof of reserves the solution to crypto’s trust problem?

Although third-party verification is a step toward greater transparency in crypto exchanges, some academics have pointed out important things that could be improved. When platforms disclose snapshots of their reserves to investors, they often conceal whether or not the platforms have pledged users’ assets for loans or adjusted their assessments of assets or liabilities in the interim. The exchange may also determine the frequency of these attestations.

Suppose a company uses third-party verification and doesn’t give auditors information about its assets or liabilities that aren’t recorded on the blockchain. In that case, there may need for more transparency about the company’s non-digital assets.

These flaws highlight the limitations of on-chain platform solutions, which risk losing touch with the real world if they do not consider it. POR is insufficient to provide reliable proof against fraud or to protect against hacking.

An emphasis on ex-ante responsibility has resulted in more significant calls for financial regulation and control of the crypto business in the wake of FTX’s devastating death spiral. Lexology has published a paper analyzing current blockchain case law, noting that it may be difficult for the crypto business to avoid off-chain regulation. Legal mediation through the courts, backed by state authority and using existing legal concepts like fiduciary obligations and constructive trusts, will remain desirable as an ex-post method of achieving accountability for people who have suffered losses.

There is mounting pressure on U.S. authorities to ensure crypto businesses comply with investor protection rules. Under Chair Gary Gensler, the SEC has promised to crack down on the cryptocurrency industry. The agency has also asked for more exchanges to register but has not mentioned how platforms use proof of reserves.

In the coming months, cryptocurrency companies will depend more and more on proof of reserves to keep their clients’ trust. However, various adjustments might be implemented to promote openness and confidence. Investors must have access to financial information regarding an exchange. This provides information about the business’s structure and income generation. As well as information about its staff and shareholders.

The cryptocurrency sector might greatly benefit from custodians implementing proof-of-reserves criteria, provided they communicate the dangers of this sort of self-regulation to their customers. Suppose the industry is thriving in instituting universal accountability rules,  in that case, it may avoid the setbacks that frequently accompany the collapse of centralized platforms like Mt. Gox, Cryptopia, QuadrigaCX, and FTX.

Users in a system where stablecoin issuers and exchanges must regularly verify their reserves would gravitate toward solutions that provide the highest level of asset safety. Therefore, more capital from institutional and individual investors would flow into the cryptocurrency market if the environment were safer.

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