Proof of Reserve Program to Prevent Future Meltdowns of Digital Currencies

Byline: Hannah Parker

The last few months of 2022 have been quite daunting for the crypto industry due to FTX, a former leading crypto exchange company, declaring bankruptcy and dealing with millions of dollars worth of crypto vanishing from users’ wallets due to a supposed hack. News surrounding the FTX financial saga had a dire impact on the crypto industry, perpetuating the incessant negative public sentiment toward crypto. As if matters could not get worse, the value of most digital assets, including Bitcoin, plummeted. The market price of Bitcoin plunged below $20,000 for the first time since late October 2022, leading to the market price of other cryptocurrencies declining even lower. 

The FTX financial crisis will go down in history as one of the most unimaginable and unforeseen events, with consequences that nearly crippled the crypto economy. However, there is a silver lining to this. Crypto, along with its technologies, is a relatively new concept, so there are bound to be mistakes, hurdles, and negative events that impact the industry’s trajectory. Though negative effects within that moment are felt intensely by investors, these hurdles could help to address issues and inconsistencies surrounding crypto as a concept. As the digital assets industry grows, systems, innovations, and regulations are established to regulate the industry and fortify encrypted online security measures for present and future use, to prevent security breaches, and to ensure the efficient running of the crypto industry.

What, then, is the silver lining after FTXs financial scandal?

After every storm, there is a rainbow. The FTX financial crisis sent shock waves throughout the industry, leaving many investors anxious and in panic. However, if we look at it clearly as an industry, we now know our shortcomings and can address them. The main shortfall here is a lack of transparency,’ which creates room for many loopholes that allow companies to misuse and mismanage funds without a trace. The digital currency industry is not centralized, meaning there are no formal or central authorities such as governments, banks, and other intermediaries to regulate the proceedings of the industry. This is how FTX, through Alameda Research (FTX’s sister company and Bankman-Fried’s trading firm), managed to violate its terms of service that prevented the company from using customer assets by misusing user funds. 

A leaked balance sheet gave evidence of the mishandling of users’ funds. It indicated that by the 30th of June 2022, Alameda had $14.6 billion in assets and $8 billion of liabilities on its balance sheet. Of these assets, $3.66 billion were “unlocked” FTT tokens, of which $2.16 billion were listed as “FTT collateral” and $3.37 billion in “crypto held.” Along with $2 billion in equity securities, $863 million “locked” SOL, the native token of the Solana blockchain, $292 million “unlocked” SOL and $41 million in SOL collateral. It was further reported that there was approximately $292 million worth of “locked” FTT and $7.4 billion in loans, which comprised most of the trading firm’s liabilities. 

However, this is not the first time such has occurred. There have been more scandals similar to that of FTX’s financial crisis. For instance, Crypto.com (a cryptocurrency exchange and trading platform) “accidentally” wired hundreds of millions of dollars worth of customer funds to another exchange. Mt.Gox, a Tokyo-based cryptocurrency exchange that operated between 2010 and 2014, lost all of its Bitcoins in a hack. Though crypto companies undergo regular audits and attestations by third parties, this may not suffice as crypto exchanges are not the same as bank accounts. Because of this, consumers cannot verifiably track the location of their funds in real time. 

But then, what if tracking the location of funds or crypto assets in real time is possible? Well, this is where we have our silver lining. The solution is having crypto exchanges adopt and actually commit to a method called Proof of Reserves and Merkle trees.

What is proof of reserves, and how are they a solution?

Proof of reserves is a form of transparency and a cryptographic method of proving that an exchange is liquid enough to process all customer withdrawals. Otherwise, it allows customers of a cryptocurrency exchange to track where their money is in real time. All of this is conducted by a third-party auditor who takes anonymized snapshots of all balances held by a company and aggregates them into a Merkle tree —  a data structure that encodes blockchain data more efficiently and securely. They are also referred to as “binary hash trees.” In essence, a Merkle tree contains information about every blockchain transaction hash on a particular block. 

The auditor then obtains a Merkle root: a cryptographic fingerprint that uniquely identifies the combination of these balances when the snapshot was created. Afterward, the auditor collects digital signatures produced by whichever exchange adopted the method, proving ownership over the on-chain addresses with publicly verifiable balances. Lastly, the auditor compares and verifies that these balances exceed or match the client balances represented in the Merkle tree and, therefore, that the client assets are held on a full-reserve basis.

Any client can independently verify that their balance was included in the Proof of Reserves audit by comparing select pieces of data with the Merkle root. Any changes made to the rest of the data, however small, will affect the root – indicating that there was tempering.

Cryptocurrency exchanges that have adopted proof of reserves

• Binance
• Gate.io
• KuCoin
• Poloniex
• Bitget
• Huobi
• OKX
• Deribit
• Bybit
• Kraken

Bitcoin 360 AI writes more about the number of crypto exchange platforms advocating for a form of transparency by adopting proof of reserves and Merkle trees.

Due to cryptocurrencies being decentralized, the technology behind all cryptocurrencies and how cryptos generally function has not allowed for much transparency by companies with their consumers or investors. Hence, irregularities like that of the FTX and Crypto.com scandals occur, where companies can lie about their reserves or hide them. Proof of reserves is a great tool that advocates for transparency by companies, allowing investors to track their funds and digital assets in real time. This is a game changer and a silver lining after the chaos caused by FTX and its CEO.