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By Stephenie Lord Eisert, Senior Director of Law Enforcement and Regulatory Relationships at Merkle Science
Since currency exchanges are both the engine and market makers of decentralized finance, the fall of FTX and other high-profile lenders, including Celsius, Voyager, and Three Arrows Capital, has rocked confidence in the entire ecosystem.
The most pressing task right now is to regain users’ trust. The way to achieve it is greater transparency.
There is no silver bullet, but a multi-faceted approach that includes regulatory guidance, cooperation on the part of key industry players, and the public sharing of data will go a long way toward restoring lost confidence.
Compared with traditional finance, the world of cryptocurrencies and DeFi lacks a comprehensive set of regulatory controls, guidance, and standardized operating procedures. After the fall of FTX, governments are under pressure to increase scrutiny.
Tighter controls have been on the global agenda for some time, notably in Europe where a harmonized set of rules for crypto assets and trading activities is on course for the statute books. But legislation, when it happens at all, does not arrive quickly. Proposals for Europe’s MiCA controls have taken years to finalize, given the need for cross-border agreement.
So what do users need to know now — and what can crypto companies do — to reduce the risk of more collapses and build trust?
The first step in this process is proof of reserves (PoR)
No process can prevent deliberate malpractice. Regardless of the wider context, however, we can see that the root cause of these collapses was a liquidity crisis. Publishing up-to-date and accurate accounts could have forestalled the worst of the impact on customers, and limited contagion spreading to other protocols. Transparent business practices can signal sinking ships like FTX before they have a chance to take more passengers on board. In turn, existing investors are more likely to leave assets where they are when reassured by evidence the ship is not holed beneath the waterline and is sufficiently collateralized to survive a storm.
Proof of Reserves, an audit that determines if an exchange holds assets covering its customer deposits, provides that reassurance. To obtain PoR, a snapshot of all balances is converted into a “Merkle Tree” – a cryptographic tool that processes the data into a format that makes it easier to identify balances that do not match up. Individual crypto wallet holders can also check for themselves whether their balance was accurately included, a key element that scaffolds both accuracy and transparency.
Financial institutions have the option to self-assess then share their latest PoR snapshot afterwards. Ideally, an independent auditor is employed to bring additional oversight, and authority to flag up anomalies or misuse of funds.
PoR snapshot is not the whole picture
The world’s largest cryptocurrency exchange, Binance, now releases proof of its reserves. CEO Changpeng Zhao has urged other protocols to do the same. PoR is certainly a step in the right direction, enhancing credibility and trust between protocols and their users. But it has limitations, such as the fact that the snapshot it provides is only accurate at the moment it was taken and that it cannot verify the exclusive ownership of a private key. This means some assets might not be secure, perhaps vulnerable to removal by an unknown third-party – or even by the exchange itself.
PoR cannot determine whether private keys have been duplicated by a hacker, nor reveal if the host exchange borrowed some of the disclosed assets as a ruse to pass the audit. Indeed, it is possible for bad actors to be virtue signaling their PoR while simultaneously gaming it.
For instance, exchanges can move funds to a wallet that will be audited, take a snapshot to show a healthy balance, and then return the borrowed funds. In fact, in Nov 2022 Binance moved over $2 billion in BTC to a reserve wallet right before their “proof of reserve” audit.
Traditionally, audits of both liabilities and reserves happen quarterly or semi-annually. But the more AUM (Assets Under Management) the longer and more costly these audits become. You can adjust the frequency here to daily, weekly, or monthly snapshots but this can be very costly and require business and security approvals that are not offered today in DeFi or TradFi.
Therefore, providing on-chain anomaly detection and reporting on suspicious transactions or the movement of funds is the early warning system that we need to anticipate potentially catastrophic events. Additionally, this can allow for impact analysis of counterparties, liquidity pools, or staking pools that can be caught in this contagion, allowing for proper risk controls and mitigations.
There is also the risk that PoR promotes a false sense of security, given that it provides only partial transparency: An overview of assets with no disclosure of liabilities.
Proof of Solvency is the gold standard
Suffice it to say, many fall into the trap of assuming that if a company has sufficient reserves to match deposits then it is solvent. But reserves are one of two variables in the equation, the second being liabilities. Little exemplifies this more potently than FTX tweeting it “passed” an audit just three months before implosion.
The fact that two small accountancy firms with no record of handling multi-billion dollar companies undertook this task, in preference to one of the Big Four global auditors, speaks volumes. A solvency test would have revealed the true state of affairs.
Attaining the gold standard of continuous proof of solvency – the highest possible level of transparent verification – can be achieved via a five-step process:
1] Self-reported verification: This step is completed by the entity in question or a third party of their choice. It entails publishing a list of their hot and cold wallet addresses.
2] Proof of Ownership: In this step, entities can verify that they actually own those addresses by signing a message with the appropriate set of keys
3] Merkle Root of Verification: After successful completion of Levels 1 and 2, an auditor can take an anonymized snapshot of Reserves & Liabilities at a point in time. The auditor then generates a Merkle Tree which outputs a Merkle Root. The Merkle Root is published on-chain (i.e. ETH or MATIC), creating an immutable record.
4] Continuous Proof of Solvency: This is a real-time step that takes reserves and liability into account.
5] Third-party auditors: In addition to the first four steps, firms can employ third-party auditors to manage their funds.
The first three stages require lists of the platform’s hot (online) and cold (offline) crypto wallet addresses. After address ownership is proved, the snapshot of reserves and liabilities can be taken and Merkle Tree data published. Step four demonstrates PoS by publishing close to real-time data on reserves and liabilities. Daily or weekly verification is sufficient to flag up on-chain anomalies and suspicious transactions.
Transparency builds trust
DeFi needs transparency now more than ever, with the current rush toward proof of reserves viewed as the start of the journey, not the destination. Partial transparency is itself a risk factor if it lulls us into a false sense of security, known as “transparency-washing.”
Therefore, responsible institutions must prioritize a culture of full transparency. When custody and ownership of reserves is publicly proven, liabilities published, and continuous proof of solvency on view, we will all be on a more secure footing.
It is time for the industry to prioritize these crucial trust mechanisms if it is to sustain and increase adoption.
Stephenie Lord Eisert is Senior Director of Law Enforcement and Regulatory Relationships at Merkle Science
The views and opinions expressed in this article are solely those of the authors and do not reflect the views of Bitcoin Insider. Every investment and trading move involves risk - this is especially true for cryptocurrencies given their volatility. We strongly advise our readers to conduct their own research when making a decision.