Centralized crypto exchanges are scrambling to improve industry transparency.
With the collapse of FTX amid allegations that ex-CEO Sam Bankman-Fried used billions in customers’ funds to shore up his teetering trading firm, centralized crypto exchanges are scrambling to improve industry transparency.
Exchanges are stampeding towards blockchain-assisted proof-of-reserve audits to provide transparency and calm skittish investors after it became clear that FTX’s opaque balance sheet hid huge holes in customers' funds.
With the failure of Sam Bankman-Fried’s FTX and FTX US exchanges and revelations about how deeply and secretly entwined they were with his also-bankrupt trading firm Alameda Research, at least 10 major exchanges have pledged to provide these proof-of-reserves (PoR) audits, and several more that already have them, like Kraken and Gate.io, are shouting it from the rooftops (or Twitter, anyway).
Coinbase, which as a Nasdaq-listed U.S. company already has even more substantial outside auditing and transparency as a regulatory requirement, is even promoting that through full pages ads in the Wall Street Journal.
The point is that with regular, audited PoR statements backed by on-chain data — notably Merkle trees — exchanges will be able to calm investors spooked by the news that FTX had secretly transferred billions of dollars worth of customer funds to keep Alameda afloat, collateralized only by its own very illiquid FTT tokens.
Exchanges that have announced they are working on getting them include Binance, Bitfinex, Bitget, Bybit, Crypto.com, Deribit, Huobi, KuCoin, OKX and Poloniex. While a number have provided unaudited PoRs, those are essentially a list of wallets where funds are stored.
Outside Auditors Needed
Getting the audited version of proof-of-reserves will take weeks if not months, as the process involves hiring an outside auditor and giving them the time to actually audit.
That’s something Binance CEO Changpeng “CZ” Zhao pointed out in his Nov. 8 Twitter announcement that the world’s largest crypto exchange would be coming out with Merkle tree proof-of-reserves, saying that all exchanges should do so. He added:
“Banks run on fractional reserves. Crypto should not.”
To which Kraken founder Jesse Powell replied, somewhat snarkily, “We look forward to your arrival, ser.”
Still, it was Zhao’s tweet that brought the issue to the forefront. And on Nov. 14, Decrypt reported that Zhao revealed that Binance was working with Ethereum creator Vitalik Buterin, who wants to create “some type of new proof-of-reserves protocol and use Binance as a guinea pig, or the first test case.”
The Other Half
Another solution that’s coming up fast is adding proof-of-liabilities audits into the mix.
There’s a simple reason for that, as CasaHODL CTO Jameson Lopp tweeted on Nov. 9::
“Proof of Reserves is not a panacea. You're still trusting the auditor's attestation. You're still hoping reserves exceed liabilities. But it's better to have PoR than to not have it. While proof of reserves is not proof of solvency, I'm not aware of any custodians that publish proof of reserves that have gone bust… It at least shows some willingness to work on slightly improving transparency.”
Meanwhile BitGo CEO Mike Belshe noted that while PoR is a good start, “it is impossible to prove non-existence of liabilities. Tracking liabilities comes with solid, clean financials, audits, and regulation.”
That’s something Bank of America analysts agreed with. In a research report, BoA wrote that while PoR Merkle trees work, they are not enough. The report pointed out that they are manipulatable snapshots in time that can be falsified by short-term borrowing at the right time and need to be backed by audits, CoinDesk reported. Proof-of-liability reports are needed to make them useful in determining leverage, and stablecoin reserves must also be audited by a reputable third party firm.
Two more things are necessary: clearly delineating exchanges and market makers, and the creation of a solid regulatory regime, BoA said.
All About Trust
Not that the results are always positive. Crypto.com released its own PoR report, revealing that nearly 20% of its user reserves was in SHIB, a meme token based on dogecoin.
https://portfolio.nansen.ai/dashboard/crypto.com
When that raised questions, Crypto.com CEO Kris Marszalek pointed out that its balance sheet is based one-to-one on what customers buy: “Those are not our funds. Those are our client funds,” he said on a livestream earlier this week.
It didn’t help that about that time Crypto.com had accidentally sent $400 million to one of its own wallets on Gate.io, which has led to vague rumors that exchanges move funds around to shore up each others’ balance sheets.
Still, the rush to PoRs comes down to a trust issue, and thanks to Sam Bankman-Fried that’s in short supply at the moment.
