The sort of “war” between crypto exchanges that began with Binance CEO Changpeng CZ Zhao’s accusations against FTX continues: this time it is Kraken co-founder and CEO Jesse Powell who is accusing Binance.
The issue on which Powell has been critical is that of reserves.
Crypto exchange reserves, Kraken exposes itself
As the FTX case has shown, unfortunately, not all crypto exchanges keep enough assets on hand to cover the full amount of customer deposits. So in the event that a sort of “bank run” is triggered, with a large number of users requesting to withdraw their funds, the exchange may be forced to suspend withdrawals, and perhaps even admit to spending their own customers’ money.
For this reason, some exchanges have begun to provide so-called Proof-of-Reserves (PoR), which is evidence that they have sufficient funds in their vaults to cover all of their customers’ deposits.
Indeed CoinMarketCap, which is the crypto aggregator owned by Binance, has even publicly added for some of the monitored exchanges information regarding their reserves.
Criticism from Powell, CEO of crypto exchange Kraken
However, this system has a major flaw: it ignores any debts.
Powell himself pointed this out, stating:
“The statement of assets is pointless without liabilities.”
I’m sorry but no. This is not PoR. This is either ignorance or intentional misrepresentation.
The merkle tree is just hand wavey bullshit without an auditor to make sure you didn’t include accounts with negative balances. The statement of assets is pointless without liabilities. https://t.co/b5KSr2XKLB
— Jesse Powell (@jespow) November 25, 2022
Within a corporate balance sheet, debts are considered liabilities. These include customer deposits, because when customers deposit funds on an exchange they are effectively giving those funds to the exchange. At that point, those amounts become a liability for the exchange, because it must be ready to return them to it at any time, and a receivable for the customer itself from the exchange.
The PoR is basically the declaration of assets, i.e., the assets held in cash by the exchanges, but without knowing how the liabilities are structured, it is by no means certain that these assets cover precisely the customer deposits.
That is, one would need to distinguish between true Proof-of-Reserves, i.e., on-balance sheet assets that cover only and exclusively liabilities due to customer deposits, and generic assets that possibly cover other liabilities as well.
For example, if it turned out that the liabilities covered by the assets declared in the PoR were not composed only of customer deposits, there would be a risk that the exchange would not be solvent even if the value of the assets exceeded the value of customer deposits.
For example, Binance claims to have more than $66.8 billion in reserves, but it is not known whether these cover only customer deposits, or possibly other liabilities as well. In short, PoR only truly works if all assets are declared as well as all liabilities, because that is the only way to be certain that all customer deposits are covered.
Liabilities
The concept is actually very simple.
Exchanges have liabilities and assets equally, but among the liabilities they do not have only debts to their customers. To be sure that these are fully covered one would have to be sure that all other debts were covered as well, otherwise some of the reported assets might have to be used to pay off other debts, thus being subtracted from the reserves for deposits.
For this reason, according to Powell, Binance’s PoR is not a true test of reserves, but “ignorance or intentional misrepresentation.”
In other words, he says that there is no certainty that the $66.8 billion in assets claimed by Binance serve precisely and exclusively as reserves to cover deposits. In order to be certain of that, one would need to know the company’s other debts as well, and to find their hedges outside of those $66.8 billion declared as reserves for deposits.
Instead, Powell would need to know whether a crypto exchange has more cryptocurrencies in custody than it owes customers.
The proposed solution
There would actually be a solution to this problem.
It would involve segregating and separately managing funds belonging to the exchange versus those owned by customers but held by the exchange (i.e., deposits).
With totally separate management, in separate accounts, it would be sufficient to make public the details of this separate management of customer funds to give evidence of hedges. In this way, exchanges would not even be forced to disclose information about their own business, but only about specifically in total deposits of their customers and their hedges.
This would provide accurate information about exactly what Powell hopes for, which is to know whether an exchange has more cryptocurrencies in custody than it owes to customers.
The war between exchanges
However, this absolutely legitimate and interesting dispute is part of the more complex picture of the “war” of competition between exchanges.
During the bear market, in fact, revenue substantially decreases for them as well, due to low average trading volumes. Moreover, when the bear market follows a bull run, exchange revenues actually plummet from their previous peaks.
In such a scenario, not only is it more than plausible that some exchanges will go out of business, as happened to FTX, but it is also quite obvious that others will go to war with each other.
If Kraken is picking a fight with Binance, in the wake of Binance messing with FTX, it is curious that in the past few weeks when there were fears that Crypto.com might have solvency problems there was no major controversy launched by other exchanges against Crypto.com.
Binance, and in particular its CEO CZ, have openly and harshly criticized Crypto.com in the past, but during the collapse of their CRO token from November 7 to 14, they did not lash out.
It almost seems as if Binance was specifically mad at FTX, and now it is the other exchanges that are mad at it.
Source: https://en.cryptonomist.ch/2022/11/28/crypto-exchanges-kraken-binance/