Last year, FTX was one of the biggest and most reputable cryptocurrency exchange platforms around. It was paying for multi-million dollar advertising campaigns and sponsorship deals, and it was also one of the biggest investors in crypto projects. Then, almost overnight, it collapsed in disgrace, following a meltdown triggered by an article in CoinDesk that looked at its close relationship with sister company Alameda Research.
The article revealed how Alameda was heavily invested in FTT, the native cryptocurrency of FTX’s platform. It hinted at the possible mismanagement of users’ funds, sparking a rush of withdrawals by FTX users. Like all good bank runs, it led to the complete collapse of the exchange in a matter of hours.
FTX finally filed for bankruptcy with just $900 million in liquid assets on its books and close to $9 billion in liabilities. Unable to cater to the withdrawal demands of its users, it had no choice but to shut its doors.
The FTX crash highlighted the urgent need for greater transparency among crypto exchanges, especially in terms of how those platforms store and use depositors’ funds. In the weeks that followed, a number of leading exchanges moved to restore faith in their platforms by publishing a “Proof-of-Reserves”.
Proof-of-Reserves Explained:
“Proof-Of-Reserves” are a technique that’s used by cryptocurrency exchanges, protocols and asset custodians to demonstrate that all customer balances are backed 1:1 with digital assets held on-chain. In other words, it’s an attempt at providing proof of their solvency to reassure customers that their funds are safe.
Binance CEO Chanpeng Zhao quickly emerged as one of the most vocal proponents of proof-of-reserves, calling on all major exchanges to publish a “Merkle Tree”-based statement that proves they’re not misusing customers’ funds.
All crypto exchanges should do merkle-tree proof-of-reserves.
Banks run on fractional reserves.
Crypto exchanges should not.@Binance will start to do proof-of-reserves soon. Full transparency.
— CZ ? Binance (@cz_binance) November 8, 2022
Three days after CZ’s tweet, Binance became one of the first exchanges to do just that, saying its proof-of-reserves audit was a clear and transparent breakdown of its digital assets. The top six assets on its books were shown to be Bitcoin, Ethereum, Binance Coin, Binance USD, Tether and USD Coin, and altogether they amounted to almost $70 billion worth of assets held in cold storage.
Binance’s example was quickly followed by exchanges such as Bitfinex (which published its proof-of-reserves on the same day), OKX, Huobi and others. Meanwhile, Gate.io and Kraken both reiterated that they had actually published a proof-of-reserves statement long before FTX’s meltdown. In Gate.io’s case, its published asset reserves actually exceeded the user deposits on its platform, meaning it has in excess of the amount needed to pay out all of its customers if ever it’s required to do so.
How Reliable Are Proof-of-Reserves?
Although Proof-of-Reserves is a sign of increased transparency in the crypto exchange industry, experts have pointed out that the concept falls short of proving that any platform is 100% reliable. The University of Minnesota accounts professor Vivian Fang pointed out in a recent lecture that proof-of-reserves do not reveal everything about a platform’s finances. For instance, they do not reveal any liabilities an exchange might have hidden away, she said. They also don’t show if customers’ assets have been pledged for loans, and they provide no insights into an exchange’s non-crypto assets.
Deniz Appelbaum, professor of accounting and finance at Montclair State University, told the Wall Street Journal that there is a danger that crypto investors might assume a proof-of-reserves is similar to a full audit.
“In reality, it is not complete and does not disclose the full assets or liabilities, nor does it discuss any controls,” she said.
Indeed, the unreliability of proof-of-reserves quickly became apparent in December, when it was revealed that FTX had actually contracted the accounting firm Armanino LLP to carry out a full audit of its assets prior to its collapse. Just one year after that audit was completed, with FTX apparently given a green light, it collapsed in flames. Armanino, which also helped Gate.io and Kraken with their audits, has since declared that it will no longer be providing its services to cryptocurrency firms.
This uncertainty over proof-of-reserves explains why some exchanges are looking for a more unambiguous way to improve transparency to their customers.
Boxwind, a new exchange focused on professional traders in emerging markets such as Southeast Asia, Sub-Saharan Africa and South America, has stated that one of its biggest priorities is to develop a more trustworthy mechanism to demonstrate its proof-of-reserves, as well as any liabilities it might have. Boxwind is currently looking at the best way to show how all client funds are segregated and held 1:1 with verifiable reserve holdings. Its reputation is boosted somewhat by its strong credentials, as a new brand born out of Exinity Group, which has been a major player in the online Forex trading world with its subsidiary Alpari Group since the 1980s.
Another exchange, Stormgain, has taken an alternative approach, giving its customers the choice of using either its centralized platform (for ease of use) or a decentralized version that allows users to retain full custody of their funds. Stormgain is unique among DEX platforms in that it’s able to tap into the liquidity of its hugely popular CEX to support high-volume traders.
The Need For Transparency Remains
There’s no doubt that proof-of-reserves is a welcome step on the way to greater transparency for the crypto industry and it goes some way towards reassuring investors. Indeed, despite the FTX crash – which was previously believed impossible – centralized crypto exchanges are still doing big business.
That said, it’s equally clear that crypto investors are more wary than they were before. Many had assumed that today’s leading exchanges were far more transparent and professional than yesterday’s market leaders, such as Mt. Gox. So the race is on for the crypto exchange industry to come up with a more transparent solution that can put pay to investors’ fears once and for all.
Source: https://coincodex.com/article/28867/centralized-exchanges-need-to-show-more-transparency-than-proof-of-reserves/