FTX Implosion TL;DR and Why Proof of Reserves is NOT the Solution We Need

You're probably reading this because the FTX implosion cascade sent every crypto-influencer into an engagement farming overdrive - "Get Your Crypto Out of Exchanges." and that's given you a niggling worry. "Don't Trust, Verify." rings in your ears, and you're one with crypto-twitter glued to your screen and wasting the weekend away doomscrolling.

Let's get you up to speed in the next few minutes and get you to go out and touch the grass.

What Brought us here? The FTX/Alameda Crash Simplified

FTX was a crypto-exchange (registered in the Bahamas) that enabled people to trade cryptocurrencies as you do on stock market exchanges. They allowed you to buy/sell bitcoins and shitcoins (every other crypto except BTC..lol), trade on margin, futures, and the whole nine yards.

Pretty nifty actually.

The 24-hr trading volume (sum of all buy and sell trades over a given period) was in the billions of dollars and were the third largest crypto-exchange.

They were backed by some of the biggest crypto-VCs and whales. They got Tom Brady and Gisele Bundchen to bat and walk for them. They were buying naming rights to sporting stadiums and sponsoring gaming events. The Founders were vegans, effective altruists, and according to Nas Daily, the most generous billionaires in the world.

The marketing was on point, but shenanigans were going on behind the facade. Shenanigans after shenanigans - in broad daylight. Shenanigans that the VCs pouring in billions of dollars would have noticed in 5 minutes (apparently) but crypto gotta move fast and ain't nobody got time for due diligence.

It all began with the FTT token (short for FTX token) - the exchange token created (allegedly out of thin air) by FTX to power the actions on their FTX exchange. The idea was that as FTX grows, the demand for FTT tokens would increase (users need FTT tokens to buy and sell stuff at cheaper rates on FTX). This worked in all bull markets and went up to over $77. However, with the bear markets returning, it was trading at around $25 - down 67% from its ATH,but that's also okay!

BTC is down by a similar percentage. Some tech stocks like Meta are down even more.

The problem is that FTX's sister entity, the trading house Alameda Research's balance sheet was largely (like really largely)made up of FTT tokens. This meant that Alameda Research could lose money infinitely as long as FTX could keep creating new FTT tokens (or keep the price up of the FTT token propped up). People jumped on the 'let's short this shit and find out' bandwagon effectively plummeting the price of FTT tokens even more.

This could have been fine too. Crypto is antifragile in that sense. Let's unpack.

Traditional banks follow the fractional reserve banking method where they only keep only about 10% of their customers' funds. So, if I deposit $100 in a Chase bank, Chase can lend out $90 immediately to a borrower. They charge interest from the borrower and share that with me. This keeps the lights on at the banks.

So, if all depositors go to their banks and start withdrawing like 11% of their funds, that bank is dead.

Cryptocurrencies were invented as an alternative to this banking system:

• No fractional reserve
• No interest
• No intermediaries

For this story, all that FTX needed to do was, wait for it, not gamble with the funds deposited by their customers. Maintain a 1:1 ratio (essentially meaning that all customers could withdraw 100% of their funds at any time, and it should not be a problem. In fact, OG bitcoiners celebrated__Jan 3rd as Proof of Keys day__. On this day, they'd remove 100% of their bitcoins out of exchanges and non-custodial wallets. The ones playing roulette with customers' funds would get decimated, and the good ones would be reminded to keep being good.

FTX was not being good.

A day after the bank run on FTX, the CEO was looking to raise $10 Billion to fill the hole in their balance sheet caused by their own (Alameda's) reckless trading strategies.

FTX was insolvent and everybody could see that.

That was the end of it.

But no.

This is crypto and far-flung rumors have curiously been understatements of the year.

People started asking whether other exchanges were 'Chancellor(s) on the brink of collapse.' You're as good as your reputation on Twitter and exchanges started publishing their Proof-of-Reserves' to quell their respective rumors of insolvency.

Many bought into the 'Proof of Reserves' narratives via hopium while the copium crowd was back to clamoring - 'Get your crypto off exchanges and into cold wallets.'

As always, the truth is neither here nor there and this brings us finally to the topic at hand.

What Exactly Makes you Solvent?

If the sum total of all your liabilities (reds on your balance sheet) is lesser than your assets (greens on your balance sheet), congrats, you're solvent.

FTX is NOT!

Crypto exchanges from the big daddy Binance to Bybit are all publishing their proofs-of-reserves - essentially signaling that they're not gambling with customer funds!

Check out all of the reports at DeFi Llama__here__ or at Nansen here.

What is A Proof of Reserves?

Strictly speaking, proof of reserves is a 3rd party audit of your balance sheet (assets and liabilities) with published results. No exchange outside of Kraken (which has been publishing it like forever) does this.

Take the case of crypto.com for an illustrative example:

(Source: Nansen)

It states that the crypto.com treasury is:

• BTC 28.82%
• SHIB 22.08%
• ETH 17.32%
• USDT 6.02%
• USDC 5.61%
• Others 20.15%

Some of you might be wondering whether having almost a quarter of your portfolio in a meme coin (SHIB) was a good decision. Well, if the crypto.com customers HODL $500M+ worth of meme coins then crypto.com needs to have that $500M+ worth of SHIB tokens.

That is an example of the 1:1 reserves claims being currently made on crypto-Twitter.

But it is still only half the picture. What you see above are just the on-chain assets.

Many exchanges can (and do) have off-chain assets and liabilities.

An on-chain asset, like the ones shown above, is simply the sum total of the funds inside the wallet addresses (claimed to be owned by the exchanges).

No one disputes that the funds are inside the wallets.

But no one really knows who owns these wallets.

Off-chain assets and liabilities can be:

• Naming rights to football stadiums
• Funding (alleged) sex orgies and Adderall for the team
• Etc etc

So why are we in this Timeline?

Occam's razor suggests that this check-my-proof-of-reserves dashboard is just a stopgap solution (and Nansen is helping for the free publicity).

All the exchanges have listed $0 as total debts, which doesn't feel right in light of the deep tentacles FTX had in the ecosystem. $10B (possibly more) have been wiped out (even at Mark-to-Market numbers), and more than just retail customers have been left holding the bag.

(Source: Fortune)

Some exchanges (like Bybit) are even supporting the 'withdraw all crypto from exchanges' movement.

What appears to be going on in the backend is the mad dash to publish the Merkle Proofs of customer holdings. This chicanery (although a step in the right direction) is forcing exchanges to maintain the 1:1 peg not only at the macro level but also at the individual wallet level.

Here is how it is supposed to work.

Let's say:

• Alice has 10 BNB and 1 ETH on Binance
• Bob has 5 BNB and 200 DOGE on Binance

Now, each wallet (Alice's and Bob's in this case) would generate a unique hash value based on the funds inside. If the hash changes, it implies that the funds have been altered.

Given that there are millions (or thousands, given the current downturn) of users, the hash of each of these wallets would be arranged in a Merkle Tree architecture (a cryptographically secure mechanism) which looks something like this:

(Source: Ethereum)

Essentially, the hash of Alice's and Bob's wallets would be used to create a new hash. This hash would be used to create a new hash with the hashes of the other wallets.

This process continues until a final hash is generated, which is the result of having hashed every other wallet on that exchange.

If even a single satoshi (price at the time of writing - 0.0001685 USD) is moved, the entire hash gets changed. This is the more real proof of reserves than the self-audits currently passing off as 'proof of reserves.'

Why Merkle Proof of Reserves is Good Enough

When you deposit your funds in an exchange (whether to YOLO x100 or for storage), they essentially stop being your funds. Period. You are just one ' withdrawal suspended' away from liquidation.

But, with Merkle Proof of Funds, there is some light at the end of the tunnel.

Your deposited funds go into the cold-storage wallets (hopefully) of that exchange and you get a corresponding balance in their exchange. You might think that you're trading bitcoin when essentially it is just squaring off numbers at the end of the day.

The hope is that with Merkle Proofs in place, users would be better aware of an exchange's health and the exchanges would be less likely to gamble with YOUR money.

This would assuage minimalists for the time being until the next crash because…

Merkle Proof of Reserves is NOT Good Enough

Not your keys, not your crypto aside, these proofs are, again, just ledger entries.

There is:

• No third-party audits
• No self-custody of funds
• No mention of liabilities
• No security protocol around the safety of the cold wallets (see Quadriga CX case)
• And above all, it doesn't solve the problems created by exchange tokens - a la FTT.

Be it a Binance with its BNB or a Kucoin with its KCS, all utility considered are still tokens created out of thin air. An argument can be made that utility is being created with their respective chains - BSC and KCC, but even the believers would agree that this does inflate holdings and gives a rosier representation of health.

Conclusion

An exchange with a 'print free money' glitch, such as the exchange token is no better than the federal reserves' backed FIAT money. Just as the USD is backed by the US Government, BNB is backed by Binance. FTT was backed by FTX.

When push comes to shove, do you want to 'trust third parties’ with your money? Is that where we are?

Well. Yes.

As long as you're craving a yield on your crypto, CEXs will flourish. Give that up, and the remaining $40B TVL in DeFi protocols vanishes overnight. This a curious case of CEXs being important for DeFi.

All in all, it would be a whole lot easier if the powers that be are not asleep at the wheel and do proper due diligence before becoming a part of the marketing hype. But, we need to ask ourselves a question too -

"Does the industry that pumps DOGE on Elon's tweets even deserve rational-headed VCs?" Would they even survive with us?

We're all degens here. Right?

Well, the market unpredictabilities are making light-work of many a degenerate, so…

Stay safe out there, fren!