The cryptocurrency industry has never shied away from making big claims. And nor should it; blockchain technology is truly revolutionary. Decentralized cryptocurrencies and stablecoins offer hundreds of millions of people an alternative to their hyperinflating local currency, an alternative that cannot be seized by a bankrupt government overnight. Smart contracts bring equitable agreements to the billions of people living in countries that lack fair and stable judicial systems.
Yet this promise of a fairer and freer world is overshadowed by the hype and scandal that has plagued the industry in recent times. As CEO of CertiK, a blockchain security firm, I have closer contact than most with the hundreds of hacks and scams that drain billions of dollars of value from Web3 every year. While there are many incredible projects out there that take security seriously and will go to any lengths necessary to protect their customers' funds while delivering a cutting-edge service, it's disappointing to see more than $3.7 billion lost in 2022 alone.
And that's just the on-chain figure, it doesn't count the many billions more currently locked up in bankruptcy proceedings after the collapse of a number of major centralized crypto firms and exchanges. FTX was the major story of the latter quarter of last year. Amid all the allegations of fraud and complete lack of due diligence, the fact remains that users were ultimately unable to access the funds they had deposited when they needed them, and many livelihoods were destroyed.
For an industry that prides itself on trustlessness and decentralization, this is not a good look. Crypto firms need to take a good hard look at the lessons that must be learned from FTX's collapse. It's the only way the industry as a whole will progress in the right direction and deliver on its real promise.
Centralized exchanges play an important role in the broader crypto landscape. They are one of the easiest ways for users to deposit and withdraw fiat currency. They allow for the low-fee trading of thousands of assets, which is invaluable to users who may not have the capital to make trading on-chain an economical choice.
Yet there remains a fundamental contradiction between centralized exchanges and decentralized assets and applications. The solution is not to abolish one in favor of the other, it's for centralized platforms to learn what they can from decentralized platforms, adopting crypto-native improvements wherever possible.
This is the right thing to do for both a centralized platform's users and its business. FTX users who were burned by the exchange's lack of transparency are unlikely to trust their assets to another exchange that doesn't go above and beyond to prove to its customers that its solvent. And more FTX-like collapses will drag the industry down further. Anyone who believes in the power of blockchain technology to change the world for the better has a duty (and financial interest) to raise the level of security and transparency across the entire industry.
Enter Proof of Reserves
One example of a crypto-native solution that can (and should) be adopted by centralized crypto firms is Proof of Reserves. The term Proof of Reserves refers to a number of methods by which cryptocurrency exchanges and other organizations can demonstrate their solvency and show that they do actually hold the assets they claim to have in reserve.
Cryptographic Proof of Reserves is a secure and user-verifiable way of proving that an exchange controls the assets they say they do. Merkle trees can be used to prove the existence of a set of customer deposits without revealing the actual balances or details of individual customer accounts.
A Merkle tree is a data structure that is often used in proof of reserves to demonstrate the authenticity and integrity of a set of transactions. A Merkle tree is a tree-like structure that is created by breaking down a set of transactions (including user deposits) into smaller hash values, which are then combined and hashed again in a recursive manner.
The root of the Merkle tree is the final hash value, which represents the combined hash of all the transactions in the set. This root hash can be published by the exchange, allowing users to verify that their account balance is included in the set.
This form of Proof of Reserves is far superior to quarterly statements or audits that merely attest to an exchange's reserves. With cryptographic Proof of Reserves, you don't need to trust anyone, you can verify, by yourself, that your deposits have been included in the Merkle tree.
One Small Step for Exchanges, One Giant Leap for Crypto
The adoption of cryptographic Proof of Reserves is an easily-achievable step for exchanges that will have broad significance for the wider industry. It will be proof that we are learning the lessons that need to be learned and making the kind of fraud that impacted millions of FTX users much more difficult to conceal.
It's also the sort of proactive self-regulation that sends a powerful message to the non-crypto world. Regulation is a tricky topic, but taking serious measures to protect users can only earn the industry goodwill. And who better to regulate the industry than those who understand it best and can build crypto-native tools themselves? If it's not us, that job falls to outsiders who will not view our failure to self-regulate kindly.
Cryptographic Proof of Reserves does not compromise on any of the foundational ethics of crypto. In fact, it helps preserve them, by calling out those organizations that trade off the name of crypto without living up to its ideals. The adoption of cryptographic Proof of Reserves is a test for the industry, and it's one that we must pass in order to really build the future we all believe in.
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