Can reserve audits avoid another FTX-like moment?

In the wake of the FTX collapse that came about as a result of the now-bankrupt cryptocurrency exchange funneling user funds to mitigate its own risks, crypto exchanges came up with a transparency solution called proof-of-reserves. 

A practice, which was recently endorsed by Binance CEO Changpeng Zhao, offers a way for exchanges to show provide transparency to users in the absence of clear regulations.

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

Proof of reserves (PoR) is an independent audit conducted by a third party that seeks to ensure that a custodian holds the assets it claims to own on behalf of its clients. 

This auditor takes an anonymized snapshot of all balances held and aggregates them into a Merkle tree.

A Merkle is a cryptographic commitment scheme in which each “leaf,” or node, is labeled with a data block’s cryptographic hash. Their chief use to is to verify data that has been handled, sent or stored between computers. While invented in 1979, the concept has found extensive use in blockchain peer-to-peer networks.

After taking the snapshot, the auditor obtains a Merkle root: a cryptographic fingerprint that uniquely identifies the combination of these balances at the time when the snapshot was created.

The auditor then collects digital signatures produced by the crypto exchange, which prove ownership over the on-chain addresses with publicly verifiable balances. Lastly, the auditor compares and verifies that these balances exceed or match the client balances represented in the Merkle tree so that the client assets are held on a full-reserve basis.

A total of five centralized exchanges (CEXs) including Kraken, Bitmex, Coinfloor, Gate.io and HBTC have completed their proof-of-reserve audits while the likes of Binance, OKX, KuCoin, Huobi, Poloniex, Crypto.com, Deribit and Bitfinex have announced their plans to do the same.

Recent: Banks still show interest in digital assets and DeFi amid market chaos

The PoR practice made sense and was lauded by many in the crypto community as it seemed like a step toward a more transparent crypto ecosystem. Centralized exchanges can note the liabilities of each account on a public ledger with specific assets held. They would have to publish with a tag that only account owners can know, thereby retaining public…