All Custodial Crypto Exchanges Should Adopt Proof-of-Reserve Programs, but Even That Isn’t Enough

Last week FTX, once the third-largest crypto exchange by volume, owned and run by founder Sam Bankman-Fried (SBF), went through a meltdown. Here’s how that went down:

• On Nov. 2, a CoinDesk scoop showed that Alameda Research, SBF’s quantitative crypto trading firm, had a funny-looking balance sheet
• On Nov. 6, Changpeng “CZ” Zhao, founder and CEO of the largest crypto exchange, Binance, announced his firm would sell all of the FTT, FTX’s exchange token (more on that below), that it held
• Then, FTX claimed there were no issues at FTX
• Then, FTT’s price tanked
• Then, we got this headline: FTX Agrees to Sell Itself to Rival Binance Amid Liquidity Scare at Crypto Exchange

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I think it’s more accurate to attribute FTX’s fall to a “solvency issue” rather than a “liquidity scare” (which just means FTX owed people some money and it couldn’t pay). But that doesn’t really matter because this potential purchase was subject to a due diligence process.

• That due diligence process took almost no time at all before we got another CoinDesk scoop: Binance Is Strongly Leaning Toward Scrapping FTX Rescue Takeover After First Glance at Books
• … followed hours later by official confirmation: Binance Walks Away From Deal to Acquire FTX

The market, unsurprisingly, was puking everywhere as it grappled with sparse details as events unfolded in real time. Binance ultimately pulled out of the deal because FTX’s issue were "beyond [Binance’s] control or ability to help."

A crude description of what this means is that FTX would be unable to satisfy customer withdrawal requests for the funds stored on its platform because FTX had been doing all sorts of things with those deposited funds and those things turned out to be bad for the value of the deposited funds. Now, this is a relatively normal practice. Even your local credit union does things with funds you deposit with them; “doing stuff” wasn’t FTX’s transgression.

By way of example, when you deposit money into a bank account, the bank lends your money out to other customers who want to buy cars, houses or a new gaming rig in exchange for an interest rate. Some banks do more exotic things, like allow customers to put up collateral (like a stock, bond or cash) to borrow some other asset to trade it. Herein lies FTX’s transgression.

FTX was doing that. It allowed customers to borrow things like bitcoin for cash to make trading bets. That’s all fine and dandy as long as FTX manages risk responsibly (whatever that means) and is transparent with its customers (much clearer, just tell customers everything).

Where FTX went wrong, besides the lack of transparency, was behavior regarding FTT, its native crypto token. FTT is like an equity stake in FTX itself, because every so often FTX uses its profits to buy some FTT off the open market (which should increase FTT’s price because of supply and demand). Customers were allowed to deposit FTT with FTX and use that as collateral to borrow other crypto assets or cash to make trading bets.

Now it’s not immediately obvious but this is an awful idea. Here’s why:

If the health of FTX is even remotely questioned (like how a company with the same founder in the same industry has a funny-looking balance sheet), then its equity (or things that are sort of equity) loses value. And if FTX is holding a lot of FTT on behalf of customers who are making trading bets, then that FTT is less valuable collateral, which means that the health of FTX degrades, which means FTT would lose value.

And so on and so forth.

You know what this sounds like? Yeah, it sounds like how roughly $60 billion of value evaporated basically overnight in May 2022 with the collapse of Terra.

Dizzy yet? Me, too. Let’s pause for a moment.

I’m not sure about you, but this sounds like something else I’ve heard about before. That is: What was happening in the leadup to the Great Financial Crisis in 2007 when financial institutions were doing all sorts of exotic things with mortgages, and taking trading bets on the performance of those mortgages.

So given the insistence of crypto-natives to avoid the failings of traditional finance (TradFi), what has the reaction been from people in the industry?

One of the more reasonable calls to action has been the urging for cryptocurrency exchanges to implement “proof-of-reserves” to combat the huge loss in credibility the collective body of cryptocurrency exchanges just felt.

So what is proof-of-reserves and how can it save us?

Proof-of-reserves is basically a fancy way of saying: “Hey, here’s proof that we have what we say we have.”

A very simple example: Let’s say you have 1 bitcoin that you bought on an exchange called “Shh! Just Trust George” and you leave it there for the exchange to take care of it on your behalf. For all intents and purposes, that 1 bitcoin is your bitcoin; Shh! Just Trust George is just holding it for you. Because of the transparency of the Bitcoin blockchain, there should exist some proof (cryptographic or whatever) that Shh! Just Trust George does in fact have your 1 bitcoin in its reserve.

From a finance-talk perspective, Shh! Just Trust George should be able to easily prove that its assets, the bitcoin it holds, match up with its liabilities, the promise that Shh! Just Trust George will give a customer their bitcoins when they ask for them.

Some proponents, like CoinDesk columnist Nic Carter, have been urging cryptocurrency exchanges to implement this for a while. Some have, like Kraken and BitMEX, and since the FTX-and-related meltdown the likes of Binance, OKX, KuCoin, Poloniex and Huobi have all promised to issue a proof-of-reserves attestation (or similar) in the coming days, weeks or months.

Papering over some technological details, there’s a way to use Merkle trees, which are data structures used in bitcoin, to do this in a sleek and cost-effective way. I think this is great. We should aspire for more transparency in our financial services, and proof-of-reserves could provide that.

But there’s a missing piece to the practical implementation of proof-of-reserves that enterprising readers might recognize as a potential flaw. In practice there will likely also have to be a third-party auditor hired to attest to the proof-of-reserves (as Kraken has).

You might see where this is going … more third parties, more potential centralizing choke points. So while implementing proof-of-reserves is a massive step in the right direction, it is certainly still not enough.

We need more than proof-of-reserves

Here are two of the (potentially many) reasons why we need more than proof-of-reserves from crypto exchanges:

1. We’re still partially depending on humans. Sure, these are humans at audit firms, but the humans at defunct accounting firm Arthur Andersen didn’t catch that the humans at Enron were engaged in fraud.
2. While a proof-of-reserves attestation might show that an exchange does in fact have the bitcoin (or other asset) you asked it to hold for you, there’s no guarantee it hasn’t done a bunch of other stuff with your funds.

So human fallibility can still upend proof-of-reserves. Somehow the hefty financial rewards that come with the financial shenanigans needs to be outweighed.

Here, though, are some shreds of hope.

Modern finance has consistently seen busts that are worse than the booms that preceded them. And the busts have hurt enough people in a short enough timespan that these people will demand more clarity and transparency going forward. If customers don’t, the policymakers will be sure to try to make that happen (even though it hasn’t really been successful so far yet).

On top of that, at risk of sounding like a Luddite, I also think consumers are wising up to one of the problems with contemporary business: complexity. Sure, without complicated things we wouldn’t have, say, circuit boards. But there’s a glut of companies, businesses, movements and jobs that can’t be simply explained anymore. That’s a problem for transparency, whatever the protagonists’ intentions.

So, after a week of dizzying revelations involving a once-heralded new business of the New Era, I leave you with one simple idea: Let’s get back to the basics.