Why publishing proof-of-reserves paints only half the picture of a crypto exchange’s health

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In the aftermath of the collapse of FTX, renewed calls have been heard for a more stringent disclosure mechanism to be adopted by cryptocurrency exchanges.

Such a system would assuage investor concerns and provide a regular update on the exchanges’ health to the larger crypto community, the reasoning goes.

The most advocated measure has been the periodic publishing of the proof of reserves, providing an indication of the standalone asset value of a crypto exchange.

However, this still doesn’t address the solvency issue that was ostensibly the reason for the FTX debacle and mandates a more holistic approach to arrive at an understanding of  the true financial health of a crypto exchange.

Founded by billionaire Sam Bankman-Fried, the FTX was a cryptocurrency exchange whose unique selling point was derivatives trading in cryptocurrencies. The exchange offered products including futures, options, volatility products and leveraged tokens. It claimed to be “built by traders, for traders.”

Bahamas-based FTX filed for bankruptcy on Friday after a rash of customer withdrawals earlier in the week. A rescue deal with rival exchange Binance fell through, triggering the crypto world's biggest collapse in recent years.

Transparency concerns  

Understanding the fact that FTX’s troubles stemmed from the misuse of its native crypto token FTT to fund its founder’s trading firm points us in the direction that crypto exchanges need to take to avoid trust concerns.

Employing a Proof of Reserves audit is the foremost step that needs to be enforced to prevent double-spending or financial misappropriation.

Explaining how this mechanism works, Johnny Lyu, CEO of crypto exchange KuCoin, said: “I think the lesson we learned from the FTX drama is that the crypto industry needs more transparency, with risk control being the preferred operation methodology.”

Lyu added that low-risk business and financial management are impossible without a dedicated risk team with many years of experience in managing trading businesses in both bull and bear cycles.

A short operating history and an aggressive financial strategy of risky deals or investments are unquestionably red flags that need to be recognized at the earliest, he said.

Commenting on why a full liabilities disclosure is essential, Lyu said: “Sharing Proof of Reserves is a good place to start, but the case of FTX shows that the full picture is impossible without Proof of Liabilities. And this is another challenging question, as actual liabilities would be hard to prove unless they were on-chain.”

This can be addressed through regular audits conducted by a reputed audit firm and integrating decentralized solutions in the reporting of off-chain processes or transactions in order to ensure 100% transparency, he added.

While almost all transactions on a crypto exchange are centralized and hence off-chain, the shift to blockchain-based or on-chain transactions will provide an added layer of security.

Liabilities disclosure  

In the case of FTX and its sister firm Alameda Research, their sudden unravelling was caused by the fact that the two firms had far fewer reserves than the liabilities on their books.

Exaggerated by the sudden devaluation of the native FTT token, it resulted in investors not being able to even withdraw funds or tokens that were held in FTX’s custody, leading to the precipitous fall of what was the world’s second-largest crypto exchange by daily transaction volumes.

Elaborating on what needs to be done to prevent such catastrophes, Aliasgar Merchant, Lead, Developer Relations, at decentralized cloud platform Akash Network, said that after the FTX episode, researchers have been compelled to think about ways in which they can detect and flag signs of a collapse at an early stage.

One of the best ways to keep a check on exchanges is through Proof of Reserves, a vetting method that involves simple steps to ensure that all crypto holdings are backed by real assets, according to Merchant.

How will it work?  

“This involves the exchange in question submitting details like account IDs and balances to an escrow that is held by an intermediary in an encrypted format,” Merchant said.

By ensuring that all on- and off-chain transactions are summarized using elements of decentralization, a vital check mechanism is created by using an auditor.

“A verification request can be sent by an auditor to the escrow, ensuring that all transactions conducted can be made transparent to users and investors at large. What’s more, based on the published addresses, the hash of individual customers can be matched to the hash in reserves, thereby creating a tighter fraud detection mechanism that can benefit all stakeholders,” Merchant added.

What should investors look out for?  

While efforts are on to create a self-regulatory framework among crypto exchanges, investors ought to perform their own research before selecting a crypto exchange for their trading needs.

The foremost consideration should be about how the crypto exchange stores investors’ digital assets and whether it forces users to invest in its native token to facilitate related transactions.

Crypto exchanges that adhere to the highest corporate governance standards would also adopt practices such as ensuring investor funds are locked on their platform, have a robust AML (anti-money laundering) framework to prevent loss of funds to a malicious attack, and have a strong balance sheet to tide over bear cycles.

Obviously, it goes without saying that any instance of a crypto exchange using user funds to engage in highly leveraged trades should be a clear warning sign for investors to take note of.

Moreover, having a Reserves-Liabilities ratio in excess of 100% for all tokens being traded on a crypto exchange is ideal, ensuring ample liquidity even in a scenario where users flock to sell their tokens.

This reporting is not mandated by any regulatory authority, but investors should   prefer crypto exchanges that voluntarily and regularly report this metric through a simple dashboard for utmost transparency.