Proof of Reserves: Can it Save CeFi Exchanges?

Ethereum co-founder Vitalik Buterin and Binance CEO Changpeng “CZ” Zhao announced a proof-of-reserves test, a new exchange liquidity transparency protocol. After FTX’s collapse, CeFi solvency is on the mind of every person with funds tied up in a crypto exchange. 

The list of arguments for taking crypto off of exchanges and securing it in a cold wallet is long. However, many casual crypto investors rely on the low barrier of entry to centralized custodial exchanges. Can the new protocol by Buterin and Zhao save CeFi?

What is proof of reserves, and how does it work?

Two days after Zhao announced Binance would liquidate its FTT, FTX’s native token, he also announced proof-of-reserves for the exchange. The protocol uses an algorithm called “Merkle Trees” to organize and verify large amounts of data in a single blockchain hash. Essentially, the protocol collects and organizes information on a custodial exchange’s liquid assets. In other words, it leaves a public paper trail of an exchange’s liquid assets. 

Although, it appears CZ and Buterin’s version of proof-of-reserves will differ slightly from the current version. Zhao said the pair will use Binance as a guinea pig for “some type of new proof-of-reserves protocol.” However, there are no details of the differences at the publication of this article.

Can the protocol save custodial exchanges? 

According to CoinDesk, while a step in the right direction, the protocol isn’t some deus ex machina for crypto exchanges. After Zhao announced Binance would implement the protocol, several other popular exchanges, including, followed suit. 

“[I]t’s going to have the potential for a standard-setting impact across the industry,” said Vanderbilt law professor Yesha Yadav. But unfortunately, even if the industry widely adopts proof-of-reserves, some experts say it’s only a bandage for a deep wound. 

“Proof-of-reserves is an interesting fix,” said Circle’s chief strategy officer, Dante Disparte. “[B]ut it’s not nearly sufficient enough for exchanges and other operations that are reaching a large-scale, potentially systemic nature.”

Disparte continued by adding that it’s essentially telling millions of custodial exchange users to trust an exchange to hold itself accountable. And that each exchange using the protocol should have unrelated third-party audits.


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