Neither the author, Tim Fries, nor this website, The Tokenist, provide financial advice. Please consult our website policies before making any financial decisions.
Even before Bankman-Fried was arrested for violating all of the book’s rules, Proof-of-Reserves (PoR) had become a popular crypto term. However, after the FTX collapse and Binance’s recent FUD, what is the real test to inspire confidence in the centralized aspect of the crypto space?
Proof of Reserves as a misunderstood first step
Barely two weeks after the FTX crash, Binance CEO Changpeng Zhao (CZ) endorsed Vitalik Buterin’s idea on how to prevent future FTX scams. The Ethereum co-founder suggested implementing Merkle trees to verify user funds on a centralized exchange (CEX).
Essentially, a Merkle tree allows auditors to verify the authenticity of data without tracing every piece of it. Instead, each branch of the data tree represents “hashes”, cryptographically compressed data. From top to bottom, auditors can contrast each branch with the data hash of the leaves (user transactions and funds) below it.
If there is a discrepancy, it is a sign that the back of the exchange may not be trustworthy. Several exchanges have implemented such verification for users: Kraken, BitMex, Gate.io, Coinfloor, HBTC, and Binance. For example, any user can use Binance’s record ID to verify that their account balance has been included in the exchange’s account balance.
Why Proof-of-Reserves Fail
According to all reports, FTX would not have passed such a basic test. Even if users’ funds are booked on an exchange, who says they aren’t tied to the liabilities of the exchange? For this reason, proof of reserves would have to be combined with proof of liability to obtain a true proof of creditworthiness as the ultimate test of trustworthiness.
After Binance successfully passed Mazars’ PoR test, the international auditor decided to delete the page with the report on December 7th. Likewise, the Paris-based firm paused all audit work for crypto clients. This includes not only Binance, but also Crypto.com and KuCoin.
“Mazars has suspended its activities related to providing Proof of Reserves Reports* to companies in the cryptocurrency sector due to concerns about the way these reports are understood by the public.”
Mazars spokesman on December 16
Mazars’ pullback was prompted by a week-long FUD (fear, uncertainty, doubt) surrounding Binance, which was responsible for over 70% of trading volume following the FTX crash. Simply put, the public misinterpreted Mazars’ Agreed Procedure (AUP) as a full audit. The resulting Binance FUD then tumbled into an avalanche, pushing Mazars himself into the spotlight.
In the end, Binance suffered a record $6 billion outflow, which is still valued at $55 billion in crypto assets. Along with other exchanges, eroded consumer confidence led to Bitcoin’s historic pullback above -100,000 BTC since Sam Bankman-Fried’s crime was exposed.
The FTX crash triggered the largest BTC (red) withdrawal frenzy in crypto history. Photo credit: Galaxy Digital Research
However, the assembled FUD did not crash Binance as a small drain crashed the FTX. Amid the FUD, Binance CEO reassured clients in one of the CNBC interviews that the world’s largest exchange “holds user assets 1-to-1 and that’s exactly what we do.”
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Is a bank run a real solvency test?
For an exchange to be considered solvent, one would need to consider its liabilities, not just proof of reserves. However, this is extremely difficult to prove, as each creditor would then have to check if they were listed on a public list of liabilities of the exchange. Other debts, rather than just user funds, would need to be coordinated and collated for easy public access.
Another way forward is to make the exchange a public company like Coinbase. Therefore, Coinbase is subject to quarterly external reviews instead of simple AUPs.
Until a more elegant solution for proving solvency is available, Binance FUD has shown that a bank run is the next best test of liquidity. Not only has Binance survived record outflows (a bank run), but Binance US has agreed to buy $1 billion in bankrupt Voyager Digital assets.
Like other lenders in the crypto space, Voyager Digital was burdened with risk since it was listed when it filed for bankruptcy and had a liability hole of between $1 billion and $10 billion filed. The epicenter was the collapse of Terra (LUNA), which passed to hedge fund Three Arrows Capital (3AC), to which Voyager Digital was exposed.
In a deadly mix of over-indebtedness and bankrun, Nansen identified Celsius Network as partially responsible for Terra’s UST stablecoin collapse. The $40 billion wipe out of Terra’s ecosystem, spearheaded by lending platform Anchor, in turn led to Celsius’ bankrun and subsequent bankruptcy.
Returning to DeFi basics?
The crypto space has gone in a strange direction. Led by Bitcoin as a peer-to-peer hard cash, its original purpose was to avoid centralized moral hazard and instead rely on smart contracts. However, it appears that a centralized and heavily indebted infrastructure was key.
The reason is simple. It is more convenient for the end user to rely on a third party for custody and set-and-forget farming with double-digit returns. This abbreviation has been completely unraveled. BlockFi, Voyager Digital, Celsius Network, Anchor, Gemini’s Earn program… are all unavailable at great cost to users.
Even now, as speculation spreads about the next CEX/lender default, decentralized exchanges (DEXes) are not being talked about. Due to the blockchain nature of DEXs, all finances are shown in full by default as users act as liquidity providers.
Due to their 100% reliance on blockchain and smart contracts, DEXes have slower transaction speeds and less liquidity than CEXes. In the end, users have to make a compromise. Is 100% solvency certainty worth it, or is less than 100% certainty worth the convenience?
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About the author
Tim Fries is co-founder of The Tokenist. He has a B.Sc. in mechanical engineering from the University of Michigan and an MBA from the University of Chicago Booth School of Business. Tim was a senior associate on the investment team of RW Baird’s US private equity practice and is also a co-founder of Protective Technologies Capital, an investment firm specializing in sensing, protection and control solutions.
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