Binance promised transparency with proof of reserves. Is that enough?

Crypto is full of these weird phrases, but Zhao — or CZ, as he’s commonly known — has hinted that proof of reserves can reform the industry by offering a new level of transparency that would prevent the patchy accounting that is being used collapse led to FTX’s rapid.

CZ doubled down on Friday’s Indonesia FinTech Summit, telling a large audience that proof of reserves is essential as regulators close in.

“That’s going to be absolutely the focus going forward, which is right,” he said. “We learned from our mistakes”

What is a proof of reserve?

Before the FTX firestorm, Binance was already the largest crypto exchange in the world, and SBF’s knee-slapping made CZ the undeniable kingpin.

In its first transparency tweet, CZ called for the exchange to perform “Merkle-Tree Proof-of-Reserves,” a data structure that encodes blockchain data. While blockchains are publicly auditable, centralized exchanges like Binance, FTX, and Coinbase don’t offer a similar level of transparency. If they were to post a Merkle tree, it would provide a sort of map of the client fortunes they hold.

The Merkle trees would organize relevant data – such as transactions involving smart contracts or between accounts – into hashes arranged in a series of parent and child nodes resembling a Christmas tree. It is a complicated cryptographic concept that would theoretically allow an external auditor to verify holdings.

“If Binance decides to implement this, it will have the potential to become a standard-setting force across the industry,” said Dr. Yesha Yadav, Vanderbilt University law professor who focuses on banking and financial regulation.

The day after CZ’s tweet, eight other exchanges announced they would be releasing Merkle tree reserve certificates.

Gautam Chhugani, Bernstein’s managing director of global digital assets, described the process as a “publicly verifiable proof of reserves” where an analyst can follow the trail and identify the exact level of reserves an exchange holds across different asset classes.

The problem with FTX was that many of its reserves were held in its own token, FTT – a precarious position that triggered a bank run. As depositors sought a return of their wealth, FTX did not have sufficient reserves, causing the exchange to become insolvent.

“There is simply a lack of transparency about the asset quality of different exchanges in relation to their actual type of safety buffers,” he said. “And that obviously came home to sleep at FTX.”

By demonstrating the reserves, exchanges would provide more transparency about the assets on the exchange and the nature of their liquidity buffers, and ensure assets are not heavily leveraged to allow users to access their holdings.

Therefore, Chhugani said that a Merkle tree proof of reserves would have revealed FTX’s sleight of hand.

“FTX would never take on something like this because of the specific actions they took using funds,” he said wealth.

Binance isn’t the only one demanding proof of reserves. Castle Island Ventures’ Nic Carter has documented other crypto companies that have embraced this practice.

“Trust but don’t verify”

While industry experts say proving reserves is a good start, they also argue that it is insufficient. Dante Disparte, chief strategy officer and head of global policy at Circle, said he was heartened by the new commitment to transparency among crypto firms. However, he warned that it is not enough for a company like Binance to just provide proof of reserves without an independent audit.

Proof of reserves “is worth about as much trust as you could possibly have in the organization providing proof of reserves,” he said wealth. “It’s not enough to take someone at their word and rely on promissory notes on Twitter.”

While blockchain data represents publicly available information, the case of the FTX empire — a knotted web of dozens of companies — shows how much deeper transparency efforts need to go.

“Proof of reserves is an interesting solution, but it falls far short of adequate for exchanges and other operations that reach large-scale, potentially systemic nature,” Disparte said. “Telling the market, ‘Well, millions of users around the world, trust me, but don’t check beyond what the chain is telling you,’ I think is problematic.”

He added that there should be an additional layer of third-party accounting.

Eric Berman, a cryptocurrency regulation expert for Thomson Reuters’ legal research business, said he doubts Binance would release a full set of its financials detailing assets and liabilities, though the exchange is likely to issue the types of cash reserves it does holds. As a private company, Binance is not required to publish its balance sheet.

“The trick will be whether Binance can provide the public with a sufficient level of confidence in the Merkle tree metrics and its disclosures,” he said wealth. “In any case, I don’t think this equates to ‘financial’ in the sense of CPA audited financial statements as we know them here in the US.”

On Saturday the investor and entrepreneur Vinny Lingham tweeted this proof of reserve was a distraction. What is really needed, he argued, is proof of debt, or a statement of how much a platform owes.

The need for regulation

Despite the shortcomings, many industry players argue that proving reserves is a positive step forward.

In a Twitter Spaces hosted by wealth On Thursday, Castle Island general partner Nic Carter said he had long been an advocate of proving reserves, although there hadn’t been much appetite until last week’s events.

One problem is that, as the concept is relatively young, auditing firms are not yet equipped to carry out the statutory audit.

“You’re taking a little bit more risk because it’s just a recent process,” said Carter, who also pointed to one of the top 25 law firms with experience, Armanino LLP, which has already been inundated with inquiries.

The constantly looming complication is that the crypto industry still lacks the regulation that exists in traditional finance, facilitating the reckless behavior of companies like FTX. As lawmakers and law enforcement agencies consider actual rules for crypto, proponents like Carter say proof of reserves could serve the industry as a form of self-regulation rather than waiting for top-down federal regulation.

“The industry could show good faith and show that the centralized organizations are totally reticent,” he said. “Of course, as a crypto bank, you have to be completely cautious because you just never know when a big withdrawal is going to happen.”

Yadav, the Vanderbilt law professor, narrated wealth that upcoming legislation could have been a motive for Binance’s announcement.

“Thinking a little more cynically, this is also a way to forestall some super-tough potential regulation,” she said. Yadav also warned that fully transparent reserves could have the opposite desired effect.

In traditional finance, transparency efforts are generally conducted by regulators, not the public. “If someone sees that you might be selling a lot of government bonds and a lot of your assets, then you might be in trouble,” she added. “It may trigger the problem you are trying to solve.”

What’s next?

Since Binance requires proof of reserves, the question will be whether the exchange will actually go ahead. A Binance spokesman said wealth that the company is currently working on the next phase and plans to share it in the coming weeks.

“We intend to provide proof of reserve audited by a third party, with user verification available on third party platforms to verify and audit our customer inventories. We will provide BTC verification first, followed by other tokens,” they said.

They pointed to an initial update on Nov. 10 in which Binance released its holdings of BTC, ETH, BSC, BNB, and TRX wealth“This is not a complete dataset, but we are working on it for the next phase and more information will be published in the full audited report.”

Castle Island’s Carter said there have never been as many doubts about the quality of financial reserves at Binance as there have been at FTX, but the exchange is far from transparent.

“There’s still the fact that they’re that kind of borderless, domicile-free exchange that’s perceived as kind of a wild card,” he said during the Twitter Spaces.

Last week, Reuters reported that Binance has processed $8 billion worth of Iranian transactions despite US sanctions. Meanwhile, the Justice Department is conducting an investigation into Binance for possible money laundering violations, highlighting the exchange’s shaky regulatory foundation.

Still, during his speech on Friday, CZ stressed that Binance would still succeed where others have failed.

“It’s another wake-up call,” he said. “The last three days have been a revelation of anger, but the anger has been there for much longer.”

Vivienne Walt contributed to the coverage.