In the last 3 days, Binance and FTX’s war shook the entire crypto industry, concluding with the downfall of FTX.
Essentially, fractional reserve was what caused the downfall of FTX, in which FTX misappropriated the funds of its users on a large-scale.
Hence, after FTX's downfall, users running were like the Sword of Damocles, which led to multiple CEXes publishing their entire proof-of-reserve.
That is notwithstanding Binance, the one who emerged victorious in the war between Binance and FTX.
All CEXes Announcing The Conducting of Their Merkle-Tree Proof-of-Reserve
Binance: Within 2 hours of proposing to fully buy over FTX, CZ stated that “banks run on fractional reserves”, but “crypto exchanges should not”. He also stated that “Binance will start to do proof-of-reserves soon. Full transparency.”
OKX: The official OKX Twitter stated, “It’s critical for all major crypto venues to publicly share their auditable merkle tree proof-of-reserves or POF. We plan to publish ours in the coming weeks (within 30 days). This is an important step to establish a baseline trust in the industry.”
Huobi: TRON’s founder and Huobi Global’s advisor, Justin Sun tweeted stating that historically, “Poloniex and Huobi Global have done it before. Huobi actually just finished it about one month ago. But we would love to do a third one with CZ’s proposal. Merkle-tree proof-of-reserves 100% is very important to our industry and transparency”.
BitMex：BitMex stated that “BitMEX was conceived in the ashes of Mt. Gox.”, “The first rule of crypto exchanges is “don’t ever lose users’ funds”” and that BitMEX “always keep 100% of our users’ funds”.
Gate：On 7 November, Gate.io published a proof-of-reserves on their official blog to show that their user asset reserves exceed 100%.
Kraken：Kraken tweeted that they are “committed to regular audits – enabling you to verify the balances you hold on our exchange are backed by real assets”, which was accompanied by their verification method.
Bitget：Bitget’s Managing Director, Gracy Chen stated that "we will soon be ready to share our merkle-tree proof-of-reserves to show transparency. Thorough and comprehensive audits are necessary to CEX”.
So, what exactly is the merkle-tree proof-of-reserves? Why can it prove 100% of reserves?
How Does The Merkle-Tree Prove 100% of Reserves?
First off, let’s understand what the merkle-tree is. The merkle-tree is a data structure. As illustrated below, there are 4 data nodes. Each data node consists of a user’s ID and their balance. Once you hash these 4 data nodes accordingly, you form the merkle leaves of the merkle tree. Then, upon combine the hash values of 2 merkle leaves together and hashing them, such an iteration will form a complete merkle branch. The uppermost node is known as the merkle root. Due to the characteristics of hash calculations, should there be any changes in the value of data node, the hash value of the merkle root will vary.
When we want to verify if any users are actually on the merkle tree – for example, User1 and their balance – we will just have to provide the value of the blue data nodes as shown in the figure below. As long as User1 knows their own user ID and balance, as long as Hash2 and Hash34 (these 2 hashes are provided by the exchange), they can verify whether or not they are on the merkle tree. Evidently, providing just these few data nodes is sufficient to hash up to the merkle root, and verifying that the value of the hash root matches is all that is required. We will use [User1, Hash2, Hash34] to verify User1’s merkle tree evidence/path.
Once the exchanges publish their merkle tree roots, there are 3 methods to prove whether it has 100% of its reserves.
1) Any user can verify their balance and UID on their tree.
2) A third party audit company to audit the aggregation of all the users’ balances on the merkle tree.
3) A third party audit company to audit all the wallet addresses and the sum of their balances from the exchanges.
Of course, although the aforementioned 3 methods can prove that the exchanges have a 100% reserve, it only indicates that the merkle tree roots that the exchanges published is 100% of their reserve at that point in time. Hence, it is still necessary that the exchanges constantly update their merkle tree roots to prove their reserves.
