In the wake of the FTX fiasco, blockchain transparency is a priority for centralized crypto exchanges, users, and policymakers. The misuse of user deposits by what was once the second-largest centralized crypto exchange has prompted the crypto community to take action and demand stringent efforts to ensure it doesn’t happen in the future. Proof of Reserves audits help centralized crypto exchanges prove they hold enough crypto assets on their balance sheets to cover user deposits. These audits use Merkle trees as part of a cryptographically-reconciled data structure to prove that assets are backed, while preserving user privacy. If you’ve ever had Merkle trees explained to you in a way that didn’t make sense, read on to learn how they work and what makes them essential for blockchain transparency.
In this article, we’re going to dive deep into the world of blockchain transparency. We’ll explore why transparency is so important for crypto exchanges and how Proof of Reserves audits help exchanges to be transparent in their asset management. Also, we’ll discuss Merkle trees and explain how they assist in audits. Additionally, we’ll look at decentralized autonomous organizations (DAOs) and how they promote transparency using governance tokens and smart contracts.
What is Proof of Reserves?
Proof of Reserves is an auditing process that crypto exchanges use to prove they have all the assets they need to cover user deposits. The ongoing FTX saga has shone a light on the number of crypto exchanges that may be putting user funds at risk. Any centralized crypto exchange that provides interest-bearing accounts is now under heavy scrutiny from investors who are keen to know how liquid an exchange is before depositing funds into it.
Several prominent exchanges are exploring Proof of Reserves audits to increase transparency and promote trust by proving all user deposits have sufficient backing. These audits rely on Merkle trees, a data structuring technique that enables auditors to prove the existence of funds in specific user accounts without disclosing sensitive data that could compromise them.
At the time of writing, investor sentiment is understandably low, especially when it comes to having funds on exchanges. Centralized exchanges that want to prove their legitimacy are considering Proof of Reserves audits to restore customer faith in these platforms and place them in good stead when the regulators come knocking.
Moreover, Proof of Reserves audits allow third-party auditors to prove that exchanges are not misusing customer deposits. Merkle trees are essential to these audits. They allow them to take place in a secure, privacy-preserving environment with cryptographic reconciliation.
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Merkle Trees Explained
If you’ve ever had Merkle trees explained to you in a way that was confusing, you’re not alone. Unless you’re a computer scientist that understands complex data structures, you’ve probably never had a good reason to explore them in detail. Merkle trees, also known as binary hash trees, allow users to encode blockchain data securely. A hash is a process that allows cryptographers to convert a string of characters into a different value. This entails taking a long string of numbers and letters and representing it as a much shorter, fixed-length value that references the original string of characters, but does not bear any semblance to its original form.
Blockchain transactions can be run through specific algorithms to create hashes and verify the data within them. This allows nodes to confirm the legitimacy of transactions without exposing the values they represent. Also, it allows network participants to verify transactions without downloading the entire blockchain. This is because each transaction is “hashed” into a block.
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Merkle Trees and Hashing Explained
The Merkle tree data structure is what determines the relationship between transactions after hashing. Different blockchains use variations of Merkle trees. To explain how Merkle trees work in basic terms, let’s look at how they work on the Bitcoin blockchain. As shown in the image below, we have the original data blocks at the bottom of the tree, with Merkle leaves above them:
The Merkle leaves are the first series of hashes, followed by the Merkle branches, which are intermediate hashes. Merkle branches are then summed into the Merkle root, which is stored in the header of the corresponding block of transactions and combined with data about the node client version in use and the hash of the previous block, along with other data. Once this data is run through a hash function, it creates a unique hash for that block of transactions.
Moreover, Merkle trees allow network participants to query blockchains and verify that all is in order without exposing the details of each transaction. By obtaining the Merkle root, network participants can verify that the sum of all balances on an exchange is equal to the account records held on-chain. Any adjustments to transactional data via tampering are present in the Merkle root, assuring network users that double-spending of assets does not occur.
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Proof of Reserves Pros and Cons
The ability for crypto exchanges to prove they hold enough assets to cover user deposits is a clear win for blockchain transparency and investor confidence. The decentralized blockchain architecture emphasizes the importance of having no single point of failure, so it’s essential that exchanges do everything they can to ensure they can attest to the safety of user deposits. Also, compared to the legacy financial system, there are no measures in place to prevent the domino effect that occurs when one crypto exchange goes bust and causes a liquidity crisis. Accordingly, a Proof of Reserves audit helps to ensure this doesn’t happen.
The transparency of asset management is beneficial for investors and is a priority for policymakers. When engineers implement Merkle trees correctly, it enables third-party auditors to safely verify an exchange’s account balances and detect any tampering or illegal use of customer assets.
Though Proof of Reserves audits increase blockchain transparency, there are some potential drawbacks to consider. For example, Proof of Reserves audits don’t work if the auditor and the auditee are colluding to manipulate the results. Also, these audits struggle to account for lost private keys or stolen funds, which can result in an incomplete audit trail. Likewise, audits fall short if an exchange has borrowed funds to cover gaps on its balance sheet.
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Why is Blockchain Transparency Important?
Blockchain transparency is essential for the mass adoption of Web3. Public blockchains like Bitcoin and Ethereum are inherently transparent. However, centralized crypto exchanges are coming under increasing pressure to prove that they take care of user deposits and don’t misuse them.
Centralized exchanges provide fiat on-ramps and convenient storage for crypto assets. However, when you hold your assets on a crypto exchange, you don’t own the private keys to your wallet and therefore don’t have custody of your assets. If the exchange misuses your funds or is the victim of a hack, you have little power to act. As so many people leave their crypto assets on centralized exchanges, the onus is on the exchanges to ensure they can secure user funds.
Initiatives like Proof of Reserves audits make it easier for exchanges to be transparent, which makes it easier for them to gain user confidence. For the mass adoption of cryptocurrencies to become a reality, users need to know they can trust exchanges to act in their interests. Also, regulators need robust frameworks to prevent crypto exchanges from exploiting user trust.
Are All Blockchains Transparent?
Public blockchains like Ethereum and Bitcoin allow anyone to publicly view the records for each transaction on the distributed blockchain ledger using a block explorer. However, private and permissioned blockchains work slightly differently. While a decentralized network of nodes maintains public blockchains, private blockchains are usually controlled by a small group of nodes, making them centralized. As such, we generally think of public blockchains as being transparent, not private ones.
On the other hand, the transparency of blockchain networks does not always translate into crypto exchanges. The places where most people buy and sell their crypto assets often disguise how they manage user funds, making them a liability in terms of blockchain transparency. Additionally, some privacy coins and coin mixers allow users to obfuscate transactional data so it’s difficult to trace crypto transactions. However, regulators and lawmakers tend to frown on these technologies.
A decentralized autonomous organization (DAO) is a community governance model that increases blockchain transparency. DAOs allow governance token holders to decide the future direction of a blockchain protocol via on-chain voting. Community members can submit update proposals to make adjustments to various parameters of a protocol. Governance token holders can vote by “spending” their tokens and locking them in a smart contract.
Smart contracts are immutable agreements that live on the blockchain. They play an essential role in automating agreements between entities without the need for trust, which is the foundation upon which decentralized finance (DeFi) is built. When DAOs vote, funds are locked in smart contracts, which anyone can view on-chain. When it comes to voting on where funding should go and how it’s spent, smart contracts and DAOs facilitate transparency by making it almost impossible to hide how funds are managed.
DAOs use monetary incentives to ensure that all members have a stake in the decision-making process. Community members can quickly identify bad actors who attempt to misuse DAO funds. Plus, members risk financial loss for attempts to defraud the DAO. DAOs aren’t perfect, and their members can manipulate them. For example, if one person owns a significant number of the total supply of governance tokens, they can game the system. However, DAOs show the benefits of blockchain transparency and are key components of the community-governed Web3 landscape.
Moreover, DAOs help blockchain networks to avoid centralization and provide additional utility to crypto assets. Plus, they allow blockchain projects to develop in the direction that the community decides instead of meeting the needs of a small group of influential individuals.
Blockchain Transparency: Proof of Reserves and Merkle Trees Explained – Summary
Although Proof of Reserves audits and Merkle trees cannot prevent all foul play in the crypto space, they facilitate the blockchain transparency that’s essential for the growth of the industry. They allow crypto exchanges to prove that they can be reliable with user funds and prevent the misuse of funds that led to the collapse of FTX, one of the biggest crypto exchanges in the world.
If you’re one of the many people who’ve had Merkle trees explained in a way that was unclear, think back to the examples we explore in this article. You don’t have to be a computer scientist to understand how Merkle trees increase blockchain transparency via Proof of Reserves audits, which look set to become a prominent feature in the crypto space.
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