Binance says 'proof of reserves' can restore trust in the crypto industry. What does that mean?

Crypto is filled with these sort of wonky phrases, but Zhaoor CZ, as hes more commonly knownhas suggested that proof of reserves can reform the industry, offering a new level of transparency that would prevent the sketchy accounting that led to FTXs rapid collapse.

CZ doubled down on Friday at the Indonesia FinTech Summit, telling a large audience that proof of reserves would be essential as regulators creep ever closer. 

That is absolutely going to be where the focus is for the next little while, which is right, he said. We have learned from our mistakes.

What is proof of reserves? 

Before the FTX firestorm, Binance already was the worlds largest crypto exchange and, by kneecapping SBF, CZ became the indisputable kingpin. 

In his initial tweet on transparency, CZ called for exchanges to do Merkle-tree proof-of-reserves, a data structure that encodes blockchain data. While blockchains are publicly verifiable, centralized exchanges like Binance, FTX and Coinbase do not offer a similar layer of transparency. If they published a Merkle tree, it would provide a map of sort for the customer assets they hold.

The Merkle trees would organize relevant datasuch as transactions with smart contracts or between accountsinto hashes, arranged into a series of parent and children nodes that resemble a Christmas tree. Its a complicated cryptographic concept that theoretically would allow a third-party auditor to verify the holdings. 

If Binance does decide to implement this, its going to have the potential for a standard-setting impact across the industry, said Dr. Yesha Yadav, a law professor at Vanderbilt University who focuses on banking and financial regulation.

In the day after CZs tweet, eight other exchanges announced they would publish Merkle tree reserve certificates. 

Gautam Chhugani, the managing director of global digital assets at Bernstein, described the process as a publicly auditable proof of reserves, where an analyst could follow the trail and identify the exact amount of reserves an exchange holds across different asset classes.

The problem with FTX was many of its reserves were held in its own token, FTTa precarious position that precipitated a bank run. With depositors seeking a return of their assets, FTX didnt have sufficient reserves, rendering the exchange insolvent. 

Theres just a lack of any transparency about the asset quality of different exchanges in terms of their actual kind of safety buffers, he said. And that obviously came home to roost with FTX.

With proof of reserves, exchanges would offer more transparency around the assets on the exchange and what kind of liquidity buffers they have, as well as ensure that the asset qualities are not deeply leveraged so users can access their holdings.

As such, Chhugani said a Merkle tree proof of reserves would have exposed FTXs sleight of hand. 

FTX would never adopt something like this because of the specific actions that theyve conducted with use of funds, he told Fortune.

Binance is not alone in calling for proof of reserves. Nic Carter of Castle Island Ventures has documented other crypto companies who have committed to the practice.

'Trust, but dont verify 

While industry experts say proof of reserves is a good start, they also argue its insufficient. Dante Disparte, the chief strategy officer and head of global policy at Circle, said he's encouraged by the new commitment to transparency among crypto firms. However, he warned that for a company like Binance, simply presenting proof of reserves without an independent audit isnt enough.

Proof of reserves is worth about as much trust as you might have in the entity providing the proof of reserves, he told Fortune. Its not enough to take someones word and rely on promissory notes on Twitter. 

While blockchain data presents publicly accessible information, the case of the FTX empirea knotted web of dozens of companiesreveals how much deeper transparency efforts must go.  

Proof of reserves is an interesting fix, but its not nearly sufficient enough for exchanges and other operations that are reaching a large-scale, potentially systemic nature, Disparte said. To tell the market, Now, millions of users around the world, trust me, but dont verify beyond what the chain tells you, I think thats problematic.

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

Eric Berman, a cryptocurrency regulation expert for Thomson Reuterss legal research business, said he doubts Binance would release a full set of its financials listing assets and liabilities, although the exchange likely will issue the types of liquid reserves its holding. As a private company, Binance is under no obligation to publish its balance sheet.

The trick is going to be whether Binance can provide the public with a sufficient level of confidence in the Merkle tree metrics and its disclosures, he told Fortune. In any event, I dont think this equates to financials in the sense of annual CPA-audited financial statements that we are familiar with here in the U.S. 

On Saturday, the investor and entrepreneur Vinny Lingham tweeted that proof of reserves was a distraction. What was really needed, he argued, was proof of liabilities, or an accounting of how much a platform owes.

The need for regulation 

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

In a Twitter Spaces hosted by Fortune on Thursday, Castle Island general partner Nic Carter said he's long been an advocate for proof of reserves, although there hadn't been much appetite until last weeks events.

One issue is that, as a relatively nascent concept, accounting firms are not yet equipped to handle the auditing.

You are undertaking a bit more risk because its just a newer procedure, said Carter, who also pointed to one top 25 firm with experience, Armanino LLP, which has already been inundated with requests.  

The ever-looming complication is that the crypto industry still lacks the regulation present in traditional finance, facilitating the reckless behavior of companies like FTX. As lawmakers and enforcement agencies consider actual rules for crypto, advocates 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 demonstrate that the centralized organizations are fully reserved, he said. Of course, you have to be fully reserved as a crypto bank, because you just never know when theres going to be a big withdrawal.

Yadav, the Vanderbilt law professor, told Fortune that impending legislation could have been a motive for Binances announcement.

Thinking a little bit more cynically, this is also one way to preempt super harsh potential regulation, she said. Yadav also warned that fully transparent reserves may achieve the opposite desired effect. 

With traditional finance, transparency efforts are generally conducted by regulators, not the public. If someone sees maybe youre selling a lot of treasuries and youre selling a big chunk of assets, then maybe youre in trouble, she added. It can trigger the problem youre trying to solve.

What comes next? 

With Binance calling for proof of reserves, the question will be whether the exchange actually follows through. A Binance spokesperson told Fortune that the company is current working on the next phase and plans to share it in the coming weeks.

"We intend to provide a proof of reserve that would be audited by a third party vendor with user verification available on third party platforms to verify and audit our customer holdings. We will first be providing BTC verification then followed by other tokens," they said.

They pointed to an initial update from Nov. 10 where Binance published its holdings of BTC, ETH, BSC, BNB, and TRX, telling Fortune, "This is not a complete set of data but we are working on it for the next phase and more information will be shared in the full audited report."

Carter from Castle Island said there has never been much doubt about the quality of financial reserves with Binance like there was with FTX, but the exchange is still far from transparent.

There is still the fact that they are this kind of borderless, domicile-free exchange thats perceived as being kind of a wildcard, he said during the Twitter Spaces.

Last week, Reuters reported that Binance had processed $8 billion of Iranian transactions, despite U.S. sanctions. Meanwhile, the Justice Department is pursuing an investigation into Binance regarding possible violations of money laundering rules, highlighting the exchanges shaky regulatory footing. 

Nevertheless, during his Friday address, CZ emphasized Binance still would succeed where others have failed. 

This is another wake-up call, he said. The last three days was a revelation of trouble, but the trouble was there way longer. 

Vivienne Walt contributed reporting.