Vitalik Buterin proposes a method to make reserve testing more reliable

Ethereum's confounder presented an alternative for exchanges to demonstrate their cryptocurrency reserves.

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One of the most important consequences of the FTX disaster is the loss of confidence of exchange users. Several of these companies, such as Binance, were quick to run reserve tests to demonstrate the liquidity of their exchange platforms. However, these tests have been questioned.

Vitalik Buterin wrote a whitepaper that seeks an alternative to this type of reserve testing.

According to a paper released today by Buterin, “exchanges could create cryptographic proofs showing that the funds they have on the chain are sufficient to cover their liabilities to their users.”

The purpose of this would be to put aside the reliance on government licenses, external auditors and the practice of having to “vet” the corporate structure and background of the people who make up these entities.

Buterin calls this method the “solvency test“. In simple terms, it is an asset test and liability test. It depends on several factors, which include a technical solution called Merkel tree (used in Bitcoin to know the veracity that a transaction is legitimate) and the zero-knowledge proof (ZK SNARK, which serves to prove that a cryptographic procedure is legitimate without revealing data about its participants).

These techniques would make it possible to preserve the privacy of people who have deposits in exchanges; something that cannot be guaranteed with just a list of deposits.

In addition, it is possible to make a public balance sheet with the total balances. But, without these techniques, every balance could be consulted by anyone on the web.

How the solvency test works

The solvency test consists of creating a public register that totals the sums of all deposits in a structure called a Merkel tree (which can improve its level of privacy if zero-knowledge testing is used). This method would guarantee the veracity of the figures declared. It would also allow anyone to check if their balance is included in this cryptographically based structure and to verify if there are no negative balances.

In other words, the exchanges would “send each user a proof of the Merkle sum of his balance. The user would then have a guarantee that their balance is correctly included as part of the total.”

To preserve privacy and avoid revealing the full set of their addresses, the exchange could even run a zero-knowledge proof on the blockchain where it proves the total balance of all addresses on the chain that have this format.

The other major issue is protection against double collateral usage. Swapping collateral with each other to do proof of reserves is something that exchanges could easily do and would allow them to pretend to be solvent when in fact they are not. Ideally, solvency testing would be done in real time, with a test being updated after each block.

Vitalik Buterin, Having a secure CEX: solvency testing and more.

Buterin suggests that not everything can be verified cryptographically, as exchanges hold balances in fiat currencies. Therefore, it is necessary to resort to corroboration methods that stem from corporate audits used by traditional banks and KYC methods.

Still, Buterin believes that both custodial exchanges (“where funds are held in something like a validating smart contract”) and non-custodial exchanges will continue to coexist.

“The simplest way to improve the security of custodial exchanges with backward compatibility is to add a proof of reserve. This consists of a combination of asset testing and liability testing,” Buterin opines.

Impact of FTX on exchanges

During the recent Binance fund consolidation, Bitcoin network congestion was created, as reported by CryptoNews. This posed a challenge for the Bitcoin network, due to the potential for fees to rise. Something that did not happen due to the adoption of improvements such as Segwit, which contribute to making the network more efficient.

In any case, it is a fact that people see a risk in the use of exchanges, since after the fall of FTX their funds have decreased.

The problem of lack of trust has extended to platforms that trade ETFs, stocks or bitcoin futures. Companies such as Grayscale have faced the lack of trust of their users by attesting to their reserves, as have companies such as Genesis, both related to traditional finance.

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