Centralized exchanges are scrambling in attempts to prove their reserves

Multiple centralized crypto exchanges have indicated over the last few days that they will be offering proofs of reserves, a system through which users will be able to check the amount of funds held on the platforms, though not necessarily their liabilities.

This is facilitated by a "merkle trees," a type of cryptographic mechanism that helps create a summary of funds in an exchange’s wallets and generates proofs that can be verified on-chain, all without exposing sensitive customer information.

Trust has been plummeting for centralized exchanges over the collapse of FTX exchange, which most traders had considered to be trustworthy. Its CEO, Sam Bankman-Fried, never disclosed that it was loaning out customers' deposits for venture investment and lending activities. Much of the current distrust stems from FTX's mishandling of customer funds.

The exchange used about $10 billion of $16 billion in customer deposits to finance other activities, according to a WSJ report. 

Exchanges are desperate to assure users

Binance, which is the largest crypto exchange by daily trading volume, in a bid to be more transparent provided a snapshot of the reserves of its crypto wallets, though it's not the final and official proof of reserves that's audited.

Working off this data, Nansen, an on-chain data provider, displayed a dashboard showing Binance’s reserves, which are currently worth more than $60 billion. Other exchanges want to emulate this and are scrambling to assure users of their transparency.

Nansen’s research analysts are currently working with exchanges to display their proofs of reserves. Alex Svanevik, CEO of Nansen, said his team had received requests from exchanges asking to display their proofs on its platform.

Representatives from exchanges — OKX, Crypto.com, Kucoin, and Bybit — have said that they will either publish a list of their crypto addresses or implement a proof of reserves system, given the pressing concerns about the backing and safety of funds on centralized exchanges.

Both OKX and KuCoin, said they planned to share their holdings in coming weeks. “We're hiring an auditor & will publish an auditable Merkle POF asap,” OKX tweeted. 

“Protecting user funds is the top priority at KuCoin. We will release the Merkle tree proof of reserves or POF in about one month,”  KuCoin CEO Johnny Lyu said.

While this may be a good step in the direction of exchange transparency, such proofs of reserves cannot provide a full picture of a firm's financial health. The metric only shows the exchange’s dollar value of token holdings across exchange-provided addresses, the source of which can be entirely customer funds. 

It does not show the amount of liabilities an exchange may have on its balance sheet, Martin Lee of Nansen said. As such, an exchange’s financial position may differ from what is provided in a proof of reserves.