- Platforms show assets only at a fixed point in time, which enables manipulation
- Proof of liabilities is needed to determine asset safety and leverage
After Alameda Research and crypto exchange FTX collapsed, crypto exchanges and trading platforms are rushing to prove client funds are safe and not being used for speculative purposes. However, the Bank of America finds that proof of reserves have too many shortcomings to be reliable, at least in the form presented. The bank said this in a research report published on Thursday.
BAC notes that many exchanges are planning to or have already reported assets using Merkle Trees through proof of reserves. You can verify these efficient data structures securely. They are effective even if reserves become complicated. Also known as “hash trees,” they behave as a map of customer funds.
Assets are easy to manipulate in the form shown
Among the weaknesses is that the platforms show assets only at a fixed point in time, which enables manipulation, like taking out a loan right before the snapshot is taken according to the report.
Proof of liabilities is required
The report added that proof of liabilities is needed to determine asset safety and leverage. One can manipulate proof-of-reserve processes because they frequently rely on third-party audit firms, which the exchange itself can create. There is no stop button even in cases where the customer notices asset-liability discrepancies.
Stablecoin reserves need auditing
At the moment, platforms only display stablecoin reserves, but they need auditing too. The report added that the crypto industry must make a clear differentiation between market makers and trading platforms, which is not a weakness of proof of reserves.
More regulation is in order
The report emphasized that the industry needs more regulation, giving FTX’s regulatory status in the Bahamas as an example of this shortcoming.
This status makes it hard to establish whether FTX CEO and founder Sam Bankman-Fried violated any laws considering the fact that his exchange was not regulated as a broker. Until confidence in the market returns, decentralized exchange (DEX) trading volumes are anticipated to keep increasing, BAC concluded in its report.
