Transparency – or lack thereof – has become a prevalent talking point in crypto, especially since the Terra Luna and FTX market crashes.
Why Lack of Transparency Is Bad For Crypto
To understand why a lack of transparency is bad for crypto, the first thing to understand is that the vast majority of crypto assets are held on centralized exchanges.
Here are several issues with exchange transparency and conditions of use:
[1] “Not your keys, not your crypto.” A frequent practice in many exchanges’ terms and conditions is that you technically don’t own the cryptocurrency, the exchange does.
They hold the rights to the crypto you purchase as they facilitate the orders and own the private keys.
[2] Withdrawal limits. During heavy sell-off periods where the crypto market is spiralling, many exchanges have been known to limit withdrawals to protect their potential downside. Often, exchanges will cite ‘volatile market conditions’ as the reason behind the withdrawal limitations, but protecting their own capital at the cost of their users is not good for reliability or longevity.
[3] Regulation. Since crypto is a mostly unregulated industry, direct legal repercussions aren’t a guarantee. So if an exchange were to withhold funds, or if funds were directed to the wrong address, a settlement in your favour is unlikely as the exchange May deem itself to be void of reimbursement. Until the money is safely moved off the exchange, the user’s funds are unprotected.
[4] Centralization. A governing body of individuals – potentially influenced by shareholders, government, and partners – has compromized motives. There has been multiple incidents – specifically Celsius and FTX – where exchanges have:
Used investors money for their own leisure.
Failed to provide correct information on how the exchange handles its liquidity.
Suffered insider theft or fraud, which is when an employee with inside access misappropriates or steals assets.
Faked balance sheets and provided skewed information that intentionally misled investors by over projecting available liquidity.
Time and time again exchanges have shown that they cannot be relied upon.
[5] Security. Due to their centralized layout, exchanges have a single governing body, which in other words is a single point of failure as it only requires one area of the exchange to be compromized to gain inside access to anything on the exchange.
Proof of Reserves (PoR)
“Proof of Reserves is a transparent auditing practice for cryptocurrency companies that provides an unbiased report of the companies’ assets in reserve.“
Proof of Reserves aims to improve crypto transparency among exchanges. PoR does this by actively monitoring exchanges through audits and ensures the exchange has enough liquidity to compensate for all potential customer withdrawals.
This system ideally would helps prevent a liquidity crisis by providing transparency to users about where their funds are so that exchanges must be reliable in order to attract customers.
PoR improves exchange-client relations.
How PoR is carried out
[1] A third party audits the exchange.
[2] The third party uses blockchain technology and cryptographic signatures to establish the exchanges on chain assets and ensure all data is correct.
[3] The PoR system publishes the report.
[4] Funds are either deemed safe or unsafe based on whether or not sufficient liquidity of the same amount or more is backed on all deposits.
Most Proof of Reserves are done periodically (eg. every week an audit is published), but some are able to update in real time as any balance changes.
To audit safely without exposing private information, Proof of Reserves uses a Merkle Root. This is a data structure that employs a hashing mechanism which means its only accessible at a snapshot in time. Put simply, it can only be used by the third party auditors at the exact moment the audit requires it. This makes merkle roots tamper proof and resilient to hackers. The merkle root is able to ensure data and information verified on the blockchain is NOT shared in the audit, only the result status can be published.
This ensures all users’ funds are looked after no matter the market conditions.
Issues to work through
Live updates are somewhat hard to sustain currently as it takes a great deal of computing power and can be quite expensive.
Off-chain assets are NOT auditable as of right now.
Tracibility of assets is not doable as of right now, which is an issue because an exchange could potentially borrow assets for the purpose of the audit to boost its balance sheets, and simply pay the loan back after the audit. This is one major hole that currently exists in PoR.
Why DeFi is more reliable
During the Terra Luna and FTX collapses of last year, numerous crypto exchanges were liquidated or filed for bankruptcy due to running out of funds. Many could not even pay their clients back, leaving a bad impression on the crypto industry as a whole and furthering the argument that stronger regulation is a must.
Yet, not one single DeFi platform went bankrupt or failed to fulfill withdrawal orders.
Why?
Because DeFi operates on raw data computation. If substantial liquidity is not provided, the loan cannot be accepted. If a user is overleveraged, they are liquidated. DeFi operates on pure mathematics and is not subject to human error – the cause of every exchange that crashed and burnt.
DeFi is built on the back of smart contracts which operate on correct data. If something is incorrect, the contract is rejected. DeFi asset pools are all updated live and public to everyone, making it a reliable, transparent, and ultimately “trustless system” that is democratized and indiscriminate for all users.
