For those who grew up in the 1980’s, you remember being taught that safe CEX is not safe. It’s about having safer CEX. So how do we all have “safe” CEX? Get tested. Show the results to your partner(s) and start communicating.
For those that actually took the time to read the citations in the bitcoin whitepaper, Merkle trees are the basis for public key cryptography.
There is a lot of confusion around the use of Merkle roots and trees for proof of reserves and proof of liabilities. This article attempts to decrypt some of the public propaganda now taking place among centralized crypto exchanges (and accounting firms) in order to set the record straight in a humanized way.
First of all, you can’t prove that your CEX partner did not cheat on you and engage in transactions that contradict a proof of reserves attestation a few minutes after a snapshot. In the wake of the collapse of FTX, large amounts of value were “mistakenly” sent to other exchanges and then returned.
If centralized exchanges want to be in an open relationship, they need to communicate that to their partners. Don’t underestimate humanity and conceal activity. They can handle the truth. Ok let’s put this in perspective. In securities law, this is literally called “affiliated relationships and related party transactions”.
Now first, we want to remind you that many consider open-source software to be a form of free speech. If you hold that view, then you must also hold that transactions on a public chain are public statements. In criminal law, anything you say can be held against you. On social media, it probably will.
In accounting, engaging in a series of transactions with third parties that obfuscate or conceal an illegal transaction is called accounting fraud. Tax authorities call it money laundering. In law, this would be considered at the very least, misrepresentation.
So how does proof of reserves provide proof? It doesn’t. It’s a highly porous condom. That’s all. It gives your CEX partners a false sense of security and it makes for good propaganda during CEX. It also provides accounting firms with another accessory to sell to make CEX a little CEXier.
Centralized exchanges are operating entities. This means that they not only have a balance sheet, but they have cash flow and a profit and loss. There is much controversy about property rights in the context of bank deposits. The balance sheet of a bank communicates that depositor’s funds are a bank asset, but it also communicates an equal offsetting liability. They have a little bit of public accountability. So the concealment of leverage, the act of hypothecation and rehypothecation by a CEX bewails the institution of existing regulation despite contradictory calls for it.
For so long as the proverbial “operating entity” exists, it is not likely that public key cryptography will replace accounting and reporting. They are the language of business. Accounting is the recording of transactions. Merkle leaves can help. Financial reporting is the communication of accounting information. Financial reporting schemes such as USGAAP and IFRS are dialects of the language of business. Merkle branches, trunks and roots are the canonical preservation of provenance.
Unless you have a bigger standing army, it is not likely that accounting, reporting and audit standard setters and regulators will be replaced.
So how can you have great CEX and a healthy relationship with your users? You must reconcile, show respect and communicate the whole truth, or they will leave you.
Auditchain Labs developed the world’s first and only Web3 financial disclosure and proof of assurance infrastructure that is aimed at solving the opaque nature of centralized crypto exchanges and the dysfunctional relationships they have had with their users. It also provides tools for users to verify the integrity and reliability of the financial disclosure information they communicate. Ralph Merkle provided us with the primitives but he’s not a therapist.
Repairing relationships takes time in order to truly restore confidence. It’s not wise to climb out of the cyclone cellar after a tornado with a few buzzwords and postulate how great it is that the wind stopped blowing.
People have feelings. They will withdraw if they are hurt. If you are a centralized exchange, proof of reserves is not the whole truth. Let us help you tell the truth, whole truth, and nothing but the truth, so help you God.
