What is next for crypto? Proof of reserves is not helping this mess

Key Takeaways

• Trust in exchanges is rightfully gone, with customers pulling thousands of bitcoins out over the last month
• Proof of reserves does nothing in its current format to broker trust
• Regulators need to step in as the industry has lost run of itself

November. Not good in the crypto markets.

But as we turn the page to December, how is the future looking?

Exchange trust at all-time low

First things first. The collapse of FTX showed the world quite how opaque these centralised companies are. The reality is that it is almost impossible for the average customer to know what is going on behind the scenes.

Sam Bankman-Fried (SBF) graced Forbes magazine covers, spoke before US Congress and was President Joe Biden’s second biggest donator during his 2020 campaign. If SBF can fall, who is safe?

Customers have responded by pulling their bitcoins from exchanges. I charted the netflows of bitcoins to and from exchanges since FTX imploded below. The pattern is pretty evident.

I had previously analysed this reaction in detail the week following the implosion.

Will proof of reserves save the day?

The response, chiefly led by Binance CEO Changpeng Zhao – he of another acronym nickname, CZ – was to instil proof of reserves on-chain. Because ironically, the blockchain was meant to be perfectly placed to solve all this.

I tweeted this to CZ as the debacle was starting to play out. To me, in addition to being painfully ironic, it’s both frustrating and sad.

https://twitter.com/DanniiAshmore/status/1589700562375016448  

But the proof of reserves which have now been implemented by several exchanges are redundant. They involve the posting of a wallet address with funds in it. Fine. But what is the point of proof of reserves without proof of liabilities?

There are far more questions too which most definitely are not answered by whacking an arbitrary address online. How do we know the exchange has access to those funds? Like Jesse Powell, the CEO of Kraken who is in the process of stepping down, said, “the proof of reserves audit requires cryptographic proof of client balances and wallet control”.

Cryptocurrency needs to grow up. This twisted version of an “audit” is not doing that.

CZ has spoken that he is working with several people, including Ethereum founder Vitalik Buterin, on addressing some of these concerns through a more robust Merkle tree reserve system. Let’s hope it arrives sooner rather than later.

Crypto needs regulation

It used to be a blasphemous view. Then it was polarising. Now, it’s hard to argue against it. Cryptocurrency needs regulation.

I’m tired of seeing people getting hurt so badly. Hearing the letter from the investor who lost $2 million as part of the FTX debacle being read out during the New York Times clownshow of an interview with Bankman-Fried was just one incident. There are thousands more stories like this of people getting crushed, and it’s heartbreaking.

Regulators are far from the sole reason any of this has happened, but whether they like it or not, it’s on them to help bring a semblance of reality to what has become a complete wild west of fraud, scams and violent risk management. Becuase crypto has clearly shown that it is not working in its current state. 

Let’s start by defining what a security is, and filtering crypto into this framework, rather than leaving everyone in the dark. The lending products which have struggled so mightily – I wrote about their plight recently here – such as BlockFi (now bankrupt), Celsius, Voyager Digital and so many others, were the most prominent parties to this nebulous legal framework.

Then we can move out to policing crypto, once we have defined what it actually is. Because this isn’t a niche game played by Internet nerds anymore. An exchange disappeared with $8 billion in client funds. Which, you know, followed a slew of other bankruptcies which also went under with billions of client funds earlier this year.

I have seen this movie too many times at this point. Proof of reserves is a step in the right direction, but the way it has been implemented thus far is totally pointless. Regulators – time to do what you have to do.