Hacks & Bankruptcies Have Shaken Trust In CEXs
Cryptocurrency exchanges are often the best gateway to crypto & other digital assets. However, in recent years we have faced a number of problems with these centralized entities.
Hackers have targeted them and stolen potentially millions of dollars worth of funds from users' wallets. For example, in January 2019 Binance reported that hackers had stolen $40 million from its hot wallet (a wallet kept online for quick withdrawals). Approximately 2% of Binance's BTC holdings were gone.
This is just one example in a long list of hacks over the past few years; some exchanges have even been hacked multiple times! These events have spurred calls for increased transparency within crypto trading platforms.
After the FTX meltdown, more people in crypto have realized the fact that centralized exchanges are banks 2.0. Even worse because the market is highly volatile. These exchanges have been caught using users' funds as banks do.
Could proof-of-reserves audits restore trust between users and centralized cryptocurrency exchanges? And what would these audits look like anyway? Let's find out
Proof-of-reserves Audits
As trust in centralized exchanges continues to wane, more and more are taking steps to restore confidence. Proof-of-reserves audits are one way for exchanges to show their customers that they're committed to transparency.
An independent third party (typically a blockchain engineer or auditing firm) checks an exchange's account balances against its published statements on social media and other channels. These types of audits have become increasingly common over the last few years as crypto trading has grown in popularity.
To date, several exchanges have gone through this process like Binance, Coinbase Pro, Gemini etc.
Proof-of-solvency Audits
Proof-of-solvency is a way to audit the reserves of an exchange. It can be thought of as an extension of proof-of-reserves audits, which only verify that funds have been deposited in an exchange’s wallet (and not necessarily held there).
Proof-of-stake is an alternative method for auditing exchanges, but it uses algorithms instead of people. Rather than having a third party examine bank records and corroborate them with other documentation such as tax returns or internal documents, proof-of-stake algorithms use complex mathematical functions to prove that certain amounts exist on the blockchain. Don't mistake it with PoS used for blockchain consensus.
With proof of assets, an exchange can prove the coins are in a bank account by providing documentary evidence of the bank account’s existence and the ownership of it.
The first step might be opening up their own accounts with various banks and documenting those relationships by showing their name on official paperwork. Or possibly even obtaining copies of internal emails from that bank acknowledging their relationship.
The second step would involve proving control over all assets held by that particular institution, which will typically require permission from said institution to allow for such access. It may also involve providing documentation about how exactly these assets are being managed (e.g., daily reports).
Trust or Trustless
Many of the top exchanges are already following these guidelines, and they are growing rapidly. Although it may seem like a lot of work for a business to get audited by an independent third party, this process can actually save them money in the long run. The cost for each audit is around $250K USD is high but anything for transparency.
Trusting an exchange can be difficult, but look for proof of their security and the transparency of their business practices before trusting them with your money.
Ultimately, trust is an important part of any relationship. If you don't trust the person or company you're dealing with, it's unlikely that your money will be safe or that you'll receive what was promised to you. That's why the future has to be trustless.
Conclusion
When you’re looking for a cryptocurrency exchange, the first thing to do is research. Look for reviews and ask around — most people have friends or family who trade on some kind of exchange, so they might be able to give you an idea of how safe their site is. If an exchange doesn’t have a good reputation or seems too good to be true (like no fees), this could be a red flag that something shady is going on behind the scenes. Even if the exchange in question passes all checks and provides all kinds of proof's, you must know that they are still prone to hacks and changing regulations. Never keep any substantial amount on exchanges. Just remember, not your keys, not your crypto.