Merkle Tree Proof of Reserves: A New Tool for CEX to Rebuild Confidence and Its Limitations

Recently, the collapse of the crypto assets exchange FTX has attracted widespread attention in the industry. In order to rebuild user confidence, several centralized exchanges (CEX) have announced that they will publicly disclose their Merkle Tree reserve proofs, aiming to increase the transparency of asset reserves and confirm that funds have not been misappropriated or transferred.

This event highlights the issue of opacity in the operation mechanisms of Centralized Exchanges. Although Merkle Tree proof of reserves technology has existed for a long time, it has recently drawn renewed attention in the industry. So, how does this technology actually work, and can it truly prove the safety of exchange assets?

A Merkle Tree is a widely used data structure in crypto assets like Bitcoin and Ethereum. It utilizes cryptographic techniques to compress data, merging multiple pieces of data into one, and can prove that specific data is included in the summarized result through cryptographic methods. By verifying the integrity of the Merkle Tree root, the integrity of all the data that makes up the tree can be proven.

The leaf nodes of the Merkle Tree consist of the hash values of each element in the dataset. Adjacent hash values are combined and hashed again to form the parent node. This process continues until the topmost hash value is generated, which is the root of the Merkle Tree. The root contains the hash characteristics of all the data, and any tampering of data at any node will result in a completely different value, thereby ensuring the immutability of the records.

Taking user account and balance information as an example, the following steps can be used to verify whether it is recorded in the Merkle Tree:

1. Calculate the hash value of account and balance information (Data A)
2. Combine the hash value of A with the hash value of B.
3. Combine the hash value of AB with the hash value of CD.
4. Compare the calculated root hash value with the given root hash value

If the two root hash values are the same, it proves that data A is indeed recorded in the Merkle Tree.

This proof system relies on a combination of Merkle Tree (dynamic deterrence) and third-party audits in practical applications. Any user can act as a detection node to verify whether their assets are on the Merkle Tree, thereby creating a deterrent against the exchange. However, relying solely on cryptographic proofs is not enough to solve all problems; practice is often more complex than theory.

Nevertheless, the introduction of Merkle Tree proofs is undoubtedly a significant advancement compared to the traditional model that relies solely on audits. It empowers users with the ability to supervise, allowing for a certain degree of decentralized monitoring of asset reserves in CEX, which is a positive signal for the current market lacking confidence.

However, Merkle Tree proof of reserves still has some limitations:

1. Update Frequency Issue: Due to the large number of transactions occurring at the exchange every second, it is not realistic to update the root in real-time. Although hash function computation is relatively fast, the root we see may not reflect the most current state.

2. Front-end fraud risk: The exchange controls the front-end pages that users interact with, and theoretically, it could return false data to deceive users. This needs to be addressed through supervision by third-party software.

3. The reliability of third-party audits: Mistakes or violations in audits are not uncommon in the traditional financial sector, and the crypto assets industry faces this challenge as well.

4. Cannot fully reflect the financial situation: Complex situations such as related-party transactions, liabilities, margin trading, etc. cannot be reflected solely through reserve proof.

Despite these issues, using Merkle Tree reserve proof as a standard configuration for crypto assets exchanges still helps to establish industry norms and rebuild user confidence. In this industry, ensuring the safety of funds remains the primary challenge faced by practitioners.

Regardless of which platforms fall or survive in the current bear market, the development of Web3 will not stop. The industry needs more open and transparent information to drive its continuous progress.