[VenturePunk #5] Can We Build Trust with Proof of Assets and Liabilities?
Since humanity began its journey into trade, the risk of a counterparty misrepresenting what it holds has been present. Even the famous Akkadian cuneiform letter complains about receiving a poorer grade of copper than what had been expected. When we think of our current situation, it is wise to remember this—contagion is by no means endemic to crypto. Firms like Lehman Brothers and Bear Stearns prefigure the fall of Celsius and FTX (and, now, BlockFi). It’s far too tempting to obfuscate the real state of one’s assets and liabilities, to position oneself, to lean into the vibes, to build up hype, and to pump your assets with obfuscation and FOMO.
What’s the best way forward? In my previous essay, I wrote about the desirability of getting back to the liberatory intent behind blockchain technology. In that time, we’ve had more contagion from FTX, and unrelated developments such as Metamask’s disclosure that default RPC Infura (and any other RPC) can both collect and store our IP addresses, and can link all wallets in a MetaMask account to a given IP.
What connects these two developments is they both touch on the issues of privacy and transparency. Crypto is more than a set of currencies or an industrial sector; it’s a culture, and we’re currently engaged in a broad debate on how to balance the interests of privacy and transparency. But, what if the way to balance these interests doesn’t require compromise on either?
Crypto is designed as an open, trustless, permissionless, auditable and transparent ledger, open and distributed. But, as any battle plan disintegrates on contact with the enemy, every economic scheme or system transforms when it is let loose in the wild.
At its conception, crypto was designed as a way to conduct commerce freely, even across global or interplanetary distances. To function in this way, it would have to go a long distance, from its start as a process networked across a handful of computers, to a universal economic tool.
Those who build in web3 do so while keeping universal adoption in mind. But crypto’s early architects never imagined the world of blockchain as a place where millions of people would see and use their entities and assets, primarily, as ways to make money. Few people imagined a world where cryptocurrencies would sponsor sports teams, where exchanges would name stadiums, where families just starting out would buy tokens and farm them for yield at an exchange. From the early days of crypto, with the rise and fall of Mt Gox, there arose a class of participants in the space who saw crypto as investments and held them on exchanges in which their only access was a password—managed, like a broker’s stocks, not bankless self-custody. The innovators who invented crypto never dreamed of crypto as a global casino: of a world where exchanges, hedge funds, and venture capitalists found it easy to lie—or even misunderstand—the balance sheet of their assets and liabilities.
A number of major players in the cryptocurrency space, including Binance, have been speaking in the past two weeks about proof-of-reserves, validated by a Merkle tree. Merkle trees are computational processes that allow the verification of data sets; they allow large sets of data to be quickly and securely looked over for signs of tampering. These data sets could include transaction records, or even account balances. Once a Merkle tree validation system has been set up and audited by independent arbiters, any depositor would be able to validate that an exchange indeed holds the full amount that that individual has deposited.
Validated and checked proof of reserves are by no means a sufficient assurance for depositors (or investors). FTX’s collapse has occurred because its liabilities have far outstripped its assets. Proof of reserves cannot defend against this risk, or the risk that a held asset can be repeatedly rehypothecated—used for purposes other than those intended by those that deposited that asset. A proof of reserves snapshot—even an audited one—can be seen as merely a gesture. Even a live, continually checked Merkle tree solution doesn’t protect against the risk of being the last creditor in a long queue for withdrawals, with big banks and institutions taking all the reserves before a small retail depositor gets a chance to get their money.
At present, Binance has posted a link to check proof of reserves for Bitcoin deposits using live Merkle tree results. It will be rolling this feature out for other tokens soon, and will be implementing ZK-SNARKs, a zero-knowledge proof validation technique, to show that clients who use Binance margin and loan services truly have other valuable assets collateralizing these margins and debts (while protecting the privacy of these clients). Other exchanges such as Kraken have been using similar techniques to prove their own reserves.
It is important to note that it’s nowhere near clear yet that these measures can offer real assurance. Reports that FTX and Binance used the same auditor, and reports that most firms are using the same proof of reserves provider, strengthen arguments that proof of reserves needs to take place publicly, without any one company or group having control over the technology forming the basis for that process.
Even if we have a proof of reserves system that everyone can trust, how can liabilities be proved? This is one of those social problems that cannot be solved with technology alone. Right now, there is a cultural consensus among many of those with access to many millions or billions in capital- whether they are in the traditional economy or in crypto- that it is absolutely fine to take huge risks with depositor funds, to obscure and distort balance sheets, to mislead and misdirect and outright lie. What we need is a different sort of consensus- where the cultural norm is to fully, provably disclose assets and liabilities, opting in to a transparent, auditable and on-chain system for doing so.
How could this work? Imagine: if a lender made a deal to lend a billion dollars to an exchange, receiving that exchange’s native token in return. As part of the deal, the recipient must agree that the transaction takes place on this opt-in, auditable system. Assets and liabilities match up, checkable and observable, even if the lending party is not making their identity public. Any other potential lenders would look for adherence to this process, and anyone wanting to perform transactions off-book would risk violating a taboo, and finding themselves excluded from the circle of firms that use the process.
It’s incredibly wishful thinking, to be sure. There is so much incentive, right now, to make a quick buck by engaging in the destructive behaviors that led companies to bankruptcy. The reward for having made the right bets in the bull market was just too high, and the risk of obloquy, public anger, and profound damage to our industry was too low. Even the risk of prison hasn’t been enough. The builder of Tornado Cash is in prison, but will SBF ever see the inside of a cell?
But our job as builders is to ask, what if? What if the most desirable investments were based on tech innovation, bringing communities together, or creating benefits for all- instead of expectations of fast profits? What if our cultural norms shifted?
Without a shift in these norms, nothing can fix this industry. We need a global system of laws that punish fraudsters, protect DeFi, and uphold privacy. But, without actual cultural change, bad actors will continue to squeeze through the loopholes, and many will celebrate their success. While SBF prepares to speak at a New York Times conference, we know the necessary changes must come from within our community.
The constructive discourse that can restore and rebuild crypto is already happening every day within our space. I mentioned Metamask earlier- who’ve received a firestorm of criticism and complaints since they updated their privacy policy and observers reported the privacy concerns with Infura’s logging IPs and associating multiple wallets with an IP. And while we’re seeing a lot of calls to switch to other wallets, advice on switching RPCs or running your own nodes- we’re also seeing some patient, clear and detailed responses from Metamask. They’ve been claiming that IP logging is a part of how the current Internet works, and outlining their commitment to cut this sort of information collection to a minimum. Employees of Metamask are engaging in direct, technical conversations with users, in public. This is just one wallet company—but this sort of dialogue, access and openness sets a good tone for building a new basis of trust. As more and more people engage with proof-of-reserves and proof-of-liabilities technologies, we’re going to see a positive feedback loop of trust, and a new standard of good practice.
The financial crashes of previous eras were devastating at the time, and the effects of historic crashes still cause suffering today. As talk of crypto recovery funds begins, and FTX recedes from the front pages, it is urgent that we take opportunities now to build new and lasting norms- we’ve got to bolster the technical proficiency and critical thinking skills of our community, and within society at large. The tech and culture of blockchain offer the promise of a global society—where people are in charge of their data and control how they associate with others. Even without the huge profits of the bulk market, there are plenty of opportunities for everyone to prosper, innovate, and grow in our space.
By
Margaret Corvid
About Margaret: Margaret Corvid (
lorepunk.eth) is a writer and poet based in the U.K.
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Disclaimer: Not financial or tax advice. This newsletter is strictly educational and is not intended to be investment advice or a solicitation to buy or sell any assets or to make any financial decisions. This newsletter is not tax advice. Do your own research.