Proof of Solvency - the new standard for every CEX?
The recent weeks have been especially rough for both retail, and institutional investors. Following substantial multi-billion dollar losses across the industry, many investors are now asking for proof that other Centralized Exchanges (CEX) are solvent.
Vitalik Buterin, founder of Ethereum, recently wrote a blog article called "Having a safe CEX: proof of solvency and beyond", explaining how exchanges could implement a technical Proof of Solvency solution.
Proof of Solvency is nothing new though; one can date it back to 2011, when MtGox sent funds to a previously announced address to prove the ownership. According to Vitalik Buterin, the first discussions of liabilities (and thus Proof of Solvency) can be dated back to 2013.
This article answers 3 questions:
• What is Proof of Solvency?
• Why is it important?
• Will it become the new standard for CEXes?
What is Proof of Solvency?
Proof of Solvency consists of two parts:
1) The amount of customer deposits (liabilities).
2) The amount of assets actually hold by the exchange (assets).
An exchange must hold the deposited balance of their users, to guarantee that each user can withdraw their money at any given time.
Therefore: Solvency = Assets - Liabilities
Some exchanges, like Kraken, refer to Solvency as “Reserves”. While they are the same (assets - liabilities), calling it Proof of Solvency is more specific.
Why is it important?
To understand why it's important not only for an exchange to be solvent, but also to be able to prove it. Let's put ourselves in the shoes of a retail investor buying crypto on a CEX.
User A is buying $1000 of Bitcoin on CEX B, but CEX B is already insolvent - holding only 60% of the liabilities (customer deposits).
As long as only a couple of users are withdrawing their money from CEX B, there seems to be no issue, as long as users do not attempt to withdraw their funds.
But what if, for whatever reason, most of the users want to withdraw their money in a short time? You will get what happened to FTX; a bank run. Since the assets the exchange holds aren't able to maintain all the withdrawal requests, the exchange will be unable to process withdrawals at some point.
Rumors and fear will spread, affecting other exchanges too - as can be seen by the amount of assets withdrawn from Coinbase.
Leading us to the next part; why it is important to prove solvency.
While it’s certainly not possible to completely avoid fear and rumors, giving users the ability to check themselves that their funds have been audited and that their exchange of choice is solvent will definitely help.
While we argue that a fully technical solution would be perfect, a good step in the right direction would be to conduct Third-Party audits by trusted companies that cover both assets and liabilities.
Will it become the new standard for every CEX?
We think that Proof of Solvency should already be the standard for any trustworthy CEX. The idea of Proof of Solvency is not new and dates back to 2011-2013 and there are exchanges, like Kraken, that offer full proof of solvency - so there really is no excuse to not provide it.
The recent FTX crash will have users demand that other centralized exchanges follow through and provide full Proof of Solvency.
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