When Sam Bankman-Fried's crypto exchange, FTX, filed for bankruptcy on Friday 11th November, it had less than USD$1bn in assets against USD$9bn in liabilities. What has ensued is a Lehman-Brothers-like crisis that has generated a chain reaction in the crypto industry, not to mention increased scrutiny, after investors like Sequoia Capital, Lightspeed Management Co. and Temasek Capital, took nine-figure losses. Even American quarterback Tom Brady fell victim to Bankman-Fried's foul play.

‘Proof of Solvency’ Has Become Integral
‘Proof of Solvency’ Has Become Integral To The Crypto Industry’s Survival Pixabay

There was a hope that the contagion caused by FTX's downfall would be somewhat limited, something which has proved less likely by the week, as proven by BlockFi's recent filing for bankruptcy. That said, the true damage for the industry will be the reputational cost.

Investors had not carried out significant due diligence into FTX's operations, underestimating the exchange's liquidity risk. If crypto exchanges are to move past this grim episode, there is a feeling that open and transparent cryptocurrency reserves must become a core component of any offering.

Cryptocurrency exchanges have been operating for more than a decade, and their business models have been continuously evolving. Apart from taking trading fees as revenue, exchanges also support lending, staking, venture, incubation business, and more. Due to the complexity of these operations, proof of solvency has become increasingly complicated.

Complicated, however, does not mean impossible. Solvency is proved once the total reserve balance acquired using proof of reserves (PoR) is shown to be sufficient to cover the total liabilities acquired using proof of liabilities (PoL). So essentially, proof of solvency is broken down into proof of reserves and proof of liabilities.

Multiple companies and exchanges Binance and Bitfinex have recently chosen to publish their PoR in order to prove their solvency, however it could be argued that this does not go far enough. Certain exchanges however seem to be taking this one step further, with BIT (Bit.com) and Bitmex announcing that they will publish Merkle Tree PoR of their assets along with Merkle Tree PoL for validation. In the case of BIT, the exchange stated that it had hired consultants such as Cactus, Cobo, Copper and others, to carry out the audit. Kevin Zhuang, CTO of BIT explained that this move was directed at 'ensuring transparency and cementing market confidence'.

The next steps for exchanges will be to implement several methods to record liabilities correctly and, at the same time, work to improve privacy and security on their platforms. For example, liability proof attributions could be added to user profiles to support validation, while exchanges need to create a suite of tools for the generation and validation of proof of reserves and proof of liabilities.

FTX's collapse and the downfall of Sam Bankman-Fried, now nicknamed 'the devil in nerd's clothes', have undoubtedly taught the crypto world some valuable lessons. The regulatory zeitgeist dictates that crypto exchanges need to move towards adopting a combination of proof of reserves and proof of liability and establishing the necessary protocols and systems to generate them.