Binance, the world's largest crypto exchange by volume, stated its belief that prioritizing risk management, transparency, disclosures and security is crucial to restoring trust in the industry, which suffered through a turbulent year, in a policy paper titled "Building Trust in the Crypto Ecosystem."
"2022 was a historic year for the crypto industry," the paper reads. "This was a watershed moment where rebuilding user and regulator trust is critical for the future of the whole ecosystem. Users will demand more from centralized exchanges, and the exchanges must rise to the occasion. With this in mind, all players in the digital assets space have a fundamental responsibility and part to play to prove that a few bad actors are not emblematic of the industry. Winning back policymakers, regulators and the community’s trust will require putting risk management, security and transparency front and center."
The paper was published on Feb. 16 amidst scrutiny from the U.S. Securities and Exchange Commission (SEC) and just two days after a Senate Banking Committee hearing that focused on how to move forward with crypto regulation.
In the policy paper, Binance stated that it is critical for crypto companies to enable users to verify any and all assets held by a centralized exchange (CEX) "through proof of reserves or similar disclosures," also arguing that the verification process needs to utilize technology such as zk-SNARKs that cannot be fabricated or manipulated, all while updating them regularly. Binance also asked all CEXs to conduct proof of custody reserves to increase transparency so users can "ensure their assets are collateralized, exist on the blockchain and are under the control of the exchange at the reporting date." The policy paper used the example of zk-SNARKs technologies used alongside Merkle tree proofs as a verification method that offers both privacy and data integrity.
"We encourage all CEXs to make use of this solution, and the whole community to share feedback so we continue to improve it further," the paper reads.
On Feb. 10, Binance published an online article explaining how zk-SNARKs technologies would operate within its proof of reserves (PoR) verification system, saying that breaking through their safeguards "would require an unfeasible amount of computational power." The new PoR system's goal is to restore trust with the public by proving that Binance backs all user funds at a 1:1 ratio, plus additional reserves. The company has also made the system open source, allowing any user to verify their holdings and other crypto community members to benefit from the technology. Following fellow crypto company FTX's bankruptcy, Binance immediately began working to demonstrate PoR by releasing Merkle tree cryptographs that enabled users to verify their holdings.
However, while Binance stated that the Merkle tree was an advancement in its push for increased transparency, it still had two admitted shortcomings. The first was that user holdings were represented by leaf nodes in hashes to guard their privacy, meaning that the Merkle root couldn't represent the sum of the lead nodes. The second was a malicious entity could potentially create a fake account and enter a false balance, causing the total required reserves to appear smaller. Binance's new zero-knowledge proof protocols resolve these shortcomings by ensuring that no user can have a negative balance in the Merkle tree and that all leaf nodes are contributing to the claimed total user balance of each asset.
According to Binance's article, zero-knowledge proof protocols such as zk-SNARKs allow the company to perform a computation and demonstrate to a verifier that it was correctly executed under certain constraints without disclosing the inputs. Binance will publish the first iteration of user proofs using the new verification system in a later announcement.
"We hope this will be instrumental in pushing the transparency of the digital asset industry to a new level," the article reads.
Binance's new PoR was met with positive reception from many members of the crypto community.
“We are encouraged by the steps taken by Binance U.S. to increase transparency and elevate the conversation around proof of reserves,” said Texas Blockchain Council president Lee Bratcher, according to an Austin Journal article published on Feb. 10. “In Texas, we have been working closely with the Texas Legislature and specifically Rep. Capriglione and Spencer Schumacher of the Innovation and Technology Caucus, to draft a bill (HB 1666) that would require exchanges doing business in Texas to have a plan for implementing industry best practices around proof of reserves.”
"I am not aware of other PoR systems using zero-knowledge proofs," said Edge & Node director of finance Max Tang. "In this context, [Binance's system] is likely industry-leading."