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digital daily: Sunlight Through the Trees

Sunlight Through the Trees: Misappropriation of customer funds on FTX's exchange is the most recent lesson in counterparty risk. Transparent ownership is a core feature of digital assets because they are visible on-chain in the bright light of day. Aren't they? Yes, and no. Operational security measures like rotating wallet addresses, disconnecting "cold storage" assets from the internet, and regular internal account transfers make transparency more complex. A moving target. To shore up confidence, several exchanges are publishing reserve wallet addresses to be tracked by analytics providers. But trust is still required. Digital assets can be moved at the speed of the blockchain, and comingled funds can be attributed to any customer deposits. One solution is the "Merkle Tree," a mathematical relationship derived from a full set of user deposits. By checking your wallet against the tree, you can quickly test that your assets are part of the comingled whole without accessing information about other depositors. This test is called "proof-of-reserves." The tree is re-calculated on a rolling basis, like an automated, frequent audit. Accounting firm Armanino has a head start with its implementation of open-source Merkle Tree technology. They instituted proof-of-reserves for Kraken, Ledn, and when confirming user deposits was a low priority. Much has changed. In the wake of FTX's meltdown, calls for proof of reserves are loud. Yet, while implementing these trees would surely be an improvement, they are not a full solution. Proof-of-reserves do nothing to create transparency on the liability side of the equation. Exchange-controlled collateral can be pledged to support borrowing activity without consent, typically subordinating depositors. Proof-of-reserves is a step forward, but only part of the answer. Broader effort is needed to gain a transparent picture of encumbered assets. Sunlight may be an excellent disinfectant, but when it shines only through dense trees, shadows remain.