A New Attempt at Transparency of Assets in Encryption Exchanges: Merkle Tree Reserve Proof

Recently, with the sudden collapse of a well-known cryptocurrency exchange, the entire cryptocurrency industry has been greatly impacted. In order to rebuild market confidence, several centralized exchanges have announced that they will publish or have already disclosed their Merkle Tree reserve proofs. This practice aims to use technical means to make the originally opaque asset reserve situation of the exchange transparent, in order to prove that user funds have not been misappropriated or transferred.

Merkle Tree reserve proof is not a new concept; in fact, this technical solution was proposed and implemented several years ago. So, what exactly is a "Merkle proof"? How does it prove that the exchange has not misappropriated user assets? Can it ensure the safe custody of assets?

A Merkle Tree is a data structure used by cryptocurrencies such as Bitcoin and Ethereum, and it belongs to cryptographic techniques that can compress data. Through a Merkle Tree, multiple pieces of data can be merged into one, and the summary results of large-scale data can be stored. At the same time, it can also prove that specific data is included in the summary results through cryptographic methods. More importantly, by verifying the data integrity of the Merkle Tree root, the integrity of all data that makes up the tree can be proven.

The leaf nodes of the Merkle Tree are composed of the hash values of each piece of data in the dataset. Specifically, two adjacent hash values are merged and then hashed again to generate the hash value of the previous layer. The hash value at the top layer is called the Merkle Tree root or root hash value. This root hash value contains the hash characteristics of all the data, meaning that any tampering with the data at any node will result in a completely different value, thus ensuring that the hash values recorded in the Merkle Tree cannot be tampered with.

Assuming that the user's account and balance information is recorded as data A in the Merkle Root, it can be verified whether A is indeed recorded through the following several data points:

1. Data A (account and balance information)
2. The hash value of B
3. The hash value of CD
4. Root Hash Value

The verification process is as follows: First, calculate the hash of data A, then calculate the hash of AB using the hash of B, and finally calculate the root hash using the hash of AB and the hash of CD. Compare the calculated root hash with the given root hash; if they are equal, it proves that A has indeed been recorded in the Merkle Tree.

If a centralized exchange records all users' assets on a Merkle Tree and proves their authenticity, then the exchange can prove to each user that "your asset data has been recorded on the Merkle Tree and exists authentically" without revealing other users' information.

The trust in this proof system is built on Merkle Trees (dynamic deterrence) and auditing (third-party professional responsibilities). The principle of dynamic deterrence is that any user can act as a detection node; if they find themselves not on the Merkle Tree, they can expose that the root provided by the exchange is false. Both aspects are indispensable; relying solely on cryptographic proofs cannot solve all problems, and practical operations are more complex than theory.

Compared to the previous reliance on audit-based monitoring, the incorporation of Merkle Tree actually grants users a certain level of oversight, allowing the exchange's asset reserves to be monitored in a decentralized manner to some extent. This is undoubtedly a significant advancement and a positive development for a market currently suffering from a severe lack of confidence.

However, does adopting Merkle Tree reserve proofs completely guarantee the safety of user assets? Although through Merkle proofs, we can verify that our assets are recorded in an immutable hash, this does not fully prove that the funds have not been misappropriated or transferred.

Centralized exchanges have a large number of transactions occurring every second, and it is impossible to update the root in real-time, so the root we see is likely not the latest. However, from another perspective, the calculation of the Merkle Tree mainly consists of a series of hash functions, and the computation speed of hash functions is relatively fast, so the update frequency will not be too slow.

In addition to the issue of update frequency, there are several other important issues with Merkle Tree reserve proofs:

1. Front-end fraud risk: The Merkle Tree data is stored on the exchange's servers, and the front-end pages that users interact with are controlled by the exchange, which carries the risk of returning false pages to deceive users. This issue needs to be addressed through supervision by third-party software.

2. Credit issues of third-party audits: In the traditional financial sector, auditing institutions have also made mistakes and even engaged in illegal activities. Although this has not yet been widely applied in the cryptocurrency field, audits are not always objective and fair.

3. Cannot reflect related transactions, liabilities, and margin trading situations.

The cryptocurrency market needs more open and transparent information, and adopting Merkle Tree reserve proof as a standard configuration for exchanges helps establish industry norms and rebuild user trust.

For investors and users, ensuring the safety of funds is always the Damocles sword hanging over every practitioner's head. Regardless of who falls and who survives in this bear market, the development of Web3 will not stop and will continue to move forward.