Merkle Tree Reserve Proof: A New Initiative by Crypto Assets Exchanges to Enhance Transparency

With the recent collapse of a well-known exchange, the Crypto Assets industry has once again fallen into a trust crisis. In order to rebuild user confidence, many centralized exchanges have announced that they will disclose their asset reserve situation, using the technical means of Merkle Tree proof of reserves. This method aims to make the previously opaque reserve status of exchange assets transparent, in order to prove that user funds have not been misappropriated or transferred.

The Merkle Tree proof of reserves is not a new concept; it was proposed and applied several years ago. So, what exactly is this technology? How does it prove that the exchange properly safeguards user assets? Can it fully guarantee the security of the assets?

Merkle Tree is a data structure used by crypto assets such as Bitcoin and Ethereum, essentially a cryptographic technique that can compress data. Through the Merkle Tree, multiple data can be merged into one, and the summary of large-scale data can be stored. At the same time, it can also prove that specific data is included in this summary result through cryptographic methods. Verifying the integrity of the Merkle Tree root can prove that all data constituting the tree is complete.

The leaf nodes of the Merkle Tree are composed of the hash values of each data item in the dataset. Specifically, adjacent hash values are combined and then hashed again to generate the parent node's hash value. The final top-level hash value is referred to as the Merkle Tree root. This root hash value contains the hash characteristics of all the data, so any tampering with the data at any node will cause the root hash value to change, thereby ensuring the immutability of the records.

Assuming the user's account and balance information is recorded in the Merkle Root, the user can verify whether their information is correctly recorded through the following data:

1. User's own account and balance information
2. Hash value of adjacent nodes
3. The hash value of the upper node
4. Root Hash Value

The verification process is that the user first calculates the hash value of their data, then merges it with the hash value of the adjacent node, and then merges it with the hash value of the upper layer node, ultimately obtaining a root hash value. If this computed root hash value is the same as the root hash value published by the exchange, it proves that the user's data has indeed been recorded in the Merkle Tree.

The trust foundation of this proof system is built on the dynamic deterrence of the Merkle Tree and the professional responsibilities of third-party audits. Dynamic deterrence means that any user can act as a detection node, and if they find that their data is not on the Merkle Tree, they can expose that the root provided by the exchange is false. Meanwhile, third-party audits offer professional oversight.

However, the Merkle Tree proof of reserves is not foolproof. It has the following main issues:

1. Update frequency issue: Considering that the exchange has a large number of transactions occurring every second, it is unrealistic to update the Merkle Tree root in real time. Therefore, the Merkle Tree root that users see may not reflect the latest state.

2. Front-end fraud risk: Since the Merkle Tree data is stored on the exchange's own servers, theoretically the exchange could deceive users by returning a false front-end page. This issue needs to be addressed through third-party software supervision.

3. Reliability of third-party audits: In the traditional financial sector, audit errors or violations are not uncommon. Although this practice has not yet been widely applied in the crypto assets field, there are still potential risks to the objectivity and fairness of the audits.

4. Cannot fully reflect financial status: Merkle Tree proof of reserves cannot reflect complex financial situations such as related party transactions, liabilities, margin trading, etc.

Despite these limitations, introducing Merkle Tree proof of reserves is undoubtedly a significant advancement compared to the previous regulatory approach that relied solely on audits. It grants users a certain degree of oversight, allowing for a level of decentralized monitoring of the exchange's asset reserves, which helps to rebuild market confidence.

The crypto assets market urgently needs more open and transparent information. Adopting Merkle Tree proof of reserves as an industry standard helps establish industry norms and rebuild user trust. However, ensuring the safety of funds remains a significant challenge faced by every practitioner. Regardless of who falls and who survives in this round of market downturn, the development of Web3 will not stop and will continue to move forward.