Merkle Tree Reserve Proof: A New Standard for Crypto Assets Exchanges?

Recently, the crypto assets industry has experienced a crisis of trust. In order to rebuild user confidence, several centralized exchanges (CEX) have announced that they will disclose or have disclosed their Merkle Tree proof-of-reserves. This initiative aims to increase the transparency of asset reserves and demonstrate that user funds have not been misappropriated or transferred.

Merkle Tree is a data structure widely used in Crypto Assets such as Bitcoin and Ethereum. It is a cryptographic technique that can compress data, combining multiple pieces of data into one and storing the summary of large-scale data. At the same time, it can prove that specific data is included in the summary through cryptographic methods. By verifying the integrity of the Merkle Tree root, the integrity of all the data that constitutes 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. Adjacent hash values are merged and hashed again to form the nodes of the previous layer. This process continues until the topmost hash value, known as the Merkle Tree root, is generated. The root contains the hash characteristics of all the data, and any tampering with the data will result in a completely different root value.

Assuming that the user's account and balance information is recorded as data A in the Merkle root, the user can verify whether A is indeed recorded in the tree through a series of data. This process includes calculating the hash value of A, combining it with the hash values of other nodes, and ultimately obtaining the root hash value. If the calculated root hash value matches the provided root hash value, it proves that A is indeed recorded in the Merkle Tree.

The trust of this proof system is built on the Merkle Tree (dynamic deterrence) and third-party audits. The principle of dynamic deterrence is that any user can act as a detection node. If they find that their data is not on the Merkle Tree, they can expose the root provided by the exchange as false. This mechanism works in conjunction with third-party audits to form a more reliable supervision system.

However, the Merkle Tree proof of reserves is not flawless. It has some potential issues:

1. Front-end fraud: The exchange may deceive users by controlling the front-end page, which needs to be addressed through oversight by third-party software.

2. Audit Credibility: In the traditional financial sector, audit errors or violations are not uncommon. Although such issues have not yet occurred on a large scale in the crypto assets field, the objectivity and fairness of audits still need to be vigilant.

3. Limitations: Merkle Tree proof of reserves cannot reflect complex situations such as associated transactions, liabilities, margin trading, etc.

4. Update Frequency: Due to the large number of transactions occurring on the exchange every second, it is not practical to update the Merkle Tree root in real time. Although the hashing function is fast, the root that users see may not reflect the most current state.

Nevertheless, the introduction of Merkle Tree proof of reserves is still a significant advancement in the crypto assets industry. It provides users with a certain level of decentralized monitoring capability, helping to establish industry standards and rebuild user trust. In the current market, where confidence is lacking, this is undoubtedly a positive development.

Ensuring the security of funds has always been a major challenge faced by practitioners in the crypto assets industry. Regardless of market fluctuations, the momentum of Web3 development will not halt. As the industry continues to mature, more transparent and standardized measures will emerge, driving the entire ecosystem towards a healthier and more trustworthy direction.