How Merkle Trees Make Exchanges More Transparent in Assets?

As the fall of FTX has shaken investors' confidence in centralized exchanges, cryptocurrency exchanges have announced their Merkle-Tree proof-of-reserves to make asset reserves transparent.

Introduction to Merkle Tree

The concept of the Merkle Tree was first proposed by Ralph Merkle, a computer scientist renowned for his work on public-key cryptography. As a tree-structured data processing system designed to verify data integrity and accuracy, the Merkle Tree is considered an essential form of blockchain technology. It is a hash tree with each leaf node marked with the cryptographic hash of a data block and each non-leaf node marked with the cryptographic hash of the labels of its child nodes.

Development and Principle of Merkle Tree

In 2014, the crypto community debated how exchanges could certify their reserves to auditors.

With more detailed solutions being studied since 2019, a proof model based on Merkle Tree has been widely recognized.

Proof of Reserves, or PoR, is an independent audit conducted by a third party to prove assets. This auditor takes an anonymized snapshot of all balances held and aggregates them into a Merkle Tree to obtain a Merkle Root.

The auditor then collects digital signatures produced by the exchange, which prove ownership over the on-chain addresses with publicly verifiable balances. Lastly, the auditor compares and verifies whether these balances exceed or match the client balances represented in the Merkle Tree to determine whether the exchange holds adequate reserves.

The underlying data of a Merkle Tree is the hash generated by the asset data held by each account, and then the Merkle Tree generates a new hash through two hashes, and so on. Therefore, the final hash represents the assets owned by the exchange.

In this model, when the data integrity of the Merkle Root is verified, the entire Merkle Tree producing the root is verified.

Summary

Merkle Tree and its upgrades enable centralized exchanges to improve asset transparency, benefiting the development of the crypto industry.