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

Recently, the crypto assets industry has experienced a major upheaval. The collapse of a well-known exchange has sparked widespread questioning of the operational models of centralized exchanges (CEX). In order to rebuild trust, several trading platforms have announced that they will adopt or have already adopted Merkle Tree Proof-of-Reserves technology to enhance the transparency of asset reserves.

Merkle Tree proof of reserves is not a new phenomenon; it has been proposed and applied several years ago. So, what exactly is this technology? How does it prove that user assets have not been misappropriated? Can it really ensure asset security?

A Merkle Tree is a widely used data structure in crypto assets such as Bitcoin and Ethereum. It utilizes cryptographic techniques to compress large amounts of data into a digest while retaining the ability to verify the existence of individual data items. By verifying the integrity of the Merkle Tree root, the integrity of all the data constituting that tree can be proven.

In a Merkle Tree, the leaf nodes consist of the hash values of each element in the data set. Adjacent hash values are paired and hashed again to form the nodes of the previous layer. This process is repeated until reaching the top of the tree, which is the Merkle root. The root hash value contains the characteristics of all the data, and any change in the data will lead to a change in the root hash value, thus ensuring the immutability of the data.

Assuming the user's account and balance information is recorded in the Merkle Root, the user can verify whether their data has been correctly recorded by following these steps:

1. Get your account and balance information
2. Obtain the hash values of other nodes on the verification path.
3. Get the Merkle Root Hash
4. Recalculate the root hash value using this information.
5. Compare the computed root hash value with the provided root hash value

If the two root hash values are the same, it proves that the user's data has indeed been recorded in the Merkle Tree.

The trust of this system is built on the dynamic deterrence of the Merkle Tree and third-party auditing. Dynamic deterrence refers to any user being able to act as a detection node; if they find that their data is not on the Merkle Tree, they can expose that the root provided by the exchange is false. However, relying solely on cryptographic proof is not enough, and many complex factors need to be considered in practical applications.

Nevertheless, compared to the traditional model that relies solely on audits, the introduction of Merkle Tree reserve proofs grants users a certain degree of supervisory power, allowing for partial decentralized monitoring of asset reserves in centralized exchanges. This is undoubtedly a significant advancement that helps restore market confidence.

However, Merkle Tree proof of reserves is not a panacea; it still has some limitations:

1. Update Frequency Issue: Due to the large number of transactions occurring on the exchange every second, it is unrealistic to update the Merkle Tree root in real time. Although hash calculations are relatively fast, the root that users see may not reflect the most current state.

2. Front-end fraud risk: The exchange may deceive users by manipulating the front-end page, which requires supervision from third-party software to address.

3. Reliability of third-party audits: Audit errors and illegal activities in traditional finance can also occur in the crypto assets industry.

4. Cannot fully reflect the financial situation: Complex situations such as related transactions, liabilities, and margin trading cannot be represented solely by asset reserves.

Despite these issues, Merkle Tree proof as a standard practice for crypto assets exchanges still helps establish industry norms and rebuild user trust. In this market, ensuring the safety of funds is always a major challenge faced by practitioners. Regardless of how the industry landscape changes in the future, the pace of Web3 development will not stop and will continue to move forward.