In response to the FTX incident, Vitalik Buterin issued a safe CEX: proof of solvency. Explores the history of attempts to bring exchanges closer to being trustless, the limitations of these techniques, and some new, more powerful ideas that rely on ZK SNARKs and other advanced techniques.
Vitalik Buterin said that using ZK-SNARKs can improve privacy and robustness, put all user deposits into a Merkle tree, and use ZK-SNARK to prove that all balances in the tree are non-negative, adding up to some claims the value of.
If we add a layer of hashing for privacy, the Merkle branch provided to each user will not reveal any other user’s balance. For going one step further, instead of just proving that the exchange has the funds to pay back the user, it is also necessary to prevent the exchange from stealing the user’s funds entirely.
According to Vitalik Buterin, the ideal long-term solution is to rely on self-custody, supplemented by technologies such as multi-signature and social recovery wallets to help users cope with emergencies. In the short term, there are two clear alternatives: custodial exchanges such as Coinbase, and non-custodial exchanges such as Uniswap. Finally, Vitalik Buterin stated that in the short term, exchanges fall into two clear categories: custodial exchanges and non-custodial exchanges.
Today, the latter category is just DEXes, such as Uniswap, and in the future we may also see crypto-restricted CEXes, where user funds are kept in something similar to validium smart contracts. We may also see semi-custodial exchanges where we trust them with fiat currencies rather than cryptocurrencies. Both types of exchanges are here to stay, and the easiest backwards-compatible way to improve the security of custodial exchanges is to add proofs of reserves. This includes a combination of proof of assets and proof of liabilities. There are technical challenges in crafting a good protocol for both, but we can and should try to make progress on both and open source the software and processes as much as possible so that all exchanges can benefit.
In the long run, Vitalik Buterin wants us to move closer and closer to all exchanges being non-custodial, at least when it comes to crypto. Wallet recovery will exist, and may require highly centralized recovery options for new users dealing with small transactions, and institutions requiring such arrangements for legal reasons, but this can be done at the wallet layer rather than within the exchange itself.