By Marie Tatibouet, CMO, Gate.io
The concept of decentralization was introduced amidst the global financial crisis in 2008 when banks and big financial institutions failed to keep up with the innovation. Ever since then, digital currencies have been considered ingenious specifically because they eliminate the middleman in the ownership and transfer of funds.
The cryptocurrency industry has been battling asset transparency and security issues for a long time now. However, noticeable steps taken by some key players such as CoinMarketCap and Messari will only strengthen our position in combating these issues. For example, in November 2019, a leading cryptocurrency market data source company announced the launch of a new “Liquidity metric” to deal with volume inflation.
How are assets managed in a centralized system?
Admittedly, centralized exchanges have benefits like faster transactions and higher liquidity that are loved by the users. Let’s deep dive into how assets are stored in a centralized exchange; Every user’s assets are recorded in a centralized database ledger; The recorded assets in the database are the total amount of the user’s assets. Just like banks where the amount of fiat currency in an individual’s bank account is the asset and is something that the bank holds rights to use in a way they want, centralized cryptocurrency exchanges also hold the private keys to users’ digital assets. Does that mean users do not have any control over their assets? Let’s discover.
Assets held by a centralized exchange can’t be monitored by the users themselves. In this sense, an exchange could potentially misuse users’ assets without their knowledge, which could lead to a situation in which the collateral turns out lower than the recorded assets in the database. As a result, users could face tremendous risks, involving delayed withdrawals. As a result, in some cases, users may not be able to withdraw their coins when they want. All these factors combined will diminish a users’ sense of trust in an exchange. Therefore, if the exchange wants to gain users’ trust, it must be able to show 100% visibility into the recorded assets of the users.
Eliminating Risks by providing 100% asset security
A Merkle tree is a binary hash tree that was invented by Ralph Merkle in 1979. Each leaf node of the tree stores the hash value of a data element. The stored data is irreversible with the hash algorithm of the tree as any changes in the data of the leaf node will lead to a different root hash. The hash value of each customer’s account can be recorded in the leaf nodes of the Merkle Tree. Therefore, the Merkle tree enables efficient and secure verification of information in a large data pool. It allows for fund transparency, keeping personal information anonymous. Each user’s data is put through a hash function. Hash functions are one-way functions that take input data and return a hash (fixed result). Since they are one-way functions, one cannot get to the original data, making the process fully secure. By using hash functions, we are able to provide transparency and make data available for users to see while still keeping personal user data private.
The Winning Combination
Providing users with a reliable method that combines the Merkle Tree approach and a financial audit could ensure 100% transparency to users’ total assets on the platform; all whilst protecting users’ privacy from hacking. There are two methods that can be adopted to prove the user’s total assets and users’ collateral held by an exchange. The first method is to store each user account’s hash value of assets in the leaf nodes of the Merkle tree. The second method is to audit those assets in the leaf node of the Merkle tree and verify all the users’ assets held by an exchange through an audit of a third-party institute.
Conclusively, consumers can verify whether their assets are recorded accurately in the Merkle tree through mathematical algorithms. Besides, the third-party audit will seal the fund transparency element for consumers.
The combination of financial cryptography techniques and data security not only enables prompt detection of unauthorized transactions but also improves fund security, user transparency and system reliability.