In finance, risk never truly disappears. Can Bitcoin mollify this? Bitcoin as a virtual commodity sitting in provable reserves in financial institutions. No one’s liability, a provable virtual commodity which a bank can rely on to attest to its viability. Bitcoin is designed to be auditable, and auditing the blockchain requires the full, unabridged ledger.
An ideal Bitcoin bank would employ schemas like Proofs of Solvency to pass through Bitcoin’s assurances to depositors. Although these aren’t faultless, and can be cheated, it is a high bar to clear. You can lie to your auditors if you’re a publicly traded company, but you’ll likely be found out at some point, and now you’ve broken the law. Any serious Bitcoin bank engaging in an audit would likely only do so if they felt that they were going to pass it. As mentioned above, if this became popular, it would segment the Bitcoin depository industry into reputable, trusted banks which routinely proved reserves, and untrusted banks held in suspicion due to their unwillingness to provide these audits.
The challenging part of the reserves is proving what you owe — that is, what your liabilities are to depositors. The Merkle tree allows users to verify that their accounts and balances are included in the final hash without leaking the details of everyone’s balances and account information. Like herd immunity, users can have relatively strong assurances that the exchange is not lying if a sufficient number of them verify their balance.
A malicious exchange can of course cheat by publishing 0 balances for dormant accounts that they expect not to perform the check; but they run a big risk in doing this — if even one of the zeroed accounts makes the check, the exchange is exposed.
As Zak says, (the Merkle approach)…..”gives you the means to check your own belief of the exchange’s liability/obligation to you is included in their publicly declared one, and to let you make an informed decision about whether to continue doing business with them if those numbers differ”. The problem with the Merkle approach is that it makes public the exchange’s liability, which many exchanges may not want to do.
A bitcoin bank could issue actual notes against deposits, serving as the pegs in a sidechain. For it to be credible though, you need redeemability. As stated, a proof of reserve audit allows a depository institution to prove that they hold a certain amount in reserve, which would then — with the help of a trusted auditor — be used to demonstrate that their liabilities matched their reserves.
Alternatively, you can let users determine that internal balances exist to match their own deposits; if enough users do this, you can have reasonably strong assurances that the exchange is solvent. Both Bitcoin reserves and fiat operations should be proven, and that snapshots are far inferior to an ongoing reserve proof.
Historically, many exchanges have conducted proofs of reserves. Interestingly, the history of proofs of reserves is mostly one of broken promises. Several exchanges have deleted any trace of their previous proof of reserves attestations and others have backtracked on promises to perform proofs of reserves on an ongoing basis.