Ethereum founder Vitalik Buterin proposed methods of improving centralized exchanges (CEXs) by bringing them closer to decentralized exchanges (DEXs).
In the introduction of his blog post, Buterin lays out his premise. In the wake of FTX, a CEX which abused its customers’ trust, he envisions ways of making exchanges increasingly trustless.
For instance, “exchanges could create cryptographic proofs that show that the funds they hold on-chain are enough to cover their liabilities to their user.”
Buterin further poses the possibility of building systems where exchanges rely on users’ explicit permission to use their deposited crypto.
The Ethereum founder then related that a spectrum exists of many possibilities between “the ‘don’t be evil’ aspiring-good-guy CEX and the ‘can’t be evil,’ but for-now inefficient and privacy-leaking, on-chain DEX.” In aspiring to reach the appropriate balance, he relates previously used methods and offers some improvements.
Merkle trees and ZK-SNARKS
“The simplest way to prove deposits is to simply publish a list of (username, balance) pairs,” Buterin said. However, this method is insufficient for users’ privacy needs, which leads to the innovation of the Merkle tree.
In such a tree, each end node would be a user and their deposit amount. These users would also have access to any antecedent nodes and the root node to verify their deposits.
As the run on FTX deposits effectively demonstrated it lacked the reserves to meet demands, exchanges endeavored to demonstrate they still retained their customers’ assets.
Many have done so through publishing their cold wallet balances. However, as Binance CEO Changpeng Zhao explained, Merkle trees enable customers with cryptographic proof their assets are accounted for.
Ultimately, Buterin said that Merkle trees too are insufficient, as they still lack robust privacy and struggle with negative balances. He suggests the use of ZK-SNARKs (Zero-Knowledge Succinct Non-Interactive Argument of Knowledge) to account for these flaws.
He further introduces concepts like Plasma and validium to demonstrate that exchanges exist on a spectrum between centralized and decentralized.
CEX to DEX Spectrum
Nearling the conclusion of his post, Buterin discusses the concept of hybrid centralization. This would retain the benefits of centralized efficiency while also featuring “cryptographic guardrails” to preclude any impropriety.
As user errors eventually become the most prominent flaw of further decentralization, Buterin remarked that a trade-off for trusting exchanges with user data is still necessary. Although self-custody is the ideal solution in the long term, Buterin distinguished two alternatives for the short term.
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