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Trust Law/Level IX · Trusts on chain/9.2 Tokens and real-world assets/Lesson 7

Proof of reserves versus a trustee’s accounting

What a Merkle-tree proof of reserves can and cannot show, what the FTX collapse revealed, and how a trustee’s accounting under UTC §813 differs in scope and legal force.

Education, not legal advice. Trust law changes from country to country and state to state, and the right structure depends on your situation. Anything you sign should be drafted or reviewed by a qualified lawyer where you live.

The lean path

The cheapest, lowest-tax, simplest and most private route the law allows, best first. Each step names the rule it rests on and the condition that keeps it lawful.

  1. Free check: when a platform publishes a Merkle-tree proof, verify your own balance’s leaf against the published root every time. Catch: it is a snapshot that omits other liabilities, such as loans, and cannot show whether assets are pledged elsewhere.
  2. Cheapest way to need no proof at all: keep long-term holdings in self-custody, where any block explorer shows the balance at any time. Catch: key loss then becomes your own risk, so pair it with a recovery plan.
  3. Trust beneficiaries can request a copy of the instrument and must get an annual report on property, liabilities, receipts, disbursements and compensation, free (UTC §813). Catch: while a revocable trust’s settlor lives, these duties run only to the settlor (Maine 18-B §813(6)).
  4. If a report is withheld or wrong, a court can order an accounting, restore losses or remove the trustee (UTC §1001). Catch: beneficiaries can waive reports, and states changed parts of §813, so check the local version.

MaterialsVitalik Buterin, ‘Having a safe CEX: proof of solvency and beyond’ (19 November 2022), free onlineUniform Trust Code §813, on the duty to inform and report, in a state enactment such as Maine Revised Statutes title 18-B §813Lesson 4.3.7, on reporting to beneficiaries, and lesson 9.2.4, on stablecoin reserves and attestations

Wonder

  1. If a platform proves it holds enough coins today, what could still be wrong?
  2. What does a Merkle tree let a customer check, and what does it leave out?
  3. What can a beneficiary do with a trustee’s report that a customer cannot do with a proof of reserves?

Explore

  1. A custodial exchange or similar platform holds coins for many customers. A proof of reserves is a voluntary disclosure meant to show that it holds enough assets to cover what it owes them. A full proof has two parts. A proof of liabilities shows the total of customer balances; a proof of assets shows that the platform controls coins on-chain, for example by signing a message with the keys to its addresses. If the assets at least equal the customer balances, the platform appears able to repay its customers. This lesson explains the method and its limits and recommends no platform.
  2. Customer balances are often committed to in a Merkle tree. Each customer’s balance becomes a leaf; pairs of leaves are hashed together, level by level, up to a single root, which the platform publishes. A customer given the branch from their leaf to the root can check that their balance is included without seeing the full list of other customers’ balances. In a Merkle sum tree, each node also carries the total of the balances below it, so a fake negative balance cannot be used to shrink the total. Discussion of this approach began in 2013; in 2011 the exchange Mt. Gox had shown its funds by moving coins on-chain.
  3. The method has limits. It is a snapshot at one moment: coins could be borrowed for the proof and returned afterwards, or the same coins shown by different platforms in turn, which Buterin calls collateral dual-use. The liabilities side covers only the customer balances in the tree, not the platform’s other debts, such as loans, which may compete with customers if it fails, and it does not show whether assets are pledged elsewhere. Customers who never check their own leaf cannot know they were included. Assets held in banks rather than on-chain still depend on banks or auditors to confirm them.
  4. FTX shows why the whole picture matters. In November 2022, a surge of withdrawals exposed a hole of about $8 billion in its accounts, and FTX filed for Chapter 11 bankruptcy on 11 November 2022 (lesson 9.1.4). Customer funds had been used by Alameda Research, a trading firm owned by FTX’s chief executive, Sam Bankman-Fried, who was convicted on 2 November 2023 of defrauding FTX’s customers and Alameda’s lenders. A proof covering coins on-chain at a single moment could at most have shown a shortfall then; it could not show where missing funds had gone or everything the group owed.
  5. A trustee’s accounting answers different questions. In US states that adopted the Uniform Trust Code, about 36 plus the District of Columbia, §813 requires a trustee to send current beneficiaries a report at least annually and when the trust ends. The report covers the trust property, liabilities, receipts and disbursements, including the source and amount of the trustee’s compensation, a list of the trust assets and, if feasible, their market values (lesson 4.3.7). Because it covers a period rather than a moment, it shows what went out of the trust as well as what remains. States changed parts of §813, so each state’s version matters.
  6. A trustee’s report is also backed by fiduciary duties enforceable in court. If a trustee breaches a duty, UTC §1001 lets a court compel the trustee to perform, order an accounting, require the trustee to restore losses, or remove the trustee. A proof of reserves is a voluntary disclosure by a company that may owe its customers only contractual duties, and its value depends on who checks it and how. Neither is the same as a full audit, and an accounting can be wrong too. They answer different questions: whether assets were present at one moment, or how property was handled over time.

Key facts

  • A proof of reserves combines a proof of liabilities, the total of customer balances, with a proof of assets, showing control of coins on-chain.
  • In a Merkle-tree proof, each customer can check that their balance is included under a published root without seeing the full list of other balances.
  • A proof of reserves is a point-in-time snapshot and does not show the platform’s other liabilities, such as loans, or whether its assets are pledged elsewhere.
  • FTX filed for Chapter 11 bankruptcy on 11 November 2022 after withdrawals exposed a hole of about $8 billion; Sam Bankman-Fried was convicted of fraud on 2 November 2023.
  • Under UTC §813, a trustee reports at least annually and at termination on trust property, liabilities, receipts, disbursements and the trustee’s compensation.
  • Under UTC §1001, a court can remedy a trustee’s breach, for example by ordering an accounting, requiring the trustee to restore losses or removing the trustee.

Exercise nine, six, three, one

9CollectList up to 9 things someone might want to know about property held for others, from this lesson or a source you are reading (some sources give fewer), such as assets held now, debts owed, money paid out, who checked the figures and what happens if they are wrong.
6ClusterSort them into 6 categories: assets at a moment, customer balances, other debts and pledges, money in and out over time, independent checking, and legal remedies.
3DistillReduce the 6 categories to 3 groups: what a proof of reserves can show, what only an accounting shows, and what neither shows on its own.
1CrystallizeWrite 1 sentence explaining, in your own words, why a snapshot of assets is not an accounting of obligations.

Fact check

Dates, figures and claims checked against the published sources listed below.

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