Blockstream Trials First Trust-Minimized P2P Bitcoin Derivatives

Blockchain technology company Blockstream has revealed that it was able to successfully complete a trust-minimized forward-contract transaction on the Bitcoin blockchain. The transaction occurred on April 16 between Blockstream and Crypto Garage. The official research paper was published on April 19, 2019.

An Intro to Crypto Garage

Crypto Garage is a Japanese firm dedicated to designing and implementing financial instruments based on Bitcoin. Crypto Garage has contributed to the Bitcoin Core software and has focused a lot of its resources to work on a number of side chains, and other additional second layer infrastructure for Bitcoin.

Crypto Garage believes the key to mainstream adoption and the maturation of the crypto sector is highly dependent on the availability of stable and viable financial instruments. Convinced that crypto-based economies are the future and determined to bring it to fruition, Crypto Garage states:

“We navigate the intersection of Bitcoin and financial engineering to accelerate ‘Cryptofinance’ adoption in financial markets.”

The firm has been at the forefront of developing bitcoin and blockchain-based financial instruments. On January 18, 2019, the Japanese firm was granted entry into a regulatory sandbox by the Japan Financial Services Agency. Crypto Garage landed a spot in the sandbox to design and implement an architecture that facilitates the sale and purchase of digital assets on an instantaneous basis. The experiment will be limited to a small number of regulator-approved digital asset exchanges.

Crypto Garage is the first firm of its kind working on blockchain technology to be granted entry into the Japanese regulatory sandbox. Its year-long experiment, within the confines of the sandbox and utilizes the Blockstream-created Bitcoin sidechain called Liquid. Using a combination of an internally developed Japanese Yen stablecoin and Blockstream’s Liquid sidechain, the duo hopes to successfully complete the rapid, secure and confidential transfer of digital assets. These are called atomic swaps and are thought to minimize many of the risks involved in trading digital assets while also removing the need for trusted intermediaries; Crypto Garages internal settlement architecture is called Settlenet.

The First Trust Minimized Bitcoin Derivatives Sale

The first ever trust-minimized bitcoin forward contract transaction is yet another collaboration between Blockstream and Crypto Garage. The transaction was made possible because of a Crypto Garage developed peer-to-peer digital asset derivative protocol.

In traditional financial markets, a forward contract is an over-the-counter derivative which allows parties involved in a transaction to buy or sell a security at a predetermined future date with the price already agreed upon. The terms of forward contracts typically include specifications about the identity and quantity of the underlying security as well as the details about the date and pre-agreed price.

Forward contracts are popular because they provide a hedge against price changes. This is because a typical forward contract involves negotiations between the parties involved to arrive at a price, as well as other specifics, that are fair to both parties. In the traditional financial market, forward contracts typically happen between the two parties without the need for an intermediary, such as clearinghouses. However, they require trust between the involved actors.

In the cryptocurrency sector, futures contracts, which are similar to forward contracts, are more commonly utilized. Bitcoin futures contracts are available on exchanges such as BitMEX and CME.

These instruments typically serve two purposes: speculation and hedging. Some investors and traders utilize them for speculation while parties who find themselves holding large amounts of BTC, such as mining pools, hedge themselves against price volatility. However, because bitcoin futures contracts depend on the exchange to collateralize the agreement, substantial price changes may mean losses for the exchange and the involved parties.

Conversely, due to their design, forward contracts differ because, as referenced earlier, they typically do not require collateral from any party or intermediary. However, they require trust between the two parties. Unfortunately, the lack of collateral means that either party runs the risk of a failure to honor their end of the agreement.

The trust-minimized forward contracts, trialed by Blockstream and Crypto Garage, represent a new kind of P2P derivative, which they believe combines the best features of the financial instruments with a trustless environment. The trust-minimized contract involves the use of a multisig smart contract which both parties are signatories to. Both parties provide collateral, in the form of bitcoin, which is safely stored until the contract matures, at which point an oracle employs publicly available exchange data to decide on a price for the digital asset.

The Crypto Garage implementation is based on a called Discreet Log Contracts. Initially proposed by the MIT Digital Currency Initiative researcher Thaddeus Dryja, a Crypto Garage scientist called Yutaka Nakasone further developed the concept to create Trustless Forward Contracts.

How It Works

To initiate an agreement, each party must indicate their maximum profit and loss exposure. The software automatically generates all possible outcomes in what is known as Contract Execution Transactions (CETx). When the contract maturities, the oracle broadcasts the spot price of BTC/USD with its signature, and either party must send a signature to the corresponding CETx.

Once the signature is received and is determined to be valid, the settlement is finalized. To keep things honest, if one party attempts to post a price lower than that of the oracle, it loses all of its collateral. Additionally, the architecture is designed to optimize for speed. If neither party signs upon maturity of the contract, it enters a delayed state where the party which signs it first receives the entire collateralized amount.

In a blog post, Blockstream explained: “Crypto Garage and Blockstream each posted collateral of roughly 0.16 BTC at the strike price of $5,250 for 1 BTC set to expire at 00:00 UTC on April 16th, to be settled within the next hour.” On the maturity date, the two parties agreed on the settlement price of $5,032, with data pulled from the ICE Cryptocurrency Data Feed. The smart contract automatically reimbursed the parties their collateral with Crypto Garage gaining 4.3 million satoshis (around $230) in profit due to its decision to go short on bitcoin in the forward agreement.