research
Transacting Bitcoin-based P2P Derivatives
April 19, 2019
|
,

On April 16th (UTC), a trust-minimized forward contract transaction took place on the Bitcoin blockchain between Crypto Garage and Blockstream, based on Crypto Garage’s exciting new peer-to-peer crypto asset derivative protocol. An oracle automatically settled the transaction by referencing the spot price from the ICE Cryptocurrency Data Feed, demonstrating the potential for derivatives to be exchanged and settled without the need for a custodial third party or peer-to-peer counterparty risk.

What is a Forward Contract?

A forward contract is a type of derivative that represents a bilateral agreement to buy or sell an asset at a specific price (the “forward rate”) at a predetermined date in the future, usually to strategically hedge against price changes. The forward rate is a mutually agreed upon fair price at settlement, that takes into account factors like the spot price at the creation of the contract, growth from interest rates, and cost of storage. Forward contracts are handled between two parties, usually without the need for an exchange or clearing house, so both parties must trust each other to meet the terms of the agreement.

Derivative Contracts in Bitcoin

Futures contracts are similar to forward contracts, but are more commonly traded in the Bitcoin industry on exchanges such as BitMEX and CME. In addition to speculative trading, futures are used for practical purposes by customers like mining pools as a hedge against the volatility risk of holding large amounts of BTC on their balance sheet. Futures are only partially collateralized, relying on an exchange acting as a middleman to secure the collateral. Due to collateral being limited, big price changes can lead to the exchange (and its customers!) being out of pocket.

Forward contracts on the other hand are typically unsecured by any collateral and require collateral management by both parties. Both approaches rely on mutual trust between the two parties engaged in the contract. The absence of collateral means that each party is at risk of the other failing to deliver upon completion of the contract.

Enter trust-minimized forward contracts, a new kind of P2P derivative.

A New Approach to Trust

A trust-minimized derivative contract allows bitcoin collateral to be posted by both parties and locked in a 2-of-2 multisignature smart contract until its maturity date, when it is automatically disbursed using signatures from the participants and a trusted price feed oracle.

Crypto Garage’s implementation on Bitcoin is based on Discreet Log Contracts, first proposed by Thaddeus Dryja from MIT Digital Currency Initiative. Yutaka Nakasone from Crypto Garage took this concept further with “Trustless Forward Contracts,” applying financial engineering to prepare DLCs for practical use as a financial instrument.

To begin the transaction, party A and party B post the maximum profit and loss exposure they each hold for the trade. All possible outcomes of the contract are then pre-generated as partial transactions, known as Contract Execution Transactions (CETx). When the maturity date arrives, the oracle broadcasts the spot price of BTCUSD with its signature, and either party A or party B sends a signature to the corresponding CETx.

Once the signature is received and matches the oracle’s signature, the settlement is complete. If one counterparty attempts to broadcast a false narrative that differs from the rate quoted by the oracle, that counterparty loses all of its collateral to the honest (or slower) counterparty. To incentivize a prompt closeout, if neither counterparty signs on the maturity date, the transaction enters a “delayed” state and the party that realizes first can sign to withdraw the entire collateral.

Trade Day

On April 9th, Crypto Garage and Blockstream each posted collateral of roughly 0.16 BTC at the strike price of $5,250 USD for 1 BTC set to expire at 00:00 UTC on April 16th, to be settled within the next hour. The trade was structured with a cap and floor on the spot price used in the forward calculation such that neither party could risk losing more than they had committed in collateral, thereby eliminating the need to trust their counterparty for additional collection. Blockstream, of course, was long on Bitcoin.

At 00:40 UTC on April 16th, Blockstream and Crypto Garage settled on the forward contract at a price of $5,032 as determined by the ICE Cryptocurrency Data Feed, and the posted collateral was automatically redistributed to their respective wallets. Crypto Garage netted 4.3 million satoshis (around $230 USD) for their astute foresight to go short.

Let the record show that Blockstream is still long on BTC, and would do it exactly the same if given a time machine.

More to Come

This transaction was completed on Bitcoin, but Crypto Garage plans to extend their work in crypto derivatives and support various types of contracts on the Liquid Network for Liquid Bitcoin (L-BTC) and other Issued Assets on the network. Crypto Garage’s JPY stablecoin on Liquid is the only Japan FSA-approved JPY token, and will provide some very interesting trust-minimized use cases in the near future.

Get Involved

P2P trust-minimized derivative applications will be coming to Blockstream’s Liquid Network soon. Any businesses that would like to learn more about becoming a member of the network should connect with Blockstream. For those interested in exploring Bitcoin-based P2P derivatives or facilitating their own trust-minimized derivative contract, reach out to Crypto Garage for more information.