Understand Cryptocurrency Escrow

If cryptocurrencies are decentralized and secure, how come do we need escrow services?

That’s a great question and it doesn’t really arise from cryptocurrencies themselves, but from the coexistence between traditional currencies and cryptocurrencies.

In fact cryptos do not require escrow!

So what’s an escrow service and why do we need it?

An escrow is a trusted third party. It is an institution that is trusted by 2 or more parties to arbitrate a particular transaction and guarantee that everyone will honor their share of a deal.

Example Escrow Transaction

Say you’re selling a house. There is a point in time where you’ll need to transfer the real estate property to your buyer and, during a couple of hours perhaps, you’ll be in a state of suspense waiting for the money transfer to come through.

Since real estate usually involves large sums, this transfer may take several hours. It may even happen overnight or take several days (for example if a wire is being sent from a distant country).

From the moment you’ve transferred the property, until you receive payment, you are vulnerable.

This is where an escrow makes everything smoother.

The house is transferred to the escrow. The escrow then contacts the buyer and says they have control of the situation. Then the buyer sends the money to the escrow as well. The escrow then notifies all parties involved that everything is OK. As each obligation is met, the escrow will distribute the correct documents and rights to the right people. There is no suspense or distrust, because a contract has been signed where the escrow guarantees that everyone will get their rights.

Crypto Escrow

With cryptocurrencies an escrow is probably only ever needed when fiat money, or some other real world asset, is exchanged for crypto.

There is an inherent impedance mismatch between cryptocurrencies and fiat money, which escrow systems seem to solve: one is irreversible while the other one isn’t.

Once you’ve started a cryptocurrency transaction, there is no going back. The transaction gets broadcast onto the network and will eventually get mined. And then, after a few block confirmations, it’s permanent.

Fiat money transfers, on the other hand, are reversible. E.g. You can call a bank manager and tell them you “messed up” and wish to undo a transaction. Or, you can open a dispute within a payments system like Paypal. Or you can void a check and claim something is wrong with the transaction. Whenever fiat money is exchanged for cryptocurrencies, the fiat side can reverse the transaction.

If you’re selling large amounts of crypto, you probably need a trusted middleman that’ll honor all obligations involved in the transaction.

Cryptographic Secret Splitting

But traditional escrows aren’t the only kind of trusted middlemen.

Cryptography makes it possible to construct several creative escrow architectures that do not require anyone to be involved in the process.

A secret cryptographic key can be split among a number of participants, for example, so that no one can decode a secret (which could be a Bitcoin amount) on their own. It would then require multiple people to enter their part of a larger secret into a system in order to open the secret.

This is called secret splitting and may also be called threshold schemes depending on context.

Threshold schemes have one particular problem: if enough people forget their part of the key, then the whole key is lost for everyone. This, of course, is inappropriate for large sums of money, so a better system is required.

Cryptographic Threshold Schemes

This is where the threshold part comes in : you need to set the threshold high enough to guarantee security, but low enough so that you don’t risk losing the entire secret because not enough people can sign the transaction.

In a threshold system, just enough of a secret key is needed to unlock the secret. Say 5 people compose the board of a corporation. The secret can be split in a way such that only 3 executives are required to sign a transaction in order for it to go through. This is the meaning of “cryptographic threshold” : you need a minimum amount of signers for a transaction to happen.

Smart Contract Threshold

With smart contracts, like those found on Ethereum and in the future with Cardano ADA and other third generation cryptos, cryptographic escrow can be automatic. A smart contract can be programmed to only ever release a certain amount of cryptocurrency once certain conditions are met.

This is a fully automated and decentralized process that, when well implemented, no one can roll back or void.

Since the cryptographic functionality is built-in into every Ethereum smart contract, all Ethereum contracts have access to several to different tools which enable them to fully verify conditions that should be met when the contract is deployed (signed). Once signed and deployed, Ethereum contracts are permanent – they work as the perfect escrow, being easily audited by anyone with access to a full node or an Ethereum block explorer such as Etherscan.

Conclusion

As you can see the technology of cryptocurrencies is incorporating real world concepts into a cryptographic ecosystem which will make business more fluid, more secure and decentralized.

With cryptographic escrow systems, the mismatch between fiat money and crypto does not happen.

All parties agree on predefined rules and these rules can be enforced by non-human and apolitical entities like smart contracts that live on the blockchain.

As more and more businesses migrate to the cryptocurrency space, the need to match the idiosyncrasies of fiat money into the world of cryptocurrencies will become obsolete and the only escrow needed will be that of cryptographic contracts that require zero trust or human intervention.

Links

Escrow protocols for cryptocurrencies [PDF]

Satoshi Nakamoto’s historic Bitcoin whitepaper suggests the use of escrow services to buy/sell Bitcoin

Escrow entry at Wikipedia

Key Escrow at Wikipedia

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