PSR, Pre-Settlement Risk
Every transaction is a commitment in some future and therefore it may default when shit happens. The pre-settlement risk is the risk that a party can not get his winning money back while it is winning against the other party. For example, a scam enters a deal with you (and you are not a scam). You send the scam some money at the first day by the obligation of the deal, but the scam immediately go away after receive your money.
One way to solve this is to set up a guarantor so that one can get the winning money back from the guarantor when shit happens to the other party. This guarantor solution is trivial and difficult to find because one is not necessarily willing to take credit risk of someone else. By centuries of banking industry development, the only nontrivial solution is as below.
The arrangement is to set up a collateral account to each other so that the value difference between the two collateral accounts mirrors the profit of the deal. The counterparty needs to sends assets to the collateral account when the counterparty is losing money.
This is especially true for bitcoin because the anonymous nature of BTC transaction and no way out for guarantor. It is fair to claim that this technique is the most vital part to allow BTC transaction smoothly in daily life except kiosk business.
You may also like to read WhyBtc to know why here valuation is in term of BTC not in fiat currency. You can also see about an online running business at the page JoshuaChen. The following briefs the concept.
Suppose both parties, Albert and Bob, of a deal agree a valuation method and the valuation is expressed in BTC. They also agree a method to handle a cash flow incurred by the deal, could be:
Either way, the values of the collateral BTC account can be calculated and assured by both parties. Details as:
In this way, no party shall be afraid of the PSR because deal is effectively closed as normal because the deal ends in the condition that the correct profit or loss has been taken. The usual escrow simply resembles the special case of this mechanism where CCCCC is a big number higher than any potential loss.
Albert is the staff of google and allowed to buy google stock at a cheaper price. However the GOOG and all its dividend will be grant to Albert one year later. Bob, not a google staff, wants to enjoy this chance. Suppose Albert provides a deal with Bob for one year privately that one year later Bob will give Albert USD 100 and Albert will return the value of the GOOG and all its dividend to Bob.
Let X denote the USD number of GOOG value plus all its dividend. Albert has the concern that what-if GOOG performs poor and 100 - X is positive and Bob disappears while Albert has spent the discount value of 100 to buy GOOG. Bob has the concern that what-if X - 100 is positive and Albert want to make the GOOG his own (legally it is always Albert who own the GOOG so Bob can not possibly sue Albert) and does not return the GOOG's value to Bob.
Beside both agree that the valuation of X is by the close price of GOOG on the exchange and the valuation of the USD 100 is 100 discount at 2%, Albert and Bob both go to Candy who doesn't know the whole story and set up a 2-of-3 address. Albert and Bob send 0.01 BTC to this 2-of-3 address and agree specific address of each other for mark-to-market tasks.
From time to time, both parties will send BTC to the other's address so that actually received BTC amount mirrors the valuation of the position in term of BTC less than error BTC 0.01.
GOOG sky rocky but Albert dies in a car accident at 0.75 year. Bob sees no mark-to-market tasks from Albert and calls Candy for help. Candy investigates the blockchain and makes sure Bob is not lying. Candy then clear the 0.02 BTC in the 2-of-3 address with Bob by sending all the 0.02 BTC to Bob.
GOOG down but Bob dies in a car accident at 0.75 year. Albert sees no mark-to-market tasks from Bob and calls Candy for help. Candy investigates the blockchain and makes sure Albert is not lying. Candy then clear the 0.02 BTC in the 2-of-3 address with Albert by sending all the 0.02 BTC to Albert.
The deal ends normally. Both Albert and Bob clear the 0.02 BTC in the 2-of-3 address in two payment amounts to Albert and Bob such that the overall actually received BTC amount is correct as equivalent BTC of USD X - 100 for Bob.