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.

Mark-to-market

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:

• accrual in the original currency by some agreed rate
• convert the cash flow number to its equivalent BTC number and starting defer because BTC has zero saving interest rate.

Either way, the values of the collateral BTC account can be calculated and assured by both parties. Details as:

1. each party creates an address for this deal. Let Albert's address be aaaaa and Bob's address be bbbbb.
2. Albert and Bob and Candy set up a 2-of-3 address ccccc
3. Albert and Bob agree an amount CCCCC and each of Albert and Bob sends this CCCCC amount to ccccc.
4. From time to time, aaaaa shall pay to bbbbb while Albert is losing money and bbbbb shall pay to aaaaa while Bob is losing money.
5. Let AAAAA be the total amount that bbbbb sends to aaaaa and BBBBB be the total amount that aaaaa sends to bbbbb. AAAAA minus BBBBB is what Albert actually receive and shall mirror the mark-to-market valuation of Albert's position within the error CCCCC. Similar for Bob.
6. Albert can withdraw amount in aaaaa and Bob can withdraw amount in bbbbb at all will
7. Albert and Bob shall clear the amount in ccccc which is 2 time CCCCC if deal closed in normal
8. When shit happens or any party finds his/her mark-to-market profit less than what actually received by amount CCCCC, Albert or Bob can call Candy to help clear the amount in ccccc

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.

Examples

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.

scenario 1

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.

scenario 2

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.

scenario 3

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.