[Bitcoin-development] Decentralized digital asset exchange with honest pricing and market depth

[Peter Todd <pete@petertodd.org>]

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Alex Mizrahi recently outlined a mechanism(1) based on SIGHASH_SINGLE
that allows colored coins and similar embedded consensus system assets
to be securely transferred to another party in exchange for Bitcoins
atomically. In summary his p2p 2-step-trade mechanism operates as
follows:

Alice controls a colored txout and wishes to sell it for 1BTC. Bob
wishes to buy that txout.

Alice signs a scriptSig using SIGHASH_SINGLE|ANYONECANPAY for a
transaction with a that time. (albeit a offer floor) single input, the
colored txout, and a single output with a scriptPubKey she controls and
nValue=1 This transaction is not valid as the value out is greater than
the value in.

She gives this partial transaction to Bob. He can now complete the
transaction by providing one or more inputs with a sum value >=1BTC, one
output for the colored coins to be directed to, and optionally any other
outputs required. (for instance for change)

Bob signs his inputs with SIGHASH_ALL and broadcasts the transaction,
completing the trade.

What Alice has signed, the first txin scriptSig, guarantees that if the
colored txout is spent she will receive 1BTC. Meanwhile what Bob has
signed, all other txin scriptSigs, sign the colored input and output,
guaranteeing that he will receive his coin in exchange for his money.
Thus the trade is trust free and atomic.


Decentralized markets and honest pricing
========================================

We can extend Mizrahi's 2-step-trade mechanism to create a decentralized
marketplace. First of all, remember that traders wishing to sell their
assets want to be sure that their assets offers reach the 100% of the
audience who may wish to buy said assets; an attacker may try to
manipulate the market to depress the price of an asset by hiding offers
from potential buyers. Similarly buyers want assurance that the offers
they are responding to represent all offers available.

Proof-of-publication(2) offers a solution. Alice can embed her
incomplete transaction as data in a second, valid, transaction. She
broadcasts this secondary transaction to some agreed upon blockchain,
either the one the colored coin is in, or potentially a secondary system
with suitable proof-of-publication security. Bidders such as Bob can now
scan the blockchain for offers with an acceptable price. (the offers can
make use of techniques like prefix filters to allow Bob to only scan
part of the blockchain, although Bob needs to know the status of all
assets of the type he is interested in anyway)

There is still some potential for manipulation with very recent offers,
particularly those embedded in unconfirmed transactions. However
typically markets have a large number of long-standing offers, which in
this case would be committed to the blockchain with one or more
confirmations.

Interestingly such a system can also provide honest historical pricing
information: any offer that goes unfilled for one or more blocks has (in
theory) been honestly published to 100% of those watching the blockchain
at that time. Thus we can assume the unfufilled offers at any
given block height are honest information about the market at that time
historically.

The overhead involved involved in Alice publishing the offer is roughly
a doubling of the overall transaction fees consumed. (remember that the
offer transaction is incomplete, and about half the size of the
acceptance transaction)


Application to other embedded consensus systems
===============================================

Any embedded consensus system can make use of the 2-step-trade mechanism
so long as it is possible to create transactions where spending a single
transaction output moves an asset appropriately.

Unfortunately extending this to circumstances where more than one input
needs to be spent, or more than out output needs to be created, is
difficult. SIGHASH_SINGLE by itself results in a signature where the
index of the output is signed, but the contents - scriptPubKey and
nValue - of all other outputs is not signed. Meanwhile all transaction
inputs are signed and changes to that set, other than modifying the
nSequence value in each CTxIn, is not possible.

If there was a SIGHASH mode that merely truncated vin and vout based on
the index of the scriptSig we could commit to data in either, but
unfortunately we can't do that.

An alternative could be to create a mechanism where some embedded data
signified the creation of a temporary transfer txout, where spending
that txout made the underlying change desired in the consensus state
atomically.


1) Alex Mizrahi, color kernel design considerations, Jan 7th 2014,
   Colored coins (BitcoinX) mailing list,
   https://groups.google.com/d/msg/bitcoinx/pON4XCIBeV4/IvzwkU8Vch0J

2) Peter Todd, [Bitcoin-development] Disentangling Crypto-Coin Mining:
   Timestamping, Proof-of-Publication, and Validation, Nov 19 2013,
   https://www.mail-archive.com/bitcoin-development@lists.sourceforge.net/msg03307.html

-- 
'peter'[:-1]@petertodd.org
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