Exchanges will soon be able to offer their customers a cold storage backup guarantee for all their blockchain-based deposits by using sidechain technology in combination with a newly developed blockchain consensus software called Graphene.
Why is this so important? Dozens of exchanges have either become insolvent, shut down, or gone bankrupt in the past few years, and almost all of them took their users funds with them. Regular users have lost a total of over $500 million due to exchange shutdowns in the past two years alone. Regardless of the reasons for these failures (mismanagement, fraud, theft, incompetence) the fact remains that you are taking a very big risk by trading on a centrally owned and operated online exchange that cannot guarantee its reserve holdings.
Today’s exchanges actually operate much like casinos. The company who runs the exchange (the “house”) holds your money and in return they issue you exchange credits (“chips”) which represent either Bitcoin or Litecoin or Dollars or whatever you have deposited. You can then trade these credits with other users on their website by placing buy and sell orders. When you are finished and want to “cash out”, you simply take your chips back to the house and exchange them for real Bitcoin or Litecoin or Dollars, which are deposited back into your corresponding account or address on the blockchain. This service – the cashing in and out – is called a gateway.
This all seems to work fine, except for one very important detail: While you are trading on the exchange, sometimes you will have orders that sit on the books for days or even weeks. During that time, your actual money is being held by a third party who is subject to virtually zero oversight. How do you know the casino will still have your money when you go to cash out? With an actual casino, there are strict accounting procedures and regulatory controls to ensure your chips are always backed by real money. But with online cryptocurrency exchanges, there is no such guarantee.
This is where Graphene, the core technology behind BitShares, can change the entire landscape. A Graphene chain enables its token holders to vote for a trusted set of deposit/withdrawal signers, who then operate a collective gateway onto an exchange by issuing tokens which represent funds held in escrow by an account requiring multiple signatures (multi-sig) to transfer.
To understand this process, let’s dig a little deeper. To start, multiple independent “trustees” could each run a software program that monitors every blockchain in the network. The holders of a Graphene chain, let’s say BitShares, could elect perhaps 20 of these trustees to run a single gateway service. The trustees would then get paid for this gateway service by charging a small transfer fee, and shareholders could vote trustees into position or remove them instantly.
Each time any user deposits coins into a designated deposit address on another chain, let’s say Bitcoin, the trustees would recognize and confirm the deposit, and 15 of those trustees would sign a multi-sig transfer that would send a “proxy BTC” token to the user’s BitShares account. These tokens would represent the BTC held in escrow by the trustees on the bitcoin blockchain at a 1:1 ratio. The user could then trade this token(s) on the BitShares Decentralized Exchange as if he or she were trading the actual bitcoin. And whenever a user wanted to withdraw their proxy BTC, they would simply send the token to a designated withdrawal address on BitShares, along with their bitcoin address in the transfer Memo, and the trustees would recognize and confirm the transaction and send the real BTC to the user’s bitcoin address via a multi-sig transfer.
Now you might say that’s great for BitShares, but how can also benefit the other exchanges? Well, the same escrow service could also be used by centralized exchanges, for example Poloniex, to both hold and prove their reserves. The owners of Poloniex could register an account on BitShares and then also run software on their server that would monitor their BitShares account for deposits. If you wanted to deposit BTC onto Poloniex, you would simply send your proxy BTC tokens to Poloniex’s BitShares account. The software Poloniex is running to monitor their own account would see your proof of deposit, and would thus issue you a “chip” on their exchange. When you wanted to withdraw, Poloniex would just send the appropriate amount of proxy BTC tokens back to your BitShares address. With this method, anyone could audit the reserve deposits of Poloniex by checking their account on BitShares. Essentially, Poloniex could use the BitShares multi-sig trustees as a 3rd party guarantor of the reserve funds for everyone’s deposits on their exchange.
So how secure is this method of sidechain transaction processing? To start, we could compare it to a standard bitcoin sidechain which uses a proof-of-work mining algorithm. In proof-of-work, if enough miners choose to join together into a pool that accumulates 51% of the hashpower, it would allow them to steal or divert all of the funds held by the sidechain. Historically, it has been shown that a small handful of mining pools usually end up with a significant portion of the hashpower on any given network, and even worse, the shareholders do not have any say over who these miners are. In fact with the right amount of money, anyone could purchase enough specialized mining equipment to become a potential threat to a small sidechain network.
The difference between a proof-of-work sidechain and Graphene is that the multi-sig trustees on the Graphene chain cannot buy their way into power, but rather they are subject to shareholder voting. In order for any funds to be stolen or diverted, perhaps 15 out of 20 independently chosen and voted for operators would have to collude with each other in a very public way. Rather than a single operator (like an online cryptocurrency exchange) or a group of unelected miners, the funds would be backed by 20 or more independently vetted and voted for entities, each with legal and business reputations to uphold. This makes a Graphene-based sidechain network a very intriguing option for cold storage backup and decentralized exchange trading tokens. And if you consider the current track record of the exchange industry, this should be a most welcome advancement.
About the Author
Michael P. Maloney (cryptoprometheus) is a written and audio communications specialist with a penchant for DAC design. He studied applied psychology at the University of Denver in 1999, and worked for 12 years as a structural architect and freelance editor. In 2013, he discovered BitShares and became passionate about blockchain technology and its many exciting potentials. He now applies his skills towards fostering a greater awareness of the movement by working as a writer and content editor for various blockchain-based initiatives.