Part one of this blog series provided an overview of blockchain fundamentals and introduced smart contracts. Readers unfamiliar with this material are encouraged to first read part one. This post will explore construction of a centralized marketplace for binary derivatives. This approach does not make effective use of the blockchain, but is presented to illustrate the numerous challenges that must be overcome when taking a centralized approach. In part three, an elegant alternative is presented which employs smart contracts deployed on the Ethereum network to facilitate transactions between parties. For the remainder of this series, blockchain will refer to the Ethereum blockchain and the underlying cryptocurrency is Ether (plural: Ether).
A centralized exchange suffers from the very requisite blockchains were designs to replace: trust. Upon account creation, customers must deposit Ether into their account(s). In other words, they must give the exchange their Ether. Customers must have confidence that the exchange will safeguard their coins and settle contracts properly. If this trust is compromised, customers will not use our exchange.
When customers deposit their Ether into our exchange, the customer is sending a transaction from their personal account to the exchange’s account. Indeed, the exchange can be represented by a single account on the Ethereum blockchain. The accounts that exist within the exchange only exist on the computers at the exchange and are not included on the blockchain ledger. As a result, customers have had little recourse when counterfeit exchanges accept deposits. The establishment of trust is a crucial component of the centralized approach. Large exchanges such as Bittrex, Kraken, and GDAX have spent millions of dollars on both infrastructure and marketing to develop credibility.
Once we have spent millions of dollars on infrastructure and developed widespread-credibility across the internet, our exchange is ready for business (I never said this approach was easy). Our exchange will trade binary derivatives on US equities. A binary derivative can be viewed as a bet on the future price of a stock. Suppose the price per share of Google Inc. is $950.00 and I make the following bet with a friend: I’ll pay you 10 Ether if the stock price of Google Inc. closes above $950.005 on next Friday, otherwise you’ll pay me 10 Ether. The outcome is binary in that the price will close above or below $950.005 (it cannot close at $950.005). In finance, the term derivative is reserved for instruments that derive their value from the price of another asset. To understand why this contract would derive its price from the stock, suppose we made the same bet, but the price of Google was $1000.00 per share. Given the share price is well above our agreed upon (strike) price of $950.005, there is a pretty good chance that I’m going to win this bet. My friend realizes this, and proposes the following modification to our agreement: You’ll pay me 10 Ether if the stock price of Google Inc. closes below $950.005 on next Friday, otherwise I’ll pay you 1 Ether. Essentially, my friend has decreased the price he is willing to pay because his risk of losing his investment has increased. If I win the bet, I receive back my 10 Ether plus his 1 Ether. If the price of Google Inc. dives below $950.005, my friend will receive back his investment plus my 10 Ether.
Our exchange will enable thousands of individuals to place bets on the future price of various US equities. What makes derivative instruments fascinating, is that anyone can to buy or sell contracts. If a contract does not exist with your desired specifications, you can create it! For example, a customer could create a contract at our exchange that offers to pay 5 Ether if Google Inc. climbs above $980.005 by the end of the month, otherwise they wish to be paid 1 Ether. If a customer agrees to these terms, our exchange will facilitate the transaction between these customers (perhaps for a small fee).
In part three we will modify the above approach to remove the requisite of trust from our exchange. We will see how smart contracts facilitate a decentralized market where two parties can enter a contractual agreement and be assured the other party will make good on their contractual obligations.