What are the Bitcoin multi-signature addresses?
And how Hodl Hodl uses them for escrow storage
Over time, Bitcoin protocol expanded its functionalities as new developers joined its evolutionary path and proposed new ideas that would allow unique use cases that had not been explored previously. And it was that, 10 years ago, on December 20, 2011, support for the multi-signature addresses was added through the Bitcoin Improvement Proposal number eleven (BIP 11).
Even though it was possible to conduct multi-signature transactions from that moment on, they began to be widely adopted thanks to another later improvement: pay-to-script-hash or P2SH.
This new format allows using the multi-signatures as easily as the single key addresses. With this new technology, many online wallets and software emerged and began to adopt multi-signatures, which made the use of Bitcoin more secure.
So what exactly is a multi-signature address?
It is the address that requires more than one signature or key to move the BTC stored on it. We will exemplify it with the case of a 2 out of 3 address, which is the type of address we use at Hodl Hodl to secure your contracts. This type of Bitcoin address requires at least 2 signatures of the 3 associated with it to be able to move the funds to another address (carry out a transaction).
Visualize it as if it were a safe with 3 locks which requires at least 2 keys to open it.
Multisig could be very useful in different cases, for example, when certain funds should only be spent if at least 2 people out of a group of 3 agree to spend them, e.g., the company’s board of directors. It should be noted that as of today, it is already possible to configure multi-signature addresses of up to 15 keys.
In this case, we are talking about “2 out of 3” type since those are the ones used to secure the deposits on both our trading and lending platforms. At Hodl Hodl we use these type of addresses for our escrow storage since they provide excellent security when doing exchanges or depositing BTC as collateral to secure the loans.
In the case of Hodl Hodl trading platform, when starting a contract, the BTC seller generates one of the keys with the Payment Password (that is why it is VERY important to safeguard it), then the buyer generates the second key by entering their Payment Password, and finally, Hodl Hodl generates a third key which will only be used for conflict resolution, if any.
Every 3 passwords generate a unique 2 out of 3 multi-signature address using a specific cryptographic function, and that address serves as an escrow only for that contract.
Once this is done, the seller sends the exact amount of BTC that he/she is going to sell within that contract to the newly generated multi-signature address. After that, he/she will no longer be able to move the funds since he/she have only one signature of the 2 necessary to do so. The buyer will also not be able to withdraw the BTC from the multisig because he/she also has a single signature, and the same is the case for Hodl Hodl, which also has only one key.
BTCs have been locked in the multi-signature escrow address.
When the funding transaction was confirmed, the buyer makes the payment directly to the seller through the agreed upon payment method, secured by the BTC locked in the escrow multi-signature address.
Once the seller receives and verifies that the payment has arrived and the money is actually in his/her possession, ONLY THEN will he/she provide the signature by entering his/her Payment Password, the buyer will also do the same, and in this way, by including the 2 signatures required to move the funds, the buyer will be able to carry out the release transaction of the funds housed in the multi-signature to their own wallet, which has previously been specified on the platform as the receiving address.
At this point, the contract is completed.
In the case of our lending platform (Lend at Hodl Hodl), the procedure is similar to the one just above, except that the BTC sent to the multi-signature escrow address will remain locked there for the whole duration of the loan contract as a guarantee of loan repayment.
If the borrower does not comply with the repayment terms, the lender and Hodl Hodl will provide their signatures to repay the loan using the BTC locked as collateral by the borrower.
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