Cryptocurrency Transactions: Multi-Signature Arrangements Explained
Cryptocurrency Transactions: Multi-Signature Arrangements Explained
Over the years, blockchain technology’s popularity has grown. Usually, a blockchain is verified by nodes, which accept block proposals and enable cryptographic, digital signatures. Therefore, an effective signature process is necessary to ensure that all nodes reach consensus and to verify a chain’s validity.
However, as cryptocurrency becomes more widespread, fraudulent activities—like hacking—have increased. For example, in 2014, the Mt. Gox hacked of several private keys resulted in a loss of approximately 160,000 bitcoin (BTC). This fraudulent activity was believed to have occurred because the company involved did not use a multi-signature approach to store private keys.
To reduce such fraudulent incidents, many have adopted multi-signature arrangements for their transactions. Multi-signature transactions provide an increased level of security.
What Is a Multi-Signature Arrangement?
Multi-signature arrangements, also commonly known as multi-sig, are a practice that requires the use of different signatures or keys, rather than one signature, to authorize a Bitcoin transaction. This long-established practice was often used to execute transactions from authorized parties.
Today, this arrangement has been widely applied to electronic transactions, including Bitcoin and other cryptocurrencies. This technology bolsters cryptocurrency transactions’ security in a transparent way. The use of multi-signature arrangements is similar to financial transactions and agreements such as multi-signature checks that require two or more signatures.
A multi-signature agreement requires more than one user to sign a transaction prior to the transaction being broadcast on a blockchain. This requirement means that, for cryptocurrencies like Bitcoin to be executed, transactions must first have more than one signature. This approach differs from standard cryptocurrency transactions, which only need one digital signature before funds can be transferred.
Multi-signature transactions are also known as M-of-N transactions, where M represents the required number of signatures and N is the total number of signatures in the transaction. Since the Bitcoin network involves many complicated transactions, multiple parties’ signatures are needed before transferring funds.
A normal Bitcoin address comprises two parts: a private key and a public key. In a single-signature arrangement, anyone who holds the private key is authorized to spend funds from the address. However, with multi-sig arrangements, multiple private keys are needed, protecting the bitcoins held at an address.
In this arrangement, at least two signatures are needed to approve Bitcoin and similar electronic transactions between three addresses. For instance, a Bitcoin transaction can involve two signatures: the signature of the sender, or the person sending their bitcoin, and a second private key.
Financial institutions use multi-signature arrangements for cryptocurrency transactions. They are also used to execute contracts and for privately selling digital assets.
Multi-Signature Arrangements’ Application
A common use of the multi-sig approach is the “Multisig Escrow”—a trading arrangement designed to offer security to both buyers and sellers. The Multisig Escrow arrangement ensures that a transaction is fully executed only when the involved parties have agreed that the transaction’s terms have been met.
In this arrangement, a third party holds the bitcoin payment and only disburses it to the seller once the buyer receives the purchased product. For instance, if Party X is purchasing from Party Y, the escrow arrangement allows Party Z to hold the transacted bitcoin and then only transfer the cryptocurrency once the purchased product has been exchanged. This approach helps prevent issues that buyers usually experience during online shopping.
In addition to normal transactions, a Multisig Escrow service can also be used in cryptocurrency payments. Under a Multisig Escrow, the buyer sends a cryptocurrency to a multi-signature address, which requires three private keys to complete the trade. The three parties agree to share a single multi-sig address in order to allow funds to transfer only when two of the three parties provide authorization.
For instance, say that Person A purchases a product from Person B. Person A then sends cryptocurrency to a multi-signature address that has three private keys: one for Person A, one for Person B, and one for a third party, Person C. When the payment to the multi-sig address is confirmed, Person B sends the product to Person A, who then responds after receiving the product without any defects. When Person B performs “2 of 3,” Person C responds to Person A’s response. The cryptocurrency stored at the multi-sig address is then released, and the trade is completed. However, if Person A does not receive the product—or if the product is defective—they contact Person C to decide the matter. If, after judging the dispute from an impartial position, Person C accepts Person A’s claims, they use their private key and Person A’s private key to refund the cryptocurrency to Person A.
The Advantages of Multi-Signature Arrangements over Single-Signature Arrangements
Multi-signature arrangements offer a number of benefits.
- Enhanced Security
A single-signature transaction involves only one private key, which is managed by a single device and password. A security breach could occur, for example, if the password is hacked or the device is infected with a virus.
However, a multi-signature transaction involves at least two keys, which helps boost security. This arrangement ensures that the keys needed for a multi-signature cryptocurrency address are created and stored across various devices. A “2-of-3” wallet can store private keys on different devices, including PCs, desktops, and smartphones. Then, parties can use any two of these keys to transfer the money in a given transaction.
This approach helps eliminate single points of failure in cases where a buyer’s device is hacked. Instead, buyers can generate one key on their computer and another key on their mobile phone. When more than two keys are required to complete a transaction, buyers will be unlikely to lose their cryptocurrency because one compromised key cannot result in theft.
- Preventing Embezzlement
Another benefit of the multi-sig arrangement is that it helps to mitigate embezzlement risk for organizations. This advantage especially applies when a Multisig Escrow arrangement is implemented.
- Providing a Backup
Additionally, a multi-signature arrangement can be used as a backup, providing a risk hedge for the loss of a private key by allowing for the storage of multiple keys in different locations as part of an M-of-N wallet. For instance, if one key is lost in a “2-of-3” wallet, the other two keys can be used to retrieve a transaction’s funds. Generally, this redundancy backup of a wallet is the difference of N minus M.
- Dividing Bitcoin Possession
In multi-signature arrangements, the responsibility for Bitcoin possession is divided among many parties. This arrangement requires that different persons must provide consent to allow funds to be spent. Thus, possession is not limited to just one individual.
Multi-Signature Cryptocurrency Wallets
Some popular multi-signature cryptocurrency wallets available on the market are Copay, BitGo, and Nanowallet. For added security, a holder can also set spending rules with the wallet provider to ensure extra protection against any dubious activities. The Copay offline HD wallet also allows users to store their cryptocurrency in an offline wallet on their PC.
The most common multi-sig wallet arrangement is the 2-of-3 wallet. This arrangement is useful and effective because the holder holds two keys, including the backup key, while the provider holds only one key. Hence, the holder has total control over their funds, and the provider can’t spend the holder’s funds without their two keys.
Nonetheless, despite the 2-of-3 option’s popularity, 2-of-2 is another common wallet arrangement. In this setup, the holder has one key and the wallet provider has one key. This case involves no backup key, and both parties are required to sign any transaction.
Multi-signature arrangements are much like contractual agreements and financial transactions that require more than one signature in order to execute a transaction. These arrangements can help reduce hacking risks and other fraudulent activities in electronic transactions using Bitcoin and other cryptocurrencies. Indeed, multi-sig arrangements generally enhance security for cryptocurrency exchanges.
Freeman Law represents Blockchain and Cryptocurrency Tax clients. Schedule a consultation or call (214) 984-3410 to discuss your Virtual Currency concerns.
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