The principles of Bitcoin transaction clearing and settlement
A good way to understand the dynamics of Bitcoin’s protocol layers and the participants utilizing them is in terms of transaction clearing and settlement. These concepts are intertwined: clearing encompasses the procedures by which a transaction reaches settlement, while settlement itself is the decisive end-goal of a trade wherein the buyer is now in possession of their purchase, and the seller is in possession of the financial instrument with which they agreed to be paid. These terms are most commonly applied to trading in securities markets, but they are more general than that—for example, bank transactions have their own processes of clearing and settlement, as do real estate purchases or even day-to-day cash transactions.
As always, drawing parallels between the Bitcoin communication protocol and traditional financial concepts is an imperfect but illustrative analogy. For Bitcoin, what is being considered in this model is the process by which the respective parties to a transaction end up in possession of private keys exerting control over the scarce UTXO information space that is being transacted. We regularly contest that, despite regulatory guidance, Bitcoin is neither a security, nor is it a commodity. But considering Bitcoin’s oft-touted parallels to the concept of a bearer instrument, and the wide variety of companies offering services to interact with it, the concepts of clearing and settlement can be helpful.
A distributed global settlement protocol
At the protocol level, the reason why there is a tendency to define Bitcoin as a bearer instrument is that there is no inherent difference between possession, control and ownership. Consider a gold coin being used in trade under a free market monetary regime. When possession of that coin is handed over in the course of trade, clearing and settlement happen instantaneously with these duties effectively decentralized among market participants. Similarly, as far as the Bitcoin protocol is concerned, the only thing that matters is whether a participant is in possession of a private key that exercises control over UTXOs for transferring value.
This might seem like a small detail, but it is a fundamental difference between Bitcoin and traditional financial instruments such as securities. When dealing with traditional financial instruments, the asset itself relies on a foundation of contracts and other legal structures to stake a legal claim. As such, legal recognition of “ownership” is part of the same legal protocol stack that also supports its transfer, possession and legal rights.
By contrast, while the concepts of possession and control in Bitcoin are governed by the protocol itself, “ownership” is a somewhat abstract idea that, from the perspective of the protocol, is emergent from the properties of possession and control. This has interesting implications for assessing the various tools that interact with the network protocol, and we will come back to the concept of ownership later as it is more directly relevant when we deal with Bitcoin through off-chain structures.
The simplest way to observe settlement and clearing in Bitcoin is at the base layer protocol and communication network. Bitcoin can be seen as an open global settlement network, but transactions must first be cleared by the protocol’s native clearing houses: the mempools. A Bitcoin transaction might be said to be executed when it is broadcast to the network. From here, the distributed nodes all check whether the signature is valid, verifying that the private key did indeed have control over the UTXO it seeks to consume. If so, the transaction is cleared into the node’s mempool where it awaits settlement by inclusion in a block by mining nodes.
Thanks to the settlement assurances provided by proof-of-work, when a cleared transaction is then included in a block by a mining node, it can be considered to have attained some degree of final settlement. The participant in possession of the sending private key no longer controls the UTXO they consumed in the transaction. Likewise, the recipient has some assurance that the new UTXO, controlled by a private key in their possession, will remain that way until they, in turn, choose to consume it. At this point it is very difficult, unlikely and expensive to violate the assurances of this settlement. However, best practice dictates that participants wait for a few more blocks to be mined on top of it, as the energy and other investment that needs to be expended to attack the transaction accumulates beyond any reasonable expectation.
So, what to make of second layer protocols in Bitcoin, such as Lightning? It is tempting to claim that they have their own clearing and settlement assurances that are simply less resolute than the base chain.
For Lightning, the clearing and settlement logic would be something like this:
Lightning channels are created by placing funds into a special two-party multisig address on Bitcoin’s base layer. From here, a transaction can be executed when it is broadcast through the Lightning network and finds a path to its destination. Clearing involves each participant to the transaction checking their channel balances and preparing an updated HTLC (a special type of Bitcoin transaction that allows for Lightning channels). Settlement might be argued to have taken place when all is said and done, and each participant holds the latest version of the HTLC. At this point, certain assurances are offered that this final state can be broadcast unilaterally to the base-layer network at any time and is difficult to cheat.
It is important, however, to be dogmatic about the settlement assurances of the base chain. Ultimately, it is agnostic to any ownership claims one might expect to have on any underlying UTXOs. When using second layers, the base layer Bitcoin network never validates or clears transactions: strictly speaking, UTXOs are under no circumstances consumed from the control of one private key to another until an updated state is broadcast, or executed, to the network. Therefore, Bitcoin transactions should never be considered to have settled until an on-chain transaction takes place.
But while it’s important to adhere to the protocol-enforced nature of Bitcoin settlement, it’s helpful to make allowances for the idea of a second layer of execution and clearing. The entire structure of the Lightning network can be taken together as a huge execution venue and pre-clearing system that does indeed validate real Bitcoin transactions, clearing them in batches to reduce the bandwidth burden on the final settlement network. These transactions are anchored in fully settled Bitcoin scripts and update the state of real UTXOs that exist in real time in the base-layer UTXO set. From a broad protocol perspective, Bitcoin simply has multiple layers of clearing capabilities.
When the legal and network protocols collide
Things get complicated when transactions move from the protocol realm to the messy world of human organizations, legal jurisdictions, and regulators. While the base layer Bitcoin protocol has its own clearing and settlement functions as we have explored above, so do early Bitcoin financial services. And because we’re getting into the realm of the contemporary legal paradigm, suddenly that third abstract component—ownership—is at center stage. Like it or not, there is a significant demand for dealing with Bitcoin by more traditional means that exist away from the protocol: bridging this gap might be a necessity, and it’s certainly a huge opportunity.
The most maligned participants in the eyes of many Bitcoiners are the early Bitcoin trading venues, which in their business logic have acted as execution venues, clearing houses, and private key custodians—meaning UTXOs held on exchange are under their exclusive possession and control as far as the protocol is concerned. Transaction and trade settlement strictly never actually occurs until the customer initiates a withdrawal, and it is unfair to even compare this structure to second layer networks like Lightning that do offer some protocol-level assurances.
As we outlined above, the protocol can’t and doesn’t care what relationship exists between trading venues and their clients; they might as well have full ownership rights. Legal jurisdiction hasn’t helped much, either: depending on emerging case law, clients have often had to fight against the idea that they are engaged in a debtor-creditor relationship. But if someone in Malta compromises a trading venue's infrastructure in Canada to wire themselves some BTC, final settlement on the Bitcoin network means the victim can’t call up SWIFT to have it reverted.
These ownership rights in the non-digital legal paradigm create a significant challenge for businesses engaged at this level, and the need to separate roles among specialized participants as in legacy markets is being rediscovered, with a Bitcoin twist.
Central to this specialization is the demand for third party private key custodians. Key custodians play a critical role in providing security services that transfer the risk of lost UTXOs off an exchange’s books, but this is not their only role.
Private key custodians are also the party best placed to bridge the gap between the protocol clearing and settlement systems, and those of the legal paradigm. They are responsible for managing and protecting access to the chain state, helping to port the Bitcoin protocol’s assurances over to the legal paradigm. Ideally, transactions can actually settle on-chain to addresses controlled by keys in the custodian’s possession that are legally owned by their customer in a bailment relationship.
In a Bitcoin key vaulting business, the exercise of possession, control and ownership is critical. The vault should have possession of the key, while the customer has legal assurances of ownership and technical assurances of control to consume UTXOs to a private key in their own hands. Critically, the vault intermediates clearing and settlement responsibilities in both realms. In the financialized world of Bitcoin trading venues, the vault may enforce legal requirements such as placing holds on sums held if required, but it also implements the actions necessary to ensure that the eventual on-chain settlement of transactions actually takes place.
This is in stark contrast with existing custodians and exchanges that hold a pool of funds, owing proportions to their various clients and updating an internal ledger to reflect the transfer of these claims. In that scenario, the trading venue becomes an accidental custodian in a structure that both neglects any of the assurances provided by Bitcoin and while also creating a high-risk relationship with their clients.
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