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@ Truth Serum
2024-09-25 05:58:25Abstract
This paper proposes a comprehensive system design for a decentralized prediction market and a game-theoretic stablecoin built entirely on Bitcoin's Lightning Network. Leveraging Discreet Log Contracts (DLCs) and off-chain transactions, the system enables leveraged trading, liquidity provision, and stablecoin creation without relying on alternative cryptocurrencies or tokens. We address potential flaws and criticisms, demonstrating that Bitcoin alone provides a secure, scalable, and efficient platform for advanced financial applications.
truthserum@iris.to
Introduction
Motivation
Bitcoin, as the original and most secure cryptocurrency, offers a stable and decentralized platform for financial innovation. While alternative platforms like Ethereum have introduced smart contracts and decentralized finance (DeFi) applications, they often suffer from network congestion, high fees, and centralization risks. This paper aims to demonstrate that Bitcoin's Lightning Network can support complex financial instruments, including a decentralized prediction market and a game-theoretic stablecoin, without the need for alternative cryptocurrencies.
Overview
We propose a system that:
- Utilizes Bitcoin's Lightning Network for scalability and low fees.
- Employs Discreet Log Contracts (DLCs) for secure, private smart contracts.
- Creates a decentralized prediction market with leveraged trading.
- Introduces a synthetic stablecoin based on the net positions of long and short traders.
- Addresses potential flaws and criticisms, ensuring robustness and security.
Background
Bitcoin and the Lightning Network
Bitcoin is a decentralized digital currency that operates on a peer-to-peer network, using proof-of-work consensus for security. The Lightning Network is a layer-two protocol that enables fast, off-chain transactions between participants, enhancing Bitcoin's scalability.
Discreet Log Contracts (DLCs)
DLCs are a type of smart contract that allows two parties to make a conditional payment based on the outcome of a future event, with privacy and security ensured by cryptographic techniques.
Prediction Markets and Stablecoins
Prediction markets allow participants to speculate on the outcome of future events, while stablecoins are cryptocurrencies designed to maintain a stable value relative to a target asset or basket of assets.
System Design
Key Components
- Liquidity Providers (LPs): Users who provide Bitcoin as collateral to the liquidity pool.
- Traders: Users who take leveraged long or short positions on asset prices.
- Oracles: Entities that provide reliable price feeds for asset settlement.
- Stablecoin: A synthetic stablecoin derived from the net positions of traders, backed by Bitcoin collateral.
Core Features
- Decentralized Prediction Market: Facilitates leveraged trading on asset prices.
- Game-Theoretic Stablecoin: Maintains stability through the balance of longs and shorts.
- Yield Generation: LPs earn yields from trading fees, funding rates, and liquidation penalties.
- Bitcoin-Only: Built entirely on Bitcoin's network without alternative tokens.
Technical Implementation
Leveraged Trading via Discreet Log Contracts
Contract Setup
Two parties, a trader and an LP, agree on contract terms:
- Asset: Bitcoin/USD price.
- Leverage: Multiplier on the trader's collateral.
- Collateral: Bitcoin amount provided by the trader.
- Duration: Contract length.
- Oracle: Selected to provide the settlement price.
Funding the Contract
- Trader: Locks collateral C_T in a multi-signature address.
- LP: Locks collateral C_LP to cover potential payouts.
Execution and Settlement
- At maturity, the oracle provides a signature of the final price P_f.
- The DLC allows funds to be distributed based on P_f and the contract terms.
Synthetic Stablecoin Creation
Mechanism
- Stablecoins are minted when traders open positions.
- Backed by Bitcoin collateral from LPs and traders.
- Stability maintained through balanced market positions and funding rates.
Funding Rates and Market Balance
Purpose
To incentivize traders to balance long and short positions, maintaining system stability.
Implementation
- Funding Rate: Funding Rate = k * (Net Position / Total Open Interest)
- Payments: Traders on the dominant side pay funding fees to the opposite side.
Risk Management and Liquidations
- Margin Requirements: Minimum collateral ratios for traders.
- Liquidation Thresholds: Positions are liquidated if collateral falls below maintenance margin.
- Automatic Liquidations: Enforced by smart contracts without human intervention.
Mathematical Foundations
Payout Calculation
Position Size
Position Size = C_T * L
Profit/Loss (P/L)
P/L = Position Size * ((P_f - P_0) / P_0)
Return on Investment (ROI)
ROI = (P/L / C_T) * 100%
Liquidation Price Calculation
For a long position:
P_liquidation = P_0 - ((C_T / Position Size) * P_0)
Game Theory and Incentive Alignment
Traders
- Incentive: Profit from accurate market predictions.
- Behavior: Manage risk to avoid liquidation.
Liquidity Providers
- Incentive: Earn yields from fees and funding rates.
- Risk: Exposure to traders' net P/L.
Oracles
- Incentive: Earn fees for accurate data provision.
- Behavior: Maintain reliability to secure future earnings.
Potential Flaws and Criticisms Addressed
Oracle Trustworthiness
Criticism
Relying on oracles introduces a single point of failure and potential for data manipulation.
Solution
- Decentralized Oracles: Use multiple oracles and aggregate data.
- Threshold Signatures: Require consensus among oracles.
- Incentive Alignment: Oracles are incentivized to provide accurate data through fees and reputation.
Liquidity Risks
Criticism
Insufficient liquidity may prevent covering traders' profits, especially during high volatility.
Solution
- Dynamic Leverage Limits: Adjust leverage based on liquidity.
- Risk Management Protocols: Implement strict margin requirements.
- Incentivizing LPs: Offer competitive yields to attract liquidity.
Price Volatility and Market Manipulation
Criticism
Extreme market movements could lead to rapid liquidations and instability.
Solution
- Anti-Manipulation Measures: Use time-weighted average prices (TWAP).
- Circuit Breakers: Temporarily halt trading during extreme volatility.
- Robust Liquidation Mechanisms: Ensure smooth liquidations without market disruption.
Technical Complexity
Criticism
Implementing DLCs and managing Lightning Network channels require advanced expertise.
Solution
- User-Friendly Interfaces: Develop intuitive platforms.
- Educational Resources: Provide guides and support.
- Community Development: Encourage collaboration and open-source contributions.
Regulatory Compliance
Criticism
Operating a leveraged trading platform may raise regulatory concerns.
Solution
- Decentralization: Structure the platform to minimize central control.
- Legal Consultation: Engage experts to navigate regulations.
- KYC/AML Policies: Implement where necessary without compromising privacy.
Network Limitations
Criticism
The Lightning Network may face limitations in liquidity and channel capacity.
Solution
- Channel Management Strategies: Utilize multi-path payments and channel factories.
- Liquidity Hubs: Establish well-funded nodes.
- Ongoing Development: Contribute to scalability improvements.
Conclusion
By leveraging Bitcoin's Lightning Network and Discreet Log Contracts, we can build a decentralized prediction market and a game-theoretic stablecoin without relying on alternative cryptocurrencies. This system addresses potential flaws and demonstrates that Bitcoin alone provides a secure, scalable, and efficient platform for advanced financial applications.
Future Work
- Prototype Development: Create a working model of the proposed system.
- Security Audits: Conduct thorough assessments to ensure robustness.
- Community Engagement: Involve developers and users in refining the system.
- Regulatory Navigation: Work with legal experts to ensure compliance.
Acknowledgments
We thank the Bitcoin and Lightning Network communities for their ongoing contributions to decentralized finance and open-source development.
References
- Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, 2008.
- Joseph Poon and Thaddeus Dryja, The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments, 2016.
- Tadge Dryja, Discreet Log Contracts, 2017.
- GMX, Decentralized Perpetual Exchange, https://gmx.io/, Accessed 2023.
- BIP 0341, Taproot: SegWit Version 1 Spending Rules, 2020.
- Rusty Russell, Generic Smart Contracts Over Lightning, 2019.