What Do Bitcoin and Mutually Assured Destruction Have to Do With Each Other?

A fascinating concept has been created by software developer Seong Yup Yoo. Yoo has created a website that allows people to exchange fiat money for Bitcoins directly with each other without having to use a third party exchange. He has accomplished this task by incorporating the concepts of mutually assured destruction and the Nash equilibrium.

The problem facing two people in a direct exchange is that no one wants to send their money first. Let's go through a simple scenario. Let's suppose there is a forum where people post Bitcoins for sale like Craig's List, and I am interested in buying Bitcoins from one of the users. I message a person who is selling 10 Bitcoins asking him to do a swap of my dollars for his Bitcoins. If I send him money through PayPal, how do I know he will send me the coins? If he sends me the coins, how does he know I will wire him the fiat money on PayPal? Clearly this ends in a stalemate with neither person willing to risk sending the money first.

The site NashX attempts to address this problem by having people risk Bitcoins for destruction before initiating a trade. Here's an example of how it works. Both the buyer and the seller create accounts on NashX. Both the buyer and the seller load Bitcoins into their NashX accounts. When a seller wishes to sell his Bitcoins for cash, he will put up an offer that looks something like this:

"I will risk 20 Bitcoins in order to sell 10 Bitcoins for $1000 USD."

The buyer will then respond by accepting this deal, and putting up 20 Bitcoins of his own.  So both the buyer and the seller now have 20 Bitcoins at stake in this deal. The buyer then messages the seller to get his PayPal information and sends him the money on PayPal. If the seller fails to send the buyer his 10 Bitcoins, the buyer can destroy the deal, sending all 40 of the "at risk" coins into a "blackhole" address where no one will ever have access to those coins.

By doubling the amount being offered for sale and putting that amount up as "at risk funds" the exchange stays within the Nash equilibrium. By pairing this concept with mutually assured destruction, trades can be made with a high level of confidence that each player will hold up his end of the bargain.

If one party only has a small amount of Bitcoins to work with, but wants to buy or sell a lot more, the solution is to simply do several smaller transactions. So my 10 Bitcoin example might take place with ten 1 Bitcoin transactions using a 2 Bitcoin risk fund for each trade. Since each party already has each other's details, these exchanges can take place in a fairly rapid succession.

While the site is still in beta, I can already tell that the concept has a tremendous amount of promise. I expect to see similar sites like this one popping up all over the internet. Sites like this will allow for virtually unlimited currency trading that occurs outside the scope of the heavily regulated and monitored banking industry. NashX's trading structure allows for anonymous trades, if users wish to go that route. People could even send cash by snail mail if they wanted to.

I encourage Yoo to open-source his code, which would allow people to rapidly build upon the concept, along with making it easier for people to set up similar sites on the Tor network. Open-sourcing his code would also garner more trust for his site from the general Bitcoin community.

Given that NashX is not tied to any financial institution, a similar site could easily be setup on the Tor network. If such a site existed on the Tor network, not only could users be assured of their anonymity, it would also completely prevent any state actors from attempting to shutdown the site by legislation. The Tor network is an encrypted anonymous web network that hosts sites like the Silk Road.

The only downside to this process is that each player must already have Bitcoins before either can initiate a trade. However, Yoo stated he is addressing this problem by "NashX taking Cash-At-Bank and sending BTC/LTC directly to their risk fund at BTC-E exchange rates." So basically, you can wire him money and he will load your account.  While this requires trusting Yoo, at least you know who he is and where his business is located, which would allow you to file a lawsuit against him if he fails to deliver.