ARC Concepts

Managing Counterparty Risk in a 24/7 Bitcoin Environment

Risk Mitigation

There are many challenges in managing risk in dynamic markets, like Bitcoin. The ARC platform is designed to mitigate that risk by using the latest technologies around Bitcoin, like the Lightning Network, to automatically reconcile the collateral assets within a contract in real-time as the market conditions change.

ARC reduces risk by addressing some of the inherent risks associated with leveraging Bitcoin as a collateral asset.

Market Volatility

Rapid and unpredictable price movements in dynamic assets like Bitcoin demand constant vigilance and swift, proactive measures to mitigate risk.

Inefficient Settlement

Ensuring the accuracy of data feeds and avoiding discrepancies in fast markets is challenging, especially when current settlement processes are batched and often manual.

Capital Utilization

24/7 market dynamics can make it difficult to allocate capital with precision, increasing jump risk and leading to over-collateralization and unfavorable terms.

Why use Bitcoin as a Collateral Asset?

In recent years, Bitcoin has emerged as a revolutionary digital asset that has captured the attention of investors, traders, and financial institutions worldwide. Beyond its role as a decentralized digital currency, Bitcoin's unique properties make it an ideal collateral for various financial instruments, particularly in the OTC derivatives and loans market.

To learn more about why Bitcoin is the ideal collateral asset, see our blog post Bitcoin: The Perfect Collateral Asset.

What is the Lightning Network?

The Lightning Network is a decentralized system for instant, high-volume micropayments that removes the risk of delegating custody of funds to trusted third parties.

Bitcoin, the world's most widely used and valuable digital currency, allows anyone to send value without a trusted intermediary or depository. Bitcoin contains an advanced scripting system allowing users to program instructions for funds. There are, however, some drawbacks to bitcoin's decentralized design. Transactions confirmed on the bitcoin blockchain take up to one hour before they are irrevesible. Micropayments, or payments less than a few cents, are inconsistently confirmed, and fees render such transactions unviable on the network today.

The Lightning Network solves these problems. It is one of the first implementations of a multi-party Smart Contract (programmable money) using bitcoin's built-in scripting. The Lightning Network is leading technological development in multiparty financial computations with bitcoin.

Source: https://lightning.network/

Why Leverage the Lightning Network Protocol?

There are several reasons we chose to leverage the Lightning Network Protocol, not the Lightning Network.

1. It's fast - Bitcoin block times average around every 10 minutes. The Lightning Network can move Bitcoin at breakneck speeds. As a peer-to-peer network, transactions are handled instantaneously, off-chain in a secure channel between two peer nodes acting as the counteparties to a contract.

2. It's secure -

3. it's Bitcoin -

How Does ARC Work?

Counterparty creation

Each counterparty has an ARC account. Part of the ARC account is a Lightning Network Remote Signer node which is used to sign all of the collateral movement transactions. The access to this is secured through a password that each counterparty sets when they create their ARC account. The Remote Signer is used across all of a counterparty's contracts.

Contract creation

A counterparty will create a contract. A Loan Contract can be requested by either borrower or lender. When the contract is created, all of the initial terms and conditions are set. Each counterparty can modify the contract terms and conditions until one of the counterparties approves the contract. Once a counterparty has approved, the contract can only be approved by the other counterparty or either counterparty can cancel the contract.

Contract approval and contract funding

When a contract is approved by both counterparties, a secure contract execution environment is created and a Bitcoin wallet address is created for the borrower to fund the contract upon receipt of the fiat currency being loaned to them. The Borrower is required to deposit the amount of Bitcoin specified by the terms of the contract.

When the initial Bitcoin collateral deposit is confirmed, the contract execution beings. ARC monitors the current price of Bitcoin vs the Fiat Currency (currently only USD). Part of the contract execution environment are peered Lightning Network nodes that maintain a set of channels between them to hold the collateral assets for the contract in a secure channel. The channel acts as a sort of dynamic escrow account. It also operates sort of like an Abacus, sliding funds back and forth as the value of the collateral asset changes.

What happens if the value of Bitcoin drops?

When the value of Bitcoin drops enough that the collateral value dips below the maintenance margin set in the terms of the contract, the borrower is required to add collateral. The terms also state how much time to give the borrower to deposit the additional Bitcoin. This is called the Grace Period and can be 1 to many Bitcoin blocks. Bitcoin block time is roughly every 10 minutes.

What happens if the value of Bitcoin really drops?

In severe market volatility, if the value of Bitcoin were to drop significantly, pushing the value of the collateral below the close out margins / loan-to-value set by the lender at the contract creation and approval, the contract would immediately terminate. Upon termination, the contract goes into settlement. The amount of collateral sitting on the lender's side would be distributed to the lender's withdrawal address and the amount wiht the borrower would be distributed to the borrower.

What happens if the value of Bitcoin rises?

When the value of Bitcoin rises, ARC ensures that the borrower only maintains enough collateral to satisfy the margins / loan-to-value (LTV) set by the lender at the contract creation and approval. Any excess collateral is moved to the borrower's side of the channel ensuring that the borrower is not over-collateralized while keeping the lender fully collateralized.