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What is Multi-signature?

Multi-signature is a simple concept and a powerful technology to have a secure bitcoin transaction. It is not hard to imagine that it is more secure to require more than one person to open the vault because no individual can gain access to it alone. Multi-signature does just that.

In a nutshell, it is a security protocol that limits the action taken only when more than one device signs a transaction and thus prevents one device from having monopolistic control. This is part of the Bitcoin core.

It used to be that, there was only one private key to release the fund. Since the private key was tied to only one device, you could lose your money if the device was hacked or infected. This is called a single point of failure.

Multi-signature has different models, which are often referred to as M-of-N transactions. These could be 1-of-2, 2-of-2, 2-of-3, 3-of-5, and such. It is more secure simply because hackers have to attack several devices or servers. Typically, a multi-signature system takes the 2-of-3 model, which means there are 3 private keys and the fund is released only when two keys are signed up.

2-of-3 Multi-signature Escrow

The best use case of a multi-sig system is an escrow. By definition, an escrow system arranges a trusted third party in between the seller and the buyer who holds and regulates payment of the funds.

Formerly, the escrow system ALWAYS had someone in the middle to make a transaction between the seller and the buyer. This obviously is expensive and does slow the process down.

The beauty of 2-of-3 multi-sig escrow is that there is NOT always someone in the middle. First, the use of multi-sig is voluntary. The user can choose not to use it in case they send money to their friends, a large reputable vendor, charity, and such. Second, even if they choose to use it, the third party comes in only when there is a dispute between seller and buyer. This makes the whole transaction cheaper and faster for escrow users.

So what happens when there is a dispute? Typically, there is a seller, a buyer and a moderator, and each of them has one key. Thus, no one has the power to release the funds on their own.

Let’s look at the case where a buyer forgets to release the funds to the seller. When a buyer purchases an item, she doesn’t want to directly send money to a seller because she is not sure if the item is legitimate or not. Likewise, the seller does not want to send his item without making sure that he can get paid. So she deposits money to a bitcoin address[1]. Once he confirms it, he sends an item to her. He signs up for multi-sig so that he can get paid once she signs up. She gets an item she wanted to have. But what if she forgot to sign up? Can the seller do anything about this? He can send her a message, but he cannot take any direct action to get paid. This is where a moderator comes along. The moderator sees the situation and signs up if he is sure that the funds should be released.

In essence, multi-sig escrow allows users to make a cheap, fast, and secure bitcoin transaction with control in the user’s hands.

Notes

[1] Multi-signature addresses start with a 3, instead of a 1.