On March 9, Abra founder and CEO Bill Barhydt gave a presentation during the 2019 MIT Bitcoin Expo. Barhydt used the presentation to give a brief but technical talk about how Abra works. Specifically, he explained the concept of crypto-collateralized contracts and Abra’s synthetic asset model.
The following transcript has been slightly edited for clarity. The transcript starts after the one-minute mark because there is a brief issue with the presentation slides at the very beginning.
01:11 All right. Since I get extra time, I will give you a business overview of Abra, then. This is free time. For those of you who don’t know, my company, Abra, is a crypto wallet platform that allows you to get price exposure as an investor to — in theory, almost any asset in the world. We started out with fiat currencies, and a large number of cryptocurrencies, and recently we’ve announced that we’ve created a synthetic version of the entire Nasdaq, which we’re going to be launching outside of the US in a few weeks, and then hopefully inside the US later this year.
And basically the product works as one big HD wallet, for the tech initiated among us, and uses Bitcoin-based multi-sig, effectively smart contracts, but P2SH smart contracts to give people synthetic price exposure to any asset. The purpose of this talk is to explain to you how that actually works, both from the consumer-facing perspective, as well as the internal-facing perspective, in terms of how we eliminate the consumer’s counterparty risk to Abra.
02:29 Inside of Abra we effectively run two different businesses. One is the technology shop, which implements all of the wallet scripting, and everything related to what’s happening on-chain. Everything that happens in the Abra wallet is 100% on-chain. It’s a noncustodial HD wallet that makes this extremely complex, because, in other words, the consumer is holding their own collateral to these contracts. There’s no chance to get this wrong. It has to work. The other part of the operation is the financial engineering part of the operation where we’re actually trading in real time to eliminate the consumer’s counterparty risk on the contracts.
03:37 This is meant to be a handout. Sorry for the oodles of text, but again the purpose of the app for Abra is facilitating global financial inclusion. Giving people who are in hard-to-reach or economies that normally wouldn’t have access to certain financial services, whether it’s investing, payments and money transfer, remittances, eventually peer-to-peer credit, to give them that access using a model that works outside of the traditional banking system in a way that’s legal. We wanted to create a 100% unhackable solution at the same time. As you can imagine, if we’re gonna be holding contracts worth billions of dollars — and I say holding in a logical sense, since we’re actually not holding consumer funds — it’s really important that somebody can’t just come in and hack the entire pool of money in the system, and so the idea is to create this synthetic asset model that effectively uses bitcoin to give consumers price exposure to any liquid asset. We call them crypto-collateralized contracts, or C3. It’s 100% bitcoin-based today. We do have the ability to do this with other crypto assets, particularly forks of bitcoin, as well as ether. We’ve launched a native ether wallet inside the app.
05:04 But the app basically has 26 synthetic cryptocurrencies, so we actually, as pretty much a large global test, created 26 synthetic altcoins using bitcoin, so if you’re holding Zcash and Abra, you’re actually getting synthetic exposure to Zcash via bitcoin, and we’ve processed almost a billion dollars in transaction volume over the last 14 or so months, between the fiat positions — there are 50 synthetic fiat currencies and 26 synthetic cryptocurrencies in the system — that has processed almost a billion dollars already, and the way this works is what you’re holding — and I’ll just skip to the next slide to show you this — what you’re holding is one big HD wallet. Whether it’s the bitcoin, or the synthetic assets, and separately to that, of course, the ether-like coin and BCH, which are also native within the HD wallet. But everything that you see that looks like a traditional asset here — dollars, or other cryptos beyond the ones I mentioned — is synthetic, meaning it’s bitcoin tied to a contract, and I’m gonna show you how that works. The user can deposit Bitcoin directly to collateralize the contract. They have to collateralize the contract somehow. In English, if you’re buying a thousand dollars price exposure to Apple the thousand dollars’ worth of bitcoin has to come from somewhere, and that’s the consumer’s responsibility.
06:31 They can either do that via the banking system— and if they do it via the banking system what they’re actually doing is buying bitcoin from one of our exchange partners — to collateralize the contract. Or if they actually own bitcoin and they can actually deposit the bitcoin directly, and because our app is global, and we don’t have the banking integration done everywhere yet — we’re working on that — about 60% of the deposits are bitcoin-based, and 40% are fiat, and the 40% that are fiat are mostly the U.S. and Europe, where we have exchange partners live and fully integrated, where you can take your fiat, deposit it at our exchange partner, and unbeknownst to you, it just shows up as collateral in the app. They don’t actually know the process for the collateralization, to them, it looks like the way you use Venmo.
07:12 That’s the first part of understanding Abra. That, at its core, it’s one big bitcoin wallet. The second part of understanding Abra is understanding how the smart contract technology works.
07:24 Today, Abra is basically using a multi-sig P2SH model, where the consumer is collateralizing one side and signing one side, and Abra is signing the other side. Soon we’ll be migrating this from two-of-two to two-of-three. Today I’m just focusing on what we’ve got, not where we’re going. I’ve actually got other slides on where we’re going, but that’s normally an hour and a half. I only have 25 minutes.
07:47 All contracts within Abra settle on the bitcoin blockchain, with actual delivery, at the latest, every 25 days. In English, the contracts roll over every 25 days. We do this for legal reasons in the related to commodity swap transactions, which I won’t bore you with, and a smart contract basically includes a normal UTXO, plus some extra information, because we have to know the price at entry time in order to determine who’s in the money at rollover or exit time.
08:23 The addressing is just a normal bitcoin payment address. There’s nothing special about that. We use bitcoin the way it was meant to be used. There’s nothing extra. There’s no extra off-chain or side-chain technology here, it is 100% on-chain settled.
08:41 We also have this ability to do smart contract hedge amendments, and what this means is that if you’re using a bitcoin wallet to get price exposure to Zcash, Monero, the US dollar, and Apple at the same time — by the way, these transactions are very, very large, so our mining fees tend to be much larger because of the nature of multi-sig transactions versus others. There are days when Abra has done significantly over one percent of on-chain transactions. That’s not a goal, by the way, we simply have no choice. The transactions have to be on-chain, and they’re larger than other transactions, so we end up with a disproportionate amount of on-chain transactions, as opposed to Coinbase, where 99.99% of their transactions are off-chain — this contract amendment concept actually allows us to simplify or improve upon the amount of data we’re using, how often we have to write to the chain, et cetera, et cetera, by basically making amendments to the existing contracts, and we can basically chain these as long as there’s enough value in the unspent output of what we’re using. Again, this is something that I could easily spend a half hour on because it’s super interesting, but in the interest of time, I want to introduce the topic to you.
09:56 This is the overall architecture of what our smart contract system looks like. It’s going to change soon when we roll out the third party oracle function. Today, it’s kind of — how would I best describe it? — mutually assured non-destruction, because it’s a two-of-two system, meaning that the consumer can’t screw Abra and Abra can’t screw the consumer, but the consumer has to write down the backup phrase to use the app because if they don’t do it we don’t let them. But if they do lose the app and the backup phrase, then Abra’s in the money on the contracts, then we obviously have a problem. To address we’re rolling out a contract oracle function later this year.
It’ll be an M-of-N oracle function, which means eventually it won’t just be in one geography, it’ll be in multiple geographies, which makes it even harder to shut down. It’ll use things like Shamir’s Secret Sharing to even further distribute the private key of the oracle. That protects both the consumer if Abra goes away, and it protects Abra if the consumer loses their key.
11:09 If you’ve studied smart contracts at all, this probably looks familiar to you. The difference is, what Abra’s doing today to create the synthetic currencies is very, very simple. It doesn’t require more than what bitcoin script does. Which is fantastic. That’s part of what makes Abra so secure, the contracts are very simple.
11:28 What’s really complex for the uninitiated, is when you enter into this contract with Abra, effectively what you’ve done, if you’re getting price exposure to Apple, is you’ve taken bitcoin and you’ve effectively shorted the bitcoin versus Apple as a consumer. To you it just looks like you’ve put collateral in the contract equal to Apple, but if the price of Apple goes up versus bitcoin, you’re expecting more bitcoin at the end of the contract, and vice versa. If Apple goes down versus bitcoin, you’re gonna actually lose bitcoin.
11:58 Abra is the counterparty to those contracts. Which means, from the consumer’s perspective, the consumer has counterparty risk versus Abra. That’s unacceptable, because we’re not marketing this as some sort of sophisticated derivative system, we’re marketing this as a consumer-facing retail investment platform. The consumer should not be in a position to have to understand anything about counter-party risk of the mechanics of hedging or any of that. The way we deal with that is that we basically create, not only the smart contract, but we create a real-time hedging system that completes eliminates that counterparty risk, with one exception. The system depends upon the price of bitcoin being above zero. It doesn’t deal with systemic risk. If you have a gold swap — if you’re buying gold versus dollars — and gold goes to zero and you’re settling in gold, you owe the counter-party an infinite amount of gold. It’s the same thing here. We can’t account for the systemic risk of bitcoin, but if bitcoin is worth one penny, even, this system works.
12:55 Last year, when bitcoin fell 85%, and people were holding synthetic dollars, and we were making them whole almost every day, Abra didn’t lose a penny.
13:06 Abra is taking the long side to the consumer’s short, from a financial engineering perspective, and it’s important, then — and we report this to our board, our board members are sitting here, they can vouch for this — in our board meeting every single month, we actually report the net exposure of the entire Abra network. Meaning, if you take all of the consumer’s positions, all the average hedges, and you net them up, what is not only the current mark to market, but what is the mark to market regardless of any movement, except for the catastrophic failure of bitcoin, we’ve done something really wrong, and it never has been, and it won’t be when you understand how this works.
13:49 There are three functional aspects to making sure the hedge works correctly. The first is the initial collateralization, meaning I want to deposit — in this example, I’m using Ethereum Classic. It could be Apple shares, it could be dollars, doesn’t matter, the mechanics are exactly the same — I wanna buy 1,000 ETC — I made these prices up — the spot price for BTC is $4,000, spot price for ETC is $4, effectively Alice has to get one bitcoin on her app, because that is the collateral to give her price exposure to the asset.
14:30 At the same time, there’s a hedging operation going on, where Abra is effectively borrowing one BTC from a lender. We’ve actually borrowed that long in advance of this happening, because we can’t borrow such small amounts in real time. We pay the extra interest on that, but we are actually converting in real-time the one BTC to 1,000 ETC, via Coinbase or another platform. That is Abra’s asset. That is not the consumer’s asset. The consumer is holding their own bitcoin. What I’m doing in the bottom half of the slide is simply for my balance sheet to hedge away counterparty risk on the transaction. The fact that I borrowed bitcoin and sold it for Ethereum Classic, that has nothing to do with Alice. That is on my balance sheet. But why are they willing to lend me that bitcoin in the first place? Because they see that I’m in a multi-sig contract with Alice that’s 100% collateralized. Even though not only are we one of the largest borrowers of Bitcoin in the world, we actually pay infinitely lower interest rates than pretty much everyone else, because our contracts are fully collateralized by the consumer.
15:37 That just gets the money in the system. Now we have to deal with what happens when the price goes up and the price goes down and you wanna take money out of the system.
15:44 Let’s start with the price of Ethereum Classic goes up. Now I basically started with the same collateral as before, but at the end of the transaction, somehow I have to end up with more bitcoin. In this case, if the price of bitcoin stays the same and the price of Ethereum Classic doubles. In theory, I should end up with double the amount of bitcoin. But, remember when I sold the bitcoin for Ethereum Classic on the last slide? That means when I convert it back to bitcoin, it buys double the amount of bitcoin that it used to. Turns out it buys just enough to make Alice whole, and just enough to make my lender whole. Which is the arrows you see in the slide.
16:33 By the way, it doesn’t matter whether the price doubles or triples, the math works. What happens if the price goes the other way? If the price goes the other way, meaning that the price of Ethereum Classic falls in half, Alice is now holding too much bitcoin. She will automatically, via the script, end up giving — in this instance — half the bitcoin to Abra. That’s good, because the Ethereum Classic that I’m holding is now worth half of what it used to, so I don’t have enough to pay back the lender, but it turns out the Ethereum Classic that I’m holding converted back to bitcoin, plus the Bitcoin Alice gives to me, is exactly enough to pay back the lender, and now both parties are holding it.
17:19 Sorry for doing that quickly. Took me a year to figure this out, and I was a quant at Goldman. Took me a year to figure this out. This is the mechanics of what we’ve automated, minus the borrow. The borrow we do in advance, because we’re borrowing millions of dollars, and balancing constantly, and you can’t do that in real-time. Plus, there’s too much of a risk with block cycles and whatnot. We go to our lenders well in advance, and we have a small trading desk where we work that out. Everything else that I’ve described to you is 100% automated. If you buy synthetic XRP in Abra, your counterparty risk to Abra is hedged away in less than a minute. It has to be, otherwise, it would be unethical in my opinion.
18:03 This is just the flows of what is actually happening behind the scenes. The customer, as I said, they’ve taken an initial long position, but then what they’re actually doing is they’re shorting Bitcoin versus that Ethereum Classic in order to get price exposure to Ethereum Classic, which is what you see in that second column there, and then Abra is taking the long position in Bitcoin by going short effectively Ethereum Classic. The consumer doesn’t really understand this, and that’s why it’s so important that this is delta neutral, and why it’s basically got zero exposure to the consumer. Because otherwise, I’d have to ethically sit every single consumer down and make sure they understand this.
18:51 If you look at our terms of service, it’s very clear that Abra is doing this in the system.
19:02 The final column here shows that we’ll have neutral exposure by being able to settle correctly under all circumstances. Again, with that specific example, there are different mechanics. If this is a dollar — a synthetic dollar, synthetic Ethereum Classic, synthetic Apple — the right-hand column looks slightly different. If I’m hedging that Ripple or Ethereum Classic, there’s only one way I can do it today. In traditional financial engineering, what you would want to do is you would want to buy an NDF — a non-deliverable forward — contract between Bitcoin and Ripple, like you would if you were British Petroleum reckoning in pounds, and you were doing a lot of business in dollars, you would buy NDF contracts to offset forex risk between the dollar and the pound. That doesn’t exist between Bitcoin and XRP or Bitcoin and ETC Those markets are just tiny. We create them synthetically by borrowing bitcoin and then selling it in realtime, and that interest is effectively the cost of the insurance contract, and that’s offset by a spread that the consumer pays when they enter into the contract in the first place.
20:11 That’s how it works for the synthetic cryptos. If it’s synthetic fiat, it’s actually much simpler. If I’m holding synthetic euros — we have lots of people in Europe using this, they put bitcoin in the app and they convert it to euros -— what actually happens is that Abra’s buying future contracts in Bitcoin versus the dollar, and then offsetting that in real time with the NDF of the dollar versus the euro, which obviously exists, and those markets are both highly liquid, and Abra can often make money on those features contracts because we’re the short counterparty, and that pays a premium most days, and that allows us to lower the cost dramatically for the consumer, and then on the announcement we recently made around making Nasdaq stocks available for our international users, it uses a similar model, where the consumer is effectively taking the position of bitcoin versus Apple, and then Abra will buy the dollar bitcoin future again, but that will be offset either by borrowing shares from a prime broker or doing something like future contracts on the other side. Again, highly liquid markets. We use directly integrated services, like interactive brokers and others, to make that work. Again, in real-time.
21:24 If you push buy on that share, the hedge has happened, usually in less than one to two minutes. It may take a little bit longer on the stock side, just because of the way the APIs work, but generally less than two minutes.
21:36 The entire system does a recalculation every five minutes, and we run these Google sheets with big red flashing lights, that say what the total exposure across the entire Abra system between consumers and our hedging operation is. And we have somebody who’s got it open on their screen literally every minute they’re in the office, and then they get paged via text message when they’re not in the office if something happens that shouldn’t. It’s never happened, but we assume that it would so that we are diligent and how we do this.
22:16 Normally this takes hours to explain correctly. You got the 19-minute version. I’m happy to take a few minutes of questions and then pick up the conversation. I think I saw your hand first. Hand over here, go ahead.
22:35 Question one: I’m a huge fan of Abra. I’ve preached the gospel of Abra the remittance community ad nauseam, and you’ve done a masterful job at circumventing the traditional regulatory machines with your primary business or your first business in the remittance area. I was just wondering, with your foray into the securities industry tangentially touching the securities industry, are you planning to implement the same strategy to basically avoid the legacy regulators who would probably want some sort of regulation on that?
23:18 It’s a complex topic. I actually spent the entire day at the SEC last week. I met the chairman. In terms of functionally, how this works, I think that there are ways to do this probably without actually being SEC-registered in some way. The problem is the marketing. I can’t market to consumers the issuance of some price exposure to Apple or to Nasdaq or SPDRs without SEC oversight. It’s just not possible. Because it looks like a security swap from their perspective. But it’s worse than that, because Dodd-Frank mandated rules for security swaps. It’s nine years later, the SEC chose to ignore the implementation of those rules in the legislation. I brought this up, and they assured me that they’re working on it, but I can also assure you that they don’t include crypto because the Dodd-Frank was passed when crypto was about 50 cents. That’s a big problem, not for me, for the industry. This is way bigger outside the US than it is inside the US. If I never market the ability to buy Apple via bitcoin in the US, it’ll mean nothing to Abra. But I want it to work here. If I’m doing it in 154 countries, I wanted to do it in 155.
24:36 We’re working on that part, to figure that out, but the US regulation is infinitely more complex in this regard than everyone else’s. Especially when it comes to something that looks like a security swap. The other side, which is commodities, if you noticed I talked about the 25-day delivery and that stuff. That has to do with the commodities area, which is different than the securities area, and I won’t bore folks with that, but the CFTC issued guidance on what actual delivery means if your asset settles in bitcoin, basically taking their old guidance on actual delivery for traditional assets like oil and other commodities. It’s a complex topic, but I’m not going to jail for anyone. We’re doing this right across the board. This is not just about how do you get around regulation. It’s a very complex topic.
25:30 The first thing is to make sure that the regulators understand that you’re doing right by the consumer. When they see that the consumer doesn’t have counter party risk to Abra, the nature of the conversation changes, and also because we’re not holding the collateral. Beyond that, you have to get into the very nuanced mechanics of what you’re doing.
25:51 Sorry for the long answer.
Question two: 25:53 As an organizer, I actually wanna ask a question. Sorry guys. I’m interested in the way you operate the multi-sig contract, because the way I understood it, every 25 days you basically have a transaction happen.
Barhydt: 26:11 Unless you close the position beforehand.
Question two continued: 26:12 Sure. Unless you close the position beforehand. If somebody’s holding synthetic ETC or UFC or whatever, and it’s an HD wallet, where every transaction has to be two-of-two signed, how do you carry out the transaction without necessarily the involvement of the user?
Barhydt: 26:31 They have pre-signed, in some cases, the transaction, and that will change when we go to the oracle model.
26:43 That’s only true in some cases. There are some cases where they’ve pre-signed. There’s other cases where we actually just don’t publish the UTXO until another transaction happens. But there’s nuances of why we’re doing that in different cases, and I’d have to get my CTO to explain.
Question three: 27:02 I’m just curious that when you have a consumer holding the bitcoin as collateral, and you are borrowing, in a sense when you have a large amount of demand, would you eventually affect the price of the bitcoin?
Barhydt: 27:15 Yeah. I think the single best use case for bitcoin over the next five years is the collateralization of real world assets to facilitate banking. As a matter of fact, I don’t even know what number two is. Until we have a second layer that can actually enable real-world payments, this is the best use case of bitcoin I’ve ever seen. By definition, there’s not enough bitcoin right now to collateralize all the assets when we’d wanna deal with this. I think there’s the answer to your question. If I’m right. I don’t think Abra’s gonna be the only company to do this.
27:44 Sorry, I didn’t hear what you said?
Question three continued: 27:45 Will that become a limitation?
Barhydt: 27:49 It wouldn’t become a limitation on price, because the price can keep going up forever.
Question three continued: 27:52 Limitation of supply of bitcoin.
Barhydt: 27:53 The limitation is layer one. That’s the limitation. Eventually, Abra wallets will also become Lightning wallets. There will be a server version of the Abra wallet for exchanges and other banks to use and hold synthetic assets, those will also be Lightning wallets, which we’re gonna announce soon, and those will all be able to communicate at layer two. That will solve most of the problem. But even then, as a settlement layer, layer one will have to scale better. That’s the biggest risk to Abra by far.
Question four: 28:27 Just wondering, thank you. When you’re taking these very complex hedge positions, I would guess that it would cost a lot of money to do that. How do you pay for that? Who’s paying for that?
Barhydt: 28:42 The hedges aren’t complex. The overall mechanics of the system are complex. In the case of an altcoin, I’m borrowing bitcoin and selling it for XRP, that’s not complex. The interest rate is non-zero. That’s offset by the consumer’s spread. On the case of equities and fiat currencies, I’m actually making money on most hedges, because the future contract on Bitcoin has a premium on one side versus the other side. In most days, the short side — which is the side I’m taking because I have short exposure — that pays a two to three basis point premium. That’s why, when we launch equities internationally, the initial cost is gonna be zero, because on average Abra should be making a reasonable percentage of return on equity, even though I’m not actually holding the crypto collateral.
Question four continued: 29:27 Amazing, thank you.