Hosting in a decentralized world: From legal guarantees to smart contract innovation

The escrow mechanism is the core foundation for building secure transaction paths.

Authors: Jen Bai, Evan Lee

In business transactions, when large sums of money or valuable assets are involved, trust is both crucial and scarce. How can a buyer be confident that they will receive what was promised? How can a seller ensure they get paid after delivery? This is where the escrow mechanism comes into play—it holds funds or assets through a neutral third party and releases them only after both parties have fulfilled their agreed obligations.

The application of the escrow mechanism goes far beyond simple fund storage services. It is a key risk management tool in various industries, including real estate, corporate mergers and acquisitions, e-commerce platforms, and even the highly volatile field of cryptocurrency transactions. By means of neutral and secure custody of funds or assets, the escrow mechanism effectively reduces the probability of fraud, minimizes transaction disputes, and provides reliable guarantees for transactions that would be difficult to conduct based solely on trust.

How the Escrow Mechanism Works

1. Agreement on Terms — The buyer and seller negotiate and mutually confirm the terms and conditions of the transaction.

2. Signing the Escrow Agreement — Both parties formally sign a legally binding escrow agreement and appoint a neutral escrow agent.

3. Depositing Funds/Assets into the Escrow Account — The buyer deposits the agreed amount or assets into a secure escrow account, ensuring that the seller cannot receive the funds in advance before fulfilling the agreed obligations.

4. Fulfillment of Obligations — The seller provides the goods or services as agreed, and the buyer checks and confirms whether they meet the terms.

5. Completion of Transaction and Release of Funds/Assets — Once the conditions are confirmed to be met, the escrow agent releases the funds or assets to the seller in accordance with the agreement.

Wide Applicability of the Escrow Mechanism

Escrow is not limited to cash; it can also be applied to any identifiable and transferable assets, such as:

- Real estate property deeds

- Financial instruments like stocks and bonds

- Intellectual property (e.g., software source codes)

- Digital assets (cryptocurrencies, NFTs)

- Legal documents such as patents and contracts

- High-value physical objects (artworks, jewelry, luxury cars, etc.)

These assets must be identifiable and transferable so that the escrow agent can accurately execute the release after verifying that the completion conditions are met.

Legal Risks and Complexities of Escrow Agreements

Although the escrow mechanism can provide protection for transactions, if the structure is not well-designed or there is insufficient supervision, it may bring serious legal and financial risks. Common risks include:

1. Ambiguity in Applicable Law

Escrow transactions often involve parties from different jurisdictions, such as a U.S. buyer, a Singaporean seller, and an escrow agent registered in the Cayman Islands. Each region has different definitions and enforcement mechanisms under contract law.

If the agreement does not clearly specify the applicable law, legal conflicts may arise. The enforcement of cross-border court rulings may be limited; for example, a judgment from a Hong Kong court may not be directly enforceable in the United States. It is recommended to specify a neutral applicable law (such as English law or New York law) in the agreement and adopt an arbitration mechanism to reduce the risk of disputes.

For example: If an escrow contract does not clearly specify the applicable law, a Singaporean escrow agent involved in a transaction dispute between a Chinese buyer and a German seller may face conflicts in procedural rules, high costs of cross-border legal consulting, and uncertain ruling results.

2. Illegal or Unlicensed Institutions

Not all institutions claiming to provide escrow services are legal and regulated. Especially in the crypto asset market or cross-border transactions, some fraudsters may impersonate legitimate platforms.

In Hong Kong, escrow services can only be provided by **authorized banks, Hong Kong law firms, or specific trust/company service providers (TCSPs)**. Providing escrow activities by non-above institutions is illegal.

In Singapore, escrow services are usually carried out by MAS-regulated banks, trust companies, or compliant law firms; informal platforms cannot legally provide escrow services without obtaining a payment license or trust authorization.

In the United States, state laws strictly stipulate that escrow services must be performed by state-licensed escrow companies, regulated insurance/title institutions, or lawyers who comply with professional ethics. Funds involved may also need to be registered as money transmission businesses.

Using unauthorized escrow services may lead to:

- The escrow agreement not being legally protected

- No regulatory authority to turn to if customers suffer fraud

- Loss of assets with no way to recover them

- Parties may bear civil or criminal liability for knowingly participating in illegal transactions

A New Era of Decentralized Escrow: On-Chain Smart Contract Mechanism

The traditional escrow system relies on intermediaries such as banks and law firms to execute escrow and release, but blockchain technology has brought revolutionary changes—on-chain escrow uses smart contracts to achieve automatic execution without the need for centralized intermediaries.

Smart contracts are self-executing codes deployed on blockchain networks, which can lock, release, or refund assets according to preset conditions.

These codes are open, transparent, and tamper-proof. Both parties to the transaction can verify in advance whether the logic conforms to the agreement, and the execution cost is usually lower than that of traditional escrow.

For example:

- The buyer transfers 1 ETH into the smart contract;

- The contract is set: ETH will be released only when a certain NFT is transferred to the buyer's wallet;

- If the NFT is not delivered within the specified time, the contract will automatically refund ETH to the buyer.

Although on-chain escrow has advantages such as transparency, automation, and low cost, it also has technical risks, such as smart contract vulnerabilities and lack of effective dispute mechanisms. Therefore, it is necessary to carefully review the contract code and platform reputation before use.

Case Study: Hodl Hodl's Peer-to-Peer Escrow Model

Hodl Hodl is a platform that allows users to conduct peer-to-peer transactions of Bitcoin or stablecoins. Its design highlight is that it does not hold users' funds but relies on on-chain multi-signature mechanisms to ensure transaction security.

The operating principle is as follows:

After a transaction is initiated, the seller's cryptocurrencies are locked in a multi-signature smart contract on the Bitcoin or Liquid network;

The contract adopts a 2-of-3 multi-signature structure:

- One private key is held by the seller

- One is held by Hodl Hodl

- The third is held by the buyer when needed, depending on the type of contract

When a normal transaction is completed, signatures from both the seller and Hodl Hodl are required to release the assets. In case of a dispute, Hodl Hodl will decide to sign the transaction together with the buyer or the seller according to the ruling to determine the ownership of the funds. Even if the Hodl Hodl platform stops operating or has problems, the seller can retrieve the funds under certain conditions because they hold their own private key. This model effectively reduces escrow risks and combines a structured dispute handling mechanism to ensure transaction fairness.

Conclusion

When escrow arrangements are properly designed and executed, they can transform trust into certainty—providing clear and reliable guarantees for both parties in situations where transactions may be full of risks. Whether it is high-value real estate transactions, cross-border business dealings, or transactions on decentralized crypto platforms, the escrow mechanism is the core foundation for building secure transaction paths.

To truly exert the effect of escrow, it is far from enough to only understand its operation process; all parties to the transaction also need to:

- Strictly check whether the escrow service provider is licensed and complies with regulatory requirements

- Clearly define the applicable law of the agreement and the dispute resolution mechanism

- Prevent ambiguous release conditions to avoid delays or ambiguities

Disclaimer: The views in this article solely represent the author's personal opinions and do not constitute investment advice for this platform. This platform makes no guarantees regarding the accuracy, completeness, originality, or timeliness of the information in the article, nor does it assume responsibility for any losses arising from the use of or reliance on the information contained herein.