Thanks again for your reply, bytemaster, during this busy time. In response to your previous points:
BitUSD Short margin requirements are based upon the highest unaccepted bid to buy BitUSD for BTS.
Shorts MUST buy back at some point if they ever want to use their collateral for anything else.
So you apply game theory between the longs and the shorts. The longs will hold out for a fair price, and it costs the shorts a lot of money to 'let it ride'. Also, for someone who is short to maximize the return on their investment they need to cover, take a profit, and re-short at the new price. As the value of BitUSD falls the collateral backing it goes from 2x to 3x to 10x to 100x... and thus the interest rate earned by those who hold BitUSD rises and the opportunity cost for the short also rises.
As a result there is constant pressure for shorts to cover and and re-short at the new price. The only way for them to cover is to convince the longs to give up their higher yield and thus agree to a price near BTS/USD.
Now the longs cannot hold out for ever either because at any time new shorts can enter the market if the longs try to push up the price by holding BitUSD off the market.
1.) So you're saying that you won't allow shorts to reduce their margin positions even if/when the bitUSD price has moved very much into the money for the shorts?
This seems silly, as the shorts can still effectively reduce their margin by covering their previous position and initiating fresh positions at their desired level of exposure with new 2x margin, which would be lower than the previous 2x margin. It forces the shorts to needlessly make extra transactions to achieve the same position they could have had by just reducing their margin. Forcing shorts to cover in this way won't cause net long demand, hence won't cause the price to rise.
2.) Fungibility: If you don't allow shorts to reduce their margin when their positions are in the money, then the bitUSD contracts lose fungibility. This is because the margin requirement of each would be contractually coded in at the time of creation, and would depend on the bitUSD price at that time. I doubt that this is really the way you intend for things to operate.
Ok, those who own BitUSD are earning dividends at 2x the rate of those who own BTS.
Those who are Short BitUSD are paying interest at 2x the value of BTS.
The only price at which someone holding BitUSD would be willing to sell is the BTS/USD exchange rate. Otherwise, they sell the BitUSD to someone who wants a high yield investment backed by BTS.
These dividends will scale down as margin scales down as shorts reduce their margin, which they will do even if you force them to cover their initial position and reenter a new one to do so. Since the margin requirements are based on the bitUSD price and not the BTS/USD exchange rate, then the goodness of the deal for the longs doesn't depend on the deviation of bitUSD from BTS/USD, so this is not a mechanism that keeps the prices tracking.
Furthermore, in panics yield-incentives typically are surpassed by fear of near/intermediate term price losses. Interest only accumulates linearly in time, whereas prices can change arbitrarily quickly. LTCMs positions had crazy yields at the market prices before they had to liquidate. Still, buyers didn't enter and didn't cause their illiquid bonds to converge to the values of similar liquid ones. Whereas in the setup you describe. . .
1.) Yields (dividends) won't effectively increase as bitUSD price drops, because shorts will reduce their margins - by exiting and reentering if you force this upon them.
2.) There's no terminal payout, so no implied yield (price appreciation) as there is for e.g. bonds.
I still see no incentive whatsoever for any market agent to buy and sell in such a way that e.g. the price of bitUSD will track the BTS/USD rate, other than the belief that it is common knowledge that they "should." I still see this as a far fragiler incentive structure that has existed in many instances in financial history where instruments that were expected to track/converge had huge deviations and didn't. On the plus side, I'll point out that your system requires far higher margin than is typical in financial markets, which should reduce the pro-cyclical feedback that occurs in financial panics. Reducing this feedback is not, however, the same thing as incentivizing convergence.
I'm open to hearing new arguments or learning where I've misunderstood how the proposed system would work.