The goal of creating a stable, highly liquid, accurate pegged crypto currency has been as elusive as it is desirable for those interested in a trust-free digital currency. BitShares has experimented with several approaches and has devised an approach that largely works, but which is still lacking. This paper presents a new approach to establishing a trust-free pegged crypto-currency. In this new approach the market rules are simple and a price feed has minimal ability to impact the market.
In finance, a contract for difference (CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time (If the difference is negative, then the buyer pays instead to the seller). In effect CFDs are financial derivatives, that allow traders to take advantage of prices moving up (long positions) or prices moving down (short positions) on underlying financial instruments and are often used to speculate on those markets.
BitShares takes the concept of a contract for difference and applies it to a crypto-currency relative to a national currency and settles it in the crypto currency. For the purpose of this paper we will assume a CFD between BitShares BTS and the US Dollar and call the long position BitUSD. Normally contracts have different settlement dates backed by different collateral amounts which makes them infungible. BitShares attempts to make all BitUSD positions fungible and thus usable as a currency.
The challenge with this approach is that there are no expirations on the BitUSD positions which creates a situation where the two sides of the market have no means of settling at a fair price if one side of the market refuses to settle. In order to address this concern BitShares has gone to great lengths to force all short positions to cover at a fair price every 30 days and guarantee redeemability to the BitUSD holders but BitShares has no ability to guarantee redeemability to the shorts. In order to guarantee redeemability to the longs the market must limit the price at which new shorts can sell. This creates an artificial barrier that is highly dependent upon a price feed in order to prevent abuse.
In an ideal world the market would operate freely and the CFD would settle all parties at a fair price once. If we assume that short and long positions settle at a trusted price once per year, then market forces will drive the price of the long side to follow the real-time USD value without the need to publish a price all year, only a single price is needed once per year.
Unfortunately, this forced settlement would expose users of the long position to the underlying crypto-currency once per year. To give users an option to stay in BitUSD year-round means that two parallel CFD markets would be required that settle once per year offset by 6 months. A user that wishes to have no exposure to the underlying crypto-currency can switch which CFD market they are in every 6 months.Minimizing Market Manipulation at Settlement
Because settlement depends upon a price feed, market participants need confidence that the settlement price will be reasonable and free from any surprises. To achieve this the price feed must be provided by multiple sources that are unlikely to collude and it must be provided on a daily basis. To further protect market participants from sudden price movements or changes in the behavior of the feed producers, the 30 day moving average (or median) of the price feed could be used as the settlement price.
From the perspective of a prediction market, speculating on the future value of a 30 day moving average is nearly identical to speculating on the exact price any time the event is more than 30 days in the future. This means that 11 months out of the year the prediction market will track the instantaneous price changes. During the last 30 days the market will start to have more information about the 30 days that are factored into the moving average and the price will start to converge on the moving average rather than tracking the instantaneous price.
If you assume there exist two markets offset by 6 months, then the real time price from the second market can be averaged into the price feed to further reduce the impact of any individual feed producer from attempting to manipulate the price for gain. Creating a Pegged Asset without Expiration
The process of rebalancing an account between two different CFD markets can be mostly automated. A market making bot can issue a new asset without any expiration that can always be redeemed for the long position with more than 30 days until expiration. Every 6 months this bot would rebalance its portfolio of assets. 10 months out of every year the two CFD markets should have a near 1:1 price which means that that natural spreads between the two otherwise nearly identical markets would allow the bot to convert with minimal cost. As the issuer of an asset, the bot would be generating income from every place its asset is used in other markets. This is a very valuable service that should easily cover the cost of rebalancing the portfolio over 5 months. The bot could rebalance its portfolio by enabling a lower spread with no fees when converting from a longer expiration CFD to a shorter expiration CFD.
In a flat market the 30 day moving average is above the daily price half of the time and below the daily price the other half of the time. This means that half of the time the expiring long position will be worth more than the long position expiring 6 months later and the trading bot would have no trouble liquidating any remaining stock in the last month. This leaves only the situation when the 30 day moving average makes the expiring position less desirable than the position 6 months away. In this event the trading bot would be exposed to the difference between the 30 day moving average and the real time price if it was unable to migrate positions in the 5 prior months.
Because the bot needs to mitigate risk it would be designed to offer a slowly growing discount on the earlier expiring contract. This discount wouldn’t need to be much, likely a fraction of a percent and far below the income earned from trading commissions which would allow the bot to operate profitably. Protecting Margin Positions
While a price feed is not needed all year, it may be beneficial to publish a feed for the sole purpose of protecting short positions from being squeezed in a thin market. Market purists would consider the risk of a short squeeze as motivation for having higher collateral. Either approach may be used and should be viable. Conclusion
A trusted organization can create an asset that will follow the value of any price feed assuming the feed is predictable based upon public information. This organization needs no ties to the outside financial system and can consist of members elected by the stakeholders. In other words we can assume the two market issued assets and the user issued asset can be managed by a multi-sig account defined as the current set of elected delegates.
The primary downside to this approach to pegging an asset is that it divides liquidity among 3 different markets rather than concentrating it within a single market. Fortunately arbitrage between these three markets is relatively cheap and instant which will make them function nearly as one. This is especially true if the exchange can simultaneously trade across all three markets in a single order.