Note: What we have been calling BitAssets 3.0 I am renaming to BitAssets 2.0 for this paper because otherwise everyone outside this forum would be confused if we started talking about 3.0 when 2.0 never existed. BitAssets 2.0
Stable Decentralized Digital Currencies
This paper introduces a practical approach to creating a stable digital currency. There have been many proposed strategies for “price fixing” a digital currency to a national currency or other commodity. Historically the goal is for the asset to have a market value within a very tight tolerance of an outside asset. This paper would like to challenge that goal and instead propose a different goal: maintain a minimum value for the asset but do not attempt to control the maximum value.
For the purposes of this paper BitUSD will refer to any digital crypto-currency that is intended to be worth $1.00. BitUSD is merely an example to facilitate discussion and in general could be substituted with any other commodity or currency. For a crypto currency token we will assume BTS, but it could just as easily be any other crypto-currency.
When two people get together to barter goods, it is often the case that neither party knows the *exact* value of the goods they are trading. Instead, each party considers the “minimum value” each item may have to them and uses this minimum value to set their prices. This principle holds true for almost all merchants that accept crypto-currencies as payment for goods and services. These merchants set their prices based upon the risk of the crypto-currency falling in value between the time they accept payment and the time they convert the payment to a stable store of value. A customer paying for something with Bitcoin often does so at an exchange rate that is lower than what they could theoretically get if they sold instantly at an exchange.
Each and every day people trade pennies which have $0.02 worth of copper in them as if they were only worth $0.01. The fact that somewhere there exists someone willing to pay $0.02 for the penny does not change the fact people use it at face value.
Attempting to construct a crypto-currency that is “pegged” to the dollar means that every merchant accepting BitUSD is willing to do so at the same ratio as they would cash. Conversely, every customer is willing to part with their BitUSD to buy a good without feeling they were overpaying. This is a far looser definition of a pegged currency than many people attempt to construct, but it is also a far more useful one.Creating BitUSD
All crypto-currencies are free floating assets with a value that is constantly changing with market perception. This is the basic building block from which a stable currency must be forged. The systems that have been proven to work are essentially variations on a *contract for difference* (CFD) where there is sufficient collateral tied up to honor the contract. In a contract for difference one party agrees to pay the other party an amount equal to the change in price between two assets over time. In this way the parties can gain opposite exposure to the price movements without ever having to own the asset they are speculating on.
BitUSD is the long position of a CFD based on the exchange rate between BTS and a US Dollar and is collateralized with BTS. All CFD contracts need a judge and this means either a trusted price feed, an arbitration agent, or voluntary settlement between the long and short side of the contract. BitShares provides all three of these options. Normally longs and shorts will choose to voluntarily settle at a fair price because it is the fastest and lowest risk option; however, at any time a long (BitUSD holder) may request to have their position settled at the median of a set of trusted price feeds with sufficient delay to ensure that neither party has access to information faster than the price feed can be updated.
The magic of BitUSD is that it makes all long positions fungible and they can be used to settle any short position. When a forced settlement is requested it is simply matched against the least collateralized of the short positions. Thus we can say that any individual BitUSD is at least as valuable as the long position of the least collateralized CFD. Its value takes into consideration the risk of the collateral becoming insufficient. Based upon this construction we can clearly see that BitUSD will meet the necessary requirement to be accepted at face value by merchants. The precise exchange rate between BitUSD and the underlying crypto-currency is not relevant from the perspective of the users of BitUSD (merchants and consumers). All merchants and consumers care about is knowing that if they pay $1.00 for a BitUSD they can sell it for $1.00 in the future. In general merchants and consumers should need little if any knowledge about the underlying crypto currency (BTS) and therefore we should presume these users will never look at the BTS/BitUSD market. The only people who care about the BTS/BitUSD market are crypto-currency speculators, market makers, and arbitrage bots.
To establish BitUSD as a viable USD alternative simply means minimizing the arbitrage opportunity between merchants accepting BitUSD at $1.00 and selling to speculators for slightly more than $1.00. Most users do not want to go from BitUSD through a crypto-currency to get to USD nor do they want to go from USD through a crypto-currency to get BitUSD. Instead BitUSD to USD becomes the market that matters and it should develop a very narrow spread as USD flows from users bank accounts to BitUSD to merchants which then sell the BitUSD back to other users. The spreads in BitUSD to USD would be so insignificant that everyone would consider them equal.
While the spreads between BitUSD and USD may be low, the spread between BitUSD and the backing crypto-currency could be much larger due to the high volatility of the crypto-currency. It is economically unviable to have large buy and sell walls any where near the price feed for the same reason that selling a large quantity in any market results in slippage. The value of a crypto-currency is far to “fuzzy” in the mind of the market for anyone to make money making the market with a very narrow spread.
The real underlying demand that drives BitUSD:USD to 1:1 is from arbitrage bots and speculators buying BitUSD first as a means to buy the BTS more cheaply than via alternative channels. This means that buying 1 BitUSD for $1.00 should always be the most cost effective means to purchase the underlying crypto-currency, BTS. This realization has many implications for the design goals of BitAssets 2.0.
First and foremost this means that BitUSD holders should always be able to force settle at a fair price in just about any quantity in a relatively short period of time. A whale looking to buy BTS in bulk would get the best price possible by buying BitUSD with USD and then selling it for BTS on the internal exchange. In a worst case they could force settle it in a large quantity and still end up buying the BTS cheaper than alternative means.
This would put pressure on the BitUSD:USD price lifting it to $1.01 USD per BitUSD. The USD : BitUSD market price combined with the BitUSD : BTS market price can and should be factored into the BTS : USD price feed. Thus a whale buying up BitUSD and raising the price would also move the price feed and keep the market balanced.
If the most effective means for buying BTS is through BitUSD then it means that selling BTS for BitUSD should also be the least efficient means of cashing out. Instead BTS should be sold for USD through other channels more efficiently than through BitUSD. The ability to sell BTS for USD is the foundation of the value of the collateral behind BitUSD. If the collateral received by forced settlement cannot be sold for USD of equal or greater value then the price feed was off. If it ever becomes more efficient to cash out of BTS into USD though BitUSD then the market will sometimes push BitUSD down to $0.99 and break the floor that merchants and consumers are counting on.
From this we can conclude that it is far better for price feeds to error in the favor of BitUSD holders than in the favor of shorts. We can also conclude that the spread on the internal market should not be of any concern so long as buying BitUSD for $1.00 remains the most cost effective means of buying BTS.
Impact on Shorts
As a result of this analysis it is clear that those shorting BitUSD into circulation must by necessity sell at price above the feed and that creating BitUSD will always cost more than $1.00. After all if buying BitUSD with USD at 1:1 is always going to be the most efficient means of buying BTS then that means someone buying BitUSD with BTS is always going to pay more than $1.00.
Thus someone buying BitUSD from a short will have to pay more than $1.00 worth of BTS for it otherwise the BitUSD will fall to less than $1.00.
BitUSD will initially be created by individuals who want to stay in a crypto currency but wish to have a price floor. They must sell their BTS and receive less BitUSD than they would have received by selling their BTS for real USD. The difference will depend upon the demand from shorts looking for leverage. For the sake of an example, lets assume that there is a bear market and thus shorts are conservative and asking for $1.05 worth of BTS per BitUSD. This means that the first BitUSD had to pay this spread. It also means that he could turn around and ask $1.04 worth of BTS to exit his position. In all likely hood there would be offers to buy at 1.03. In other words, the BitUSD / BTS market should never be expected to trade centered on the price feed, but above the feed by an amount proportional to how bearish the market is. In other words the spread of BTS to BitUSD will depend upon willingness of shorts to borrow and ultimately the how bullish/bearish the market is.
In a BTS bull market then the premium to create BitUSD would be low, perhaps $1.01 or even $1.00. In a BTS bear market then the premium to create BitUSD would be high, perhaps $1.10 or more. Shorts have no way to force a BitUSD holder out of their position and thus must price in the risk of being unable to buy BitUSD cheaply to cover. In either case the result is proper, in a bear market BitUSD becomes the cheapest way to buy BTS and thus causes new money to flow in through BitUSD and ultimately allows shorts to cover from this new money at a fair price.
The rules of BitAssets need to guarantee a floor on the value of BitUSD of $1.00 and the cost of providing this floor is certainly greater than 0. Therefore, the cost of buying BitUSD from a short and thus creating new BitUSD should always be more than $1.00. When things are bullish for BTS then the cost of providing the floor is lower than when things are bearish. In a bear market the BitUSD supply would contract as all new money flowing into BTS via BitUSD would be sucked up by shorts covering.