Produced by Agent86 as one of his first tasks... the following is a draft that needs to be cleaned up and properly formatted.
BitShares Market Pegged Assets
BitShares market pegged assets are a new type of freely traded digital asset whose value is meant to track the value of a common asset such as the U.S. dollar or gold. BitShares uses an advanced decentralized consensus ledger that takes some cues from Bitcoin. While Bitcoin has demonstrated many useful properties as a currency, its price volatility makes it risky to hold and difficult to use for everyday pricing and payments. A currency with the properties and advantages of Bitcoin that maintains price parity with a globally adopted currency such as the US dollar has high utility for convenient and censorship resistant commerce. The purpose of this introduction to market pegged assets is to explain how this price parity is achieved.
Bitcoin and similar crypto-currencies enable value storage and exchange over the internet that is beyond the control or censorship of a centralized party. Demand for this utility has driven up the price of crypto-currencies. Bitshares uses an analogous blockchain based core token simply called Bitshares that is traded with the abbreviation "BTS" on well-known crypto-currency exchanges.
Market pegged assets are created on the Bitshares blockchain using a similar method to a contract for difference. The open source Bitshares software program implements a decentralized internal marketplace for these assets and enforces the market rules. A BTS holder may use her BTS to place a buy order on the internal market for her asset of choice. Market pegged assets are created when a buyer is matched with a "short seller" of the asset. The short seller takes on the obligation of buying back the asset in the future and must maintain collateral sufficient to repurchase the asset at current market rates. This creates systemic demand for the asset.
"BitUSD" is the name of the BitShares market pegged asset that tracks the US dollar and we will use this as an example. In order to ensure that the internal market participants trading bitUSD for BTS have the opportunity to settle at the real USD to BTS exchange rate, the external exchange rate is fed into the system by a network of independent "delegates." Delegates are elected by BTS holders to run the network, process transactions, and provide exchange rate information. This external exchange rate information is often called a "price feed." The delegate election process is covered in detail in documentation on the BitShares' "DPOS" consensus algorithm. Delegates typically combine price information from multiple sources such as exchanges to generate a price feed and update it regularly. The system takes a median of all price feeds so that manipulation of the price information would be very difficult by any single delegate or party without massive collusion.
It is important to understand how the price feed is used to regulate the internal market. It does not directly control the market or the sale price between buyers and sellers of market pegged assets. It functions to regulate creation and destruction of market pegged assets in a way that pushes the market price toward the long term expected exchange rate (parity with the dollar). While the internal exchange rate of bitUSD to BTS has no restriction, new "short sales" are prevented from executing below the median price feed. Short selling is the process by which new bitUSD is brought into existence and the rule that short sales are not executed below the real exchange rate prevents new bitUSD creation when price is below parity with the dollar. New bitUSD is created only when demand for bitUSD is at parity with the dollar or above.
When a short seller buys back bitUSD and covers their position they repay their obligation and can recover their collateral BTS. At this time they are taking bitUSD out of circulation and reducing the total supply. The current Bitshares market rules force short sellers to cover their position within 30 days of opening the short position. This means that the full amount of outstanding bitUSD must be purchased off the market every 30 days. BitUSD holders are not required to sell; therefore short sellers covering their positions are eventually forced to purchase from newly opened short sales at or above the exchange rate. This is effectively a guarantee to any bitUSD holder that they can sell bitUSD for the dollar equivalent of BTS within any 30 day period.
Short sellers are typically bullish on the direction of BTS vs. the market pegged asset. If the market value of BTS rises with respect to the asset the short seller can buy back the asset for significantly less BTS than they originally sold it for and profit from the transaction. If BTS value falls in relation to the market pegged asset, the short seller must buy back the asset at a loss. If the price of the asset rises a lot, a short may face a "margin call" where the rules of the program use the posted collateral to automatically buy back the asset from the market to repay the obligation. A margin call is triggered in the current BitShares system whenever the collateral contains less than 1.5 times the amount of BTS required to cover the obligation. Stated another way, if the value of BTS falls by 33% from the time the short position is entered, then a margin call will occur. The value of BTS would have to fall by 66% before the collateral would be insufficient. These rules are extremely conservative compared to any traditional banking practice and is designed to protect the system even in the most extreme volatility.
Market orders and other signed transactions on the BitShares blockchain are grouped into 10 second blocks by delegates. When buy and sell orders on the internal BitShares' market are matched, the highest buy orders are matched with the lowest sell orders and any BTS contained in the overlap are captured as fees so that each party gets exactly what they paid for. The reason for this is twofold. Firstly, it prevents high frequency trading that attempts to insert an order between two placed orders to profit from the overlap, this is sometimes called "front running". It also makes it very costly for a large buyer or seller to quickly move the market by placing a large order far from the current market rate. Doing so would require the buyer or seller to pay the more expensive rate and lose any overlap with all orders their order is matched with. The destruction of BTS from the overlap of orders creates value for BTS holders as a whole by making the token more scarce.
Risks:
The market pegged asset system is designed to minimize risk of loss, however some risks remain.
Sudden unexpected crash in value of BTS, often termed a "black swan event.":
Market pegged assets maintain their value due to being backed by collateral that has an established real world value. When this collateral falls in value the system is designed to react by driving the internal market pegged asset exchange to match the new real world exchange rate and trigger margin calls as necessary. However, there exists a possibility that the value of the underlying asset used for collateral (BTS) drops in value so quickly that the market pegged assets become under-collateralized. In this event, the full amount of collateral is no longer sufficient to purchase the market pegged asset back at the new real exchange rate. This event would require a sudden and dramatic price change that would prevent the system from adjusting in time. In such an event bitAssets may trade below the value of the underlying asset. It is possible that the market could recover on its own if BTS regained value. It is also possible that the market would need to be "reset" and asset holders forced to settle for BTS collateral worth less than the intended face value of their assets.
Counterparty risk:
Unlike some attempts to create a digital asset that tracks the dollar, bitUSD is not and "I owe you" issued by any entity. For this reason, it does not rely on a specific counterparty to honor its value. The process of buying market pegged assets or BTS on an external public exchange requires trusting the exchange with your funds for the time period that you have them deposited with the exchange. In almost any market the possibility for manipulation exists, however, this risk is minimized by the open source auditable nature of the BitShares market and carefully considered market rules.
Systemic risk:
Systemic risk is essentially a catch-all for any other risks involved with using the system. The primary risk is that individuals are responsible for protecting the cryptographic private keys that can sign transactions proving ownership of their assets. These keys must be protected from theft or loss. This risk can be greatly reduced and virtually eliminated by following best practices. Systemic risk also includes the possibility of an overlooked fatal flaw in the open source software or the possibility of large scale failure of global network infrastructure.
No system is without risk. The current banking system allows private funds to be frozen or confiscated without consent (often by court order). Banks are also not immune to insolvency. The quality of access to banking services varies greatly across the globe. Bitshares brings publically auditable open source banking to anyone with access to the internet. Market pegged assets allow savers and spenders to choose preferred asset types. This brings flexibility and ease of use to the open source banking experience.