SmartCoins provide the freedom of cryptocurrency with the stability of the dollar
Cryptocurrencies are unique in that they are the only digital currency that is not someone else’s liability. They are fungible, decentralized, and as valuable as the network of users that support them. Unfortunately, they suffer from very high volatility, because their perception of value constantly changes as users enter and leave the ecosystem.
The traditional approach to creating a stable asset is to accept deposits and issue a digital token as a claim receipt. Under this approach, the token is valued by the market as a dollar, discounted by any credit risk associated with the issuer. This can work well for transactions, but less well as a form of savings. History has repeatedly proven that issuers eventually go bankrupt due to fraud, incompetence, or government intervention.
SmartCoins implement the concept of a collateralized loan and offer it on the blockchain. For the purpose of this discussion, we will assume that the long side of the contract is BitUSD and that the backing collateral is BTS (the BitShares blockchain core asset). To achieve this, SmartCoins use the following set of market rules:
- Anyone with BitUSD can settle their position within an hour at the feed price.
- The least collateralized short positions are used to settle the position.
- The price feed is the median of many sources that are updated at least once per hour.
- Short positions never expire, except by hitting the maintenance collateral limit, or being force-settled as the least collateralized at the time of forced settlement (see point 2).
- In the event that the least-collateralized short position lacks enough collateral to cover at the price feed, then all BitUSD positions are automatically force settled at the price of the least collateralized short.
A simple metric for testing the validity of our claim that 1.00 BitUSD is always worth at least $1.00 is to demonstrate that, if you can find someone willing to sell 1.00 BitUSD for $1.00, that it would be the cheapest option for buying BTS. This means that 100% of the buying demand for BTS would be available to give liquidity to BitUSD holders as a priority over BTS holders. In the following sections I will attempt to prove that this condition is met.
While the rules are simple, the consequences are less obvious. Let’s analyze this from the perspective of the various players.
When deciding a price at which to enter a short order, a trader must consider the risk of forced settlement. In this case, no trader will attempt to short at or below the price feed, because they could be forced to settle at the price feed. In fact, a smart trader would allow enough of a spread to account for the risk of being forced to settle at a feed price that was off by a small amount. In practice, the risk posed by the feed error is balanced equally between being in the favor of the short and in the favor of the long, leaving only the risk of being forced out of their position at an inopportune time.
A short can minimize their exposure to the feed by providing enough collateral to keep far above the least collateralized positions, and thus very unlikely to be forced to settle at the feed or at an inopportune time.
In practice, the only way new BitUSD enters circulation is if there is someone willing to pay enough of a premium to convince a short to provide guaranteed liquidity at the price feed on demand, while also covering the cost of exchange rate risk. This premium will be higher for the backing cryptocurrency in a bear market, and will be lower in a bull market.
Someone who is short has only one way to exit their position: by buying BitUSD off the market. This means that a short must also factor in the risk that the premium may change. If a short position is entered in a bull market with a 0.1% premium, it may be forced to exit during a bear market with a 5% premium. In this event a short position is exposed to both exchange rate of the dollar vs. BTS and the premium risk. On the other hand, a short entered during a bear market with a 5% premium may get to cover during a bull market with a .1% premium.
For all intents and purposes, the premium is expected to move in the same direction as the price, and thus speculators who only care about relative price changes can ignore the premium.
The Long (BitUSD holder)
The very first buyer of BitUSD will have to pay the lowest premium set by the shorters. For the sake of discussion, let’s assume the first BitUSD was created in a bear market and cost $1.05 to create. The holder of that BitUSD has two options: sell it on the market for $1.04, or request forced settlement for $1.00. Clearly, the forced settlement option would only be used in situations where there was a decrease in total demand for BitUSD and there were no offers to buy it above $1.00.
As a trader only looking to trade back and forth between BitUSD and BTS, this premium doesn’t matter. Such as trader is exposed to volatility in the premium, but that risk is limited to $0.05 in this example. In practice, the premium is expected to be relatively stable and predictable.
The BTS Buyer
A buyer with dollars, looking to buy BTS, knows that 1 BitUSD can be used to buy $1 worth of BTS (plus the current premium). He also knows that this premium can never be negative, because of the option to force-settle at the price feed. In this situation, he can know with certainty that if he can convince someone with BitUSD to sell for $1.00, he can buy more BTS than if he simply buys BTS with his dollars directly. The higher the premium, the more incentive exists to buy BitUSD for $1.00.
This means that, in a BTS bear market, the BitUSD price gives the highest premium of the BTS price, and BitUSD becomes the easiest to sell. In practice, the BitUSD:USD market will reflect the premium, and traders will usually be unable to find anyone willing to sell for exactly $1.00.
If a buyer is looking to purchase a large quantity of BTS without moving the price, he can start by buying up BitUSD with dollars. This will slowly raise the BitUSD:USD price, which is a signal to other market participants. A careful buyer might be able to avoid signaling the market. Then, after acquiring the position in BitUSD, the buyer can request forced-settlement all at once and get the price feed on the entire purchase.
Because all positions and trades are visible on the blockchain, all of this trading activity can be factored into the price, minimizing any potential profits to be made by attempted manipulation.
A merchant wants to be able to price merchandise in BitUSD, and obtain real USD in the bank account, in a reasonable time, with minimal risk. In this case, a merchant would place BitUSD on the market at $1 per BitUSD. As discussed, BTS buyers fight for the opportunity to buy BitUSD at that price.
A smart merchant might recognize that 1 BitUSD can actually fetch $1 plus a variable premium, and start preferring that customers pay them in BitUSD at face value. An even smarter merchant might offer a discount to customers that pay in BitUSD.
Any way you slice it, merchants have a financial incentive to advertise BitUSD as the preferred payment mechanism, because they know that $1.00 is the lower bound on what BitUSD is worth.
A customer looking to buy goods and services with BitUSD finds himself paying a premium to acquire BitUSD from the market. This means that customers will prefer merchants that offer a discount equal to the premium paid. On the other hand, the premium is a wash for a customer that earned BitUSD at a nominal value of $1.00. In fact, the only people to whom the premium matters are those who are looking to enter or exit the ecosystem. Once a customer or merchant is within the ecosystem, it is easy to simply trade BitUSD at parity, even if it is theoretically worth slightly more outside the ecosystem.
Customers use BitUSD because it provides them the convenience and freedom of a cryptocurrency, and has the lowest transfer fees of any other payment platform.
Merchants and customers are free to negotiate the best way to split the premium, and the free market will take care of the rest. In the mean time, all participants can rest assured that BitUSD is always worth at least $1, and can consider the premium for entering the ecosystem as a one-time fee.
There is always concern of price manipulation. Someone with a large amount of money on both sides of a trade can use their funds to manipulate the markets and thus the price feed. If the amount of money they lose manipulating the markets is less than the amount of money they can gain by manipulating the price feed, then it will be profitable to manipulate the market at the expense of either the BitUSD longs or the shorts. A low-collateralized short that sees a large force-settlement order requested can attempt to manipulate the markets and thus the feed against the BitUSD holder.
The risk of price manipulation is priced into the premium on BitUSD charged by the shorts, and thus should already be priced into the market. If price manipulation became a serious problem that caused very high premiums, then it could be addressed by the price feed producers, who can adopt a moving average over wider time windows to increase the difficulty of short-term manipulation. A variety of algorithms could be used to estimate a “fair price” that keeps BitUSD valued at least $1.00.
In practice, a feed producer can observe the BitUSD-to-USD market as an indicator on which way to adjust the feed. Generally speaking, the strategy that the feed producers adopt for controlling the feed should be public knowledge, because the shorts will ultimately rely on it. For the feed producers to change strategies in unpredictable ways could cause losses to both longs and shorts.
Black Swans – Extreme Market Conditions
All guarantees of SmartCoins are subject to the caveat that a SmartCoin can never be worth more than the collateral backing the least-collateralized short position. In normal market conditions, the value of the collateral is always more than sufficient, but, from time to time, markets can rapidly revalue the collateral. If this revaluation happens faster than the short positions can be forced to cover, then all SmartCoins are liquidated at the exchange rate of the least collateralized short position. This is similar to an insolvent bank converting its deposits to equity.
The BitShares blockchain offers entrepreneurs an opportunity to create their own SmartCoins with custom parameters and price feeds.
User-issued SmartCoin managers can experiment with different parameters such as collateral requirements, price feeds, force settlement delays and forced settlement fees. They also earn the trading fees from transactions the issued asset is involved in, and therefore have a financial incentive to market and promote it on the network. The entrepreneur who can discover and market the best set of parameters can earn a significant profit. The set of parameters that can be tweaked by entrepreneurs is broad enough that SmartCoins can be used to implement a fully functional prediction market with a guaranteed global settlement at a fair price, and no forced settlement before the resolution date.
Some entrepreneurs may want to experiment with SmartCoins that always trade at exactly $1.00 rather than strictly more than $1.00. They can do this by manipulating the forced settlement fee continuously such that the average trading price stays at about $1.00. By default, the BitShares blockchain prefers fees set by the market, and thus opts to let the price float above $1.00, rather than fixing the price by directly manipulating the forced settlement fee.
SmartCoins are a powerful tool for everyone from speculators and savers, to traders and entrepreneurs. The BitShares platform provides a toolset with which innovators can experiment to find optimal currency solutions using free market discovery.
New to the BitShares Blockchain? Read more about the BitShares Blockchain core features in the following articles. They have been posted originally at www.BitShares.org
What is the BitShares Blockchain? The Ultimate Guide for Beginners What is the BitShares Blockchain? Originally written by Aaron Mangal at Coincentral 12 NOVEMBER 2017.