Chapter 1: DEFINITIONS
Can it be possible to pay for your coffee in dollars with your phone but without any intermediary between you and the coffee shop?
We'll get to it but first a few definitions to avoid ambiguity:
- "Bitshares X" is a Decentralized Autonomous Company (DAC). Bitshares X being a DAC is not crucial here so if you are not familiar with the concept of DACs then for now you can think of it as a money payment business similar to PayPal or Visa.
- "btsx" is a share in the Bitshares X business. You could think of it as a currency unit but for now it is easier to think of it as a share in a business.
- "bitUSD" is a concept that does not have a direct analogy in the current financial system so it might be a bit difficult to grasp at first. bitUSD is an asset that represents as many btsx as there are needed to be worth one USD. So if the current market price of btsx is 0.028 USD per btsx then one bitUSD represents 34.48 btsx (=1/0.029). If the price moved to 0.050 USD per btsx then one bitUSD would represent 20.00 btsx and so on.
Chapter 2: PRIMARY PURPOSE
The primary purpose of the Bitshares X system is the ability to generate bitUSD (and other similar assets like bitEUR, bitGold etc). bitUSD is useful because (by definition) it has the same purchasing power as fiat USD and at the same time is as easily transferable as bitcoin.
So how can bitUSD come into existence? In essence by matching into pairs two kinds of people:
- those who prefer stability (i.e. they prefer avoiding losses even if it means the possibility of renouncing gains)
- and those who prefer risk (i.e. they prefer to have the chance to earn profits even if it means the risk of incurring losses).
As we will see in Chapter 4 the side effect of this matching happens to be our primary purpose: the bitUSD.
Chapter 3: STANDARD WAY
Imagine two people: Alice and Bob. Each of them owns a balance in btsx (in other words both have a long position in btsx). And for both of them the base currency is USD (which means they have bought their btsx with USD and their main concern is valuation of btsx in terms of USD).
Let's assume that Alice prefers stability and is worried that the value of her btsx [relative to USD] might fall soon and she would like to hedge against it: she wants the value of her btsx [relative to USD] to be maintained in case the market price of btsx falls. In other words she would like to hedge her long position in btsx.
Bob has the opposite view: he is confident that market price of btsx will rise soon and he would like to take advantage of his prediction: he wishes he had more btsx than he already has so that he could profit from the predicted price rise even more. In other words he would like to leverage his long position in btsx.
If btsx was a standard crypto-currency Alice in order to execute her hedge would have to sell all of her btsx and keep her wealth in USD for a while (at least until she decides the danger of btsx falling further in value [relative to USD] is over and it's safe to convert her wealth back into btsx).
Also, if btsx was a standard crypto-currency Bob in order to take advantage of his prediction would have to borrow USD (or in some other way get USD funds) and buy some extra btsx to increase the amount of btsx he already has and then he would have to hold this increased amount of btsx for a while (at least until he decides his prediction of btsx rising further in value [relative to USD] is no longer valid and then to reduce his btsx holding to its original size and sell the extra btsx to pay back his USD debt).
Chapter 4: P2P WAY
But maybe there is a smarter way to do this. Consider this:
Let's assume Alice finds Bob and says "Hey, Bob, I know you like the risk so here are my btsx, please take care of them. I don't care how many btsx will be left when I come to get them back. All I care is that they maintain their value in the future as it is now."
And Bob says: "That's fine, I'll be glad to do that. So I am taking your btsx and here is a receipt you need to show me in the future to claim your btsx back. I cannot promise how many btsx will be left but I can promise that their dollar value will be as it is today."
Both parties should be happy to make a deal because this way they both get what they initially wanted: Alice is hedged in case the market price goes down and Bob is able to keep the profits from Alice's btsx in case the market price goes up. Obviously the opposite is also true: Alice will have to give up any gains on her btsx in case the market price goes up and Bob will have to cover (using his own btsx) Alice's loss in valuation on btsx in case the market price goes down.
And here comes the final trick: we can see that Alice's part of the deal with Bob has a constant revaluation in terms of USD so we can package it as a separate asset and call it "bitUSD". What's more, we can make it transferable to other people - this is possible as from Bob's perspective it doesn't really matter who the counter-party is, all he really cares for is that his part of the deal is unchanged.
Chapter 5: IMPLEMENTATION
[This chapter is a bit technical and can be skipped if you are not curious what is under the hood of Bitshares X. The crucial thing is to understand the idea presented in Chapter 4, this chapter only describes how this idea is implemented in Bitshares X. The only tricky part here is how to force Bob to deliver on his promise.]
How can the relationship between Alice and Bob be implemented inside Bitshares X? Let's try to translate it into financial terms:
- Alice's and Bob's complementary needs are matched together by the system inside Bitshares X. This can be easily done through the standard bid/ask matching.
- Alice converts her btsx into bitUSD, i.e. she sells her btsx for bitUSD. And now she is free to do with her bitUSD whatever she wants: she can keep it or sell it (for fiat USD or btsx) to anyone who is willing to buy. This way bitUSD is released into the world.
- The amount of btsx received from Alice gets "frozen" inside the system and now we need Bob to take care of its dollar value. By taking up this role Bob becomes the actual issuer of the bitUSD that Alice has released into the world.
- To perform his part of the deal, Bob is required to supply an amount of btsx equal to the "frozen" btsx received from Alice and these sums together will make a collateral which will be needed in case Bob is not able to deliver on his promise (thus the collateral is twice as big as the initial value of the issued bitUSD, theoretically it could be smaller than that but safety is a priority for us here).
- Bob just like Alice can easily free himself from the deal but in a bit different way than her. To terminate his part of the deal Bob uses his own btsx to buy on the market the same amount of bitUSD that has been initially issued by him. The important thing is that it does not need to be the same bitUSD he has issued: it can be any bitUSD existing in circulation.
- Now that Bob has equal long and short positions in bitUSD the following things happen simultaneously. First: Whatever is left from the collateral is returned to Bob - this way he is forced to accept any losses or profits resulting from the contract. Second: Bob's long and short positions in bitUSD cancel out so they can be safely removed from the system. And when this happens the amount of bitUSD initially issued by Bob ceases to exist.
- In case things go wrong for Bob and the collateral gets close to being insufficient the system automatically uses the collateral to buy back the bitUSD on Bob's behalf and then it unwinds Bob's position using the sequence of events described in .
Chapter 6: MARKET PEG
The existence of market peg means that in real life the bitUSD is what we wanted it to be, i.e. that one bitUSD is valued by the free market at one USD at all times. The definition of bitUSD implies that it should be the case but how can we be sure that the free market respects that?
Let's introduce Eve. She doesn't hold any btsx, doesn't even care about the Bitshares X concept, all she wants is a small but risk-less profit. Eve holds some USD she can use to apply the following strategy:
- If the price of bitUSD is well below one USD Eve does the following: with her USD she buys bitUSD and then with her bitUSD she buys btsx and then immediately sells her btsx for USD. She is sure to make a profit as USD has more purchasing power than bitUSD so she can buy btsx low and sell high. She ends up with more USD than she initially had.
- If the price of bitUSD is well above one USD Eve does the following: with her USD she buys buys btsx and then immediately sells her btsx for bitUSD and then sells her bitUSD for USD. She is sure to make a profit as bitUSD has more purchasing power than USD so she can buy btsx low and sell high. She ends up with more USD than she initially had.
So this is a classic arbitrage that effectively makes the price of bitUSD gravitate to one USD. This is why:
- If the price of bitUSD is well below one USD every time Eve decides to arbitrage her action will increase demand for bitUSD, thus increasing the price of bitUSD.
- If the price of bitUSD is well above one USD every time Eve decides to arbitrage her action will increase supply of bitUSD, thus decreasing the price of bitUSD.
Chapter 7: ASSUMPTIONS
Let's examine what kind of assumptions we needed to make to arrive at this point. It looks like there are only three of them:
- At all times the market cap of Bitshares X needs to be above zero so that its shares can be used to backup the issued bitUSD.
- There always needs to be an Alice and a Bob among Bitshares X shareholders so that bitUSD can come into existence.
- There needs to be an Eve, i.e. there needs to be liquidity on the btsx/bitUSD, btsx/USD and bitUSD/USD markets to allow arbitrage to keep the market peg.
Notice that we've made no assumptions about the stability of the btsx price [relative to USD]: it can be extremely volatile and the system still works. In fact the volatility can be quite helpful as it makes Alice and Bob need each other even more.
Chapter 8: THE BIG QUESTION
Actually, we've made one more little assumption: that the Bitshares X system is at all times somehow aware of the market price of btsx [relative to USD]. This can be easily done by providing a constant feed from outside sources (e.g. coinmarketcap.com). But the trick is it may turn out that even this is not necessary: the market consensus can turn out be so strong that all market participants who do not respect it will incur financial losses and thus will be discouraged from trading btsx/bitUSD outside a close proximity of the btsx/USD market rate.
A couple of years ago Bitcoin asked this question: can a currency have value without any assets backing it up? The answer so far is "yes".
Now Bitshares X asks this question: can a prediction market successfully exist with no settlement date and no delivery of the underlying asset?
If the answer turns out to be "yes" - that will be a major breakthrough: it will mean Bitshares X can exits totally free from outside dependencies.
If the answer turns out to be "no" - then Bitshares X has a solid back-up plan: the use of an external feed to supply the btsx/USD rate into the blockchain. In this case Bitshares X will turn into a prediction market betting on the future price of its own shares (with bets being between Alice and Bob).
Whatever the answer is the main purpose of Bitshares X will still be achieved: bitUSD is created and once we have that you'll be able to pay for your coffee in dollars with your phone but without any third-party intermediary.
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