Bitcoin and similar crypto-currencies track transferrable digital tokens secured by private cryptographic keys over a decentralized computer network. A consensus mechanism ensures tokens are not duplicated and all participants agree on the state of the system without need for a central validating authority. This consensus is recorded on a decentralized shared ledger called a "blockchain." These systems have been found to enable value storage and exchange over the internet 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 core token simply called BitShares that is traded with the abbreviation "BTS" on well-known crypto-currency exchanges. Like Bitcoin, the exchange rate between BTS and major currencies remains volatile.
A BitShares market pegged asset can be viewed as a contract between an asset buyer seeking price stability and a "short seller" seeking greater exposure to BTS price movement. The open source BitShares software program implements a decentralized marketplace for market pegged assets where all transactions are recorded on the shared blockchain ledger and the software enforces the market rules. This blockchain based marketplace is referred to as the "internal market" to distinguish from "external markets" such as websites that facilitate the exchange of government issued currencies with crypto-currency. A BTS holder may use her BTS to place a buy order on this internal market for her asset of choice. Market pegged assets are created on the BitShares blockchain when a buyer and short seller of an asset are matched at an agreed price. In exchange for the BTS received from the asset buyer the short seller takes on the obligation of buying back the same quantity of assets in the future from the market. BTS paid by the asset buyer and additional BTS contributed by the short seller are sequestered as "collateral". This collateral is only returned to the short seller when assets are purchased back from the market and effectively destroyed to fulfill the contract. This is referred to as "covering a short." If the value of the collateral relative to the current price of the market pegged asset falls below a certain margin of safety the assets can be automatically repurchased from the market before collateral becomes insufficient. These rules create systemic demand for market pegged assets while allowing them to remain fungible.
The previously described implementation for market pegged assets was conceived and outlined by Daniel Larimer in June, 2013. It was hypothesized at the time that with sufficient market depth, market pegged assets may track the value of their counterparts by virtue of self-reinforcing trading behavior. For example, if market participants expect the most likely value of a market pegged asset called "bitUSD" is to track the US dollar then buying bitUSD when it is less than $1 and selling it when it is above $1 would be profitable so long as other market participants do the same. Conversely, traders selling "underpriced" bitUSD or buying "overpriced" bitUSD would incur added cost as the broader market trades toward dollar parity. However, It has more recently become clear that this market prediction mechanism is not sufficient. In the absence of persistent demand for bitUSD, short sellers might push the bitUSD price lower and lower. It would eventually be possible for a short seller to sell millions of bitUSD for the price of only $1 worth of BTS. This newly abundant bitUSD would allow previous short positions to cover and no one would pay face value for bitUSD backed by insufficient collateral. The idea there would always be buyers to buy "underpriced" bitUSD is replaced by the reality that another restriction is needed.
It is reasonable to question what additional mechanism, if any, will ensure that the internal market between bitUSD and BTS reliably tracks the external market between USD and BTS. To achieve this reliable long term parity the BitShares' market algorithm will need access to reliable information about the real exchange rate between BTS and US dollars on external markets. It is not immediately obvious how to get this external exchange rate information into the BitShares internal market in a way that is resistant to control and manipulation by a central party. Thankfully, the consensus mechanism used for BitShares utilizes a carefully considered real-time stake weighted approval voting system to elect "delegates" who are motivated to act in the best interest of the system and its stakeholders. These delegates are tasked with running the BitShares network and checking and committing broadcasted transactions to the blockchain ledger. The trusted delegates can also be used to input external exchange rates into the blockchain so that the software algorithm can incorporate this information into the market rules. This external exchange rate information is called a "price feed." Delegates typically combine price information from multiple sources, such as external 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 considerable collusion. The price feed and other delegate behavior is publically auditable and delegates may be voted out by BTS holders at any time.
It is important to consider how the price feed can be used to regulate the internal market. Both BTS and market pegged assets are freely transferrable tokens. If the internal market restricted trading to occur only at the specific exchange rate determined by the median price feed, it would simply encourage anyone willing to trade at a different price to do so outside the system, such as on an external exchange. However, if we consider that short selling is the mechanism by which new market pegged assets are created, then selectively restricting short selling controls the conditions under which supply is created. Rather than allow short sellers to sell at any price, short sellers will only execute at a price above the median price feed. This prevents short sellers from devaluing market pegged assets as new assets are only created when the market demand pushes the price equal to or above parity.
The price feed functions to regulate creation and destruction of market pegged assets in a way that pushes the market price toward parity. When a short seller buys back bitUSD and covers their position they are taking bitUSD out of circulation and reducing the total supply. In fact, the current BitShares market rules force short sellers to cover their position within 30 days of opening the position. This means that the full amount of outstanding bitUSD must be purchased off the market every 30 days. Market pegged asset holders have no requirement to sell and therefore short sellers covering their positions are eventually forced to purchase from newly opened short positions 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 (determined by price feed) within any 30 day period.
The motivation to participate in the system is different for short sellers and market pegged asset buyers. Market pegged asset holders are typically looking for predictable value coupled with the properties of a crypto-currency. Short sellers are typically bullish on the price of BTS and wish to capitalize on increased exposure to market movement relative to 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 and profit accordingly. If BTS value falls in relation to the market pegged asset, the short seller faces a greater loss than if they were to have simply held BTS. Ultimately a short seller may face a "margin call" where his collateral is automatically used repay the obligation. A margin call is triggered in the current BitShares system whenever collateral contains less than 1.5 times the amount of BTS required to cover the obligation. The system also charges an additional 5% fee to any short seller subject to a margin call and this fee is intended to motivate short sellers to maintain sufficient collateral.