Chapter 4: What are Bitassets (like bitUSD)?
Now it's time to talk about the products that Bitshares offers.
Please be mindful that although it may be complicated under the hood, the usage and benefits for the consumer is super simple to understand.
Just like the average Bitcoin user has no idea what en elliptical curve is or how cryptography works, so too users of Bitassets need not know how the technology behind Bitshares or derivative markets work.
I have aimed this book more at individuals interested in understanding and investing in the next generation of crypto businesses, and therefore, it is more educational than promotional in nature. Because of my audience, I will be going into details that most end users of the products will not be interested in.
I believe that bitUSD will be even simpler to use than Bitcoin however the underlying system is quite complicated. In this chapter I will explain the more complicated aspects of Bitassets. In the next video I will explain the simple but powerful result that customers can enjoy without having to know any of what you are about to learn.
Let's begin.
As we explained in the previous chapter, derivative contracts are assets. On the Bitshares Blockchain, we call those assets Bitassets.
These Bitassets can be transferred from one party to another just like Bitcoin. The cool thing is that we can structure these assets to have a stable value. The result will be a crypto-currency just like Bitcoin, but with the stability of the underlying asset, like the US dollar.
ABitasset like that is called bitUSD.
So let's start by taking a look at the underlying derivative.
A bitUSD is created when two parties enter into a contract.
Bob says to the marketplace "I am an investor in Bitshares. I have bought and own shares in Bitshares. However, I think it is such a great investment that I would like to buy more Bitshares. Can anyone lend me $1 so I can buy an additional $1 worth of Bitshares?" Bob continues his pitch, "So that you can be sure I will pay the loan back, I will put that $1 worth of Bitshares on the Blockchain in escrow, and I will put 2 additional dollars worth of my own Bitshares into that escrow so that your loan is securitized by 300% capital. For the privilege of borrowing your money I will pay you an interest rate on your $ 1 until I pay it back. Will anyone enter into this contract with me?"
Sally hears this. Sally is not much of risk taker. She does not care much for speculating on the future value of Bitshares. She just wants to keep her savings nice and safe, and hopefully get a nice little interest rate return on her money. Sally wants the peace of mind that she can get her $1 back at any time. She recognizes that Bitshares is a new concept and is liable to have large fluctuations in price. She is concerned about the safety of her money. Sally is comforted by the fact that the Blockchain is holding 300% security for her loan. That means the price of Bitshares can fall by up to 66%, and her money is still protected. Upon further examination, Sally learns that the Blockchain will check regularly what the price of Bitshares is compared to the US dollar to make sure that Bob has enough security. That means that Bitshares would have to fall by 66% in value in a matter of minutes or possibly hours in order for her to potentially lose money.
She recognizes that in Bitcoin's entire history it has never been so volatile as to lose more than 66% of its value in minutes or hours, and she knows Bitcoin was really volatile back in its early days. Sally decides the reward of the interest rate is worth the potential risk. She enters into a contract with Bob.
Sally puts S1 worth of Bitshares on the Blockchain for Bob. Bob adds his $2 worth of Bitshares on the Blockchain to protect Sally and a bitUSD (a derivative asset) is born.
A bitUSD is a derivative contract that promises one party, in this case Sally, one US dollar in value at any future date.
The contract also states that Sally will earn interest on you her loan. To secure the contract, 300% collateral is held on the Blockchain.
Sally holds this bitUSD in her online wallet. Just like all crypto-currencies, there are no third parties, and only with Sally's private key can the bitUSD be sent to another party.
Because the bitUSD is a promise to pay $ 1 worth of value at a future date, its value is always close to $1. The result is a crypto currency just like Bitcoin, but with the stability of the US dollar.
What Bitshares has just done is replicate the Locks feature of Coinapult in a decentralized way, with no third parties, and for a fraction of the cost.
Whoa!!! That is a huge achievement. Previously, it was not possible to have a crypto-currency with a stable value.
We will explore some of the implications of this in the next chapter, but for now, let's go back and fill in some details.
Detail #1
Just like in the traditional market for gold derivatives, real gold is not necessary. So too, real US dollars are not needed to secure these US dollar promises. As long as the value is there in some form and is offered as security, the market functions.
In the traditional markets, you might deposit dollars to a trusted third party as your security to enter into a gold derivative.
On the Bitshares platform, you deposit shares in the Bitshares exchange to the trusted Blockchain as your security to enter into a US dollar derivative.
Detail #2
What is the interest rate Bob offered to pay Sally? In fact there are many Bob's and many Sally's. The Bob's specify the interest rate they are willing to pay to borrow dollars. When the Sally's come along, they take the highest interest rate on offer. When a Sally lends to a Bob, then a bitUSD derivative contract will be born.
Now if all of the bitUSD contracts had a slightly different interest rate, then they would not be fungible. This is not desirable. So while all of the Bob's may pay a slightly different interest rate, the interest is pooled and all of the Sally's get the exact same interest. It is a variable rate that depends on the interest rate promised by all of the Bobs on all of the outstanding loans. The result: All holders of bitUSD earn the variable interest rate on each bitUSD they hold.
I would also like to mention one other useful aspect of a Bitasset.
They are divisible. This is different to traditional derivative products. In those markets a contract may be for, say, 5000 ounces of gold. There is no way to cut that contract up into smaller pieces. With Bitassets that is not the case. They are divisible. Sally could open a contract for 500 bitUSD with Bob, and then pay 75 cents for a newspaper with that bitUSD.
Detail #3
How much collateralization is behind a Bitasset like bitUSD? Bitshares is very conservative in its collateralization limits. By comparison, on most major FOREX exchanges, you could trade a currency pair with only 1 % security. That means that by only putting up $1 of collateral, Bob could promise Sally $100 of value. In other words, only 1% collateral is required. This is because those currencies are traditionally very stable. As long as the value of that $100 does not fall below $99, then the $1 collateral will be sufficient.
Because Bitshares is new and its volatility for the short term is high, it must gain the trust of the community. Therefore it chooses to demand 300% security to engage in contracts. That means that the $100 worth of value that Sally lent Bob to buy Bitshares is combined with the $200 worth of Bitshares that Bob already has. This $300 worth of collateral is held on the Blockchain to securitize the 100 bitUSD. The Bitshares remain there until Bob repays his loan plus interest and retires the bitUSD that he and Sally created.
That is 300% collateral in Bitshares versus 1% collateral in traditional markets.
Detail #4
At what point is Bob margin called? Again, because Bitshares is new, it uses a very conservative approach. When the $300 worth of Bitshares falls below $200 in value, the Blockchain will automatically use Bob's security to go out and buy $100 of bitUSD from a Sally to close out this Bob. Not necessarily the same Sally, though. Of course for a price there will always be a Sally. If you had 100 bitUSD, would you sell it to me for $110 worth of value? Of course you would, as you just got $10 for free. In this way, bitUSD is always collateralized by at least 200%. Of course, it could also be much higher, assuming lots of different Bobs with various levels of collateralization of at least 200%.
If the Blockchain does margin call Bob, he is charged a rather large 5% fee on security that is released back to him. For this reason, most Bobs choose to keep an eye on their investment and top up their collateral before a margin call ever takes place.
Detail #5
How does the Blockchain know the price? While Blockchains are great at working on their own in a trustless way, they are not very good at interacting with the outside world. If the Blockchain needs to initiate a margin call, it must know the price of one Bitshare compared to one US dollar. How does it know?
This is another of the technological leaps that Bitshares has pioneered. In the bonus chapter at the end of this book we discuss Delegated Proof of Stake (DPOS). You may have heard that Bitcoin uses a consensus algorithm called Proof of Work. Bitshares uses DPOS, which has a number of advantages that we will explain in detail in the Bonus Chapter.
At this point we just need to understand that a panel of 101 elected delegates secures the Bitshares Blockchain.
These delegates have two primary functions: The first is to create blocks and secure the network, much like the function of Bitcoin miners. The second is to provide price information to the Blockchain. This is called the price feed. Delegates enter in the real world price of the Bitassets underlying commodity, like the US dollar or gold. The software establishes the median to reduce the potential for a bad acting delegate to manipulate the price. Prices published by the delegates are public, and any attempt to manipulate the price would result in a delegate being voted out pretty swiftly. In practice, delegates update prices quite often during high volatility and less often during stable times.
No guarantee can be offered as to how often the price feed is updated, but delegates' income is on the line. Failure to produce regular price data during times of high volatility will most likely result in them being fired and their income going to someone who will be more prudent.
This is the one area in which Bitshares relies on trust of humans and not on mathematics. There are many mechanisms in place to provide the right incentives for good behavior and eliminate any upside for bad or tardy behavior. The net result is a system that is not quite perfectly trustless. It is however completely transparent and requires significantly less trust than legacy or traditional systems.
I think these are the most important points for you to understand about Bitassets like bitUSD.
Now let's start to revise and take a look at the implications of what we have learned.
Bitshares is a powerful marketplace that matches buyers and sellers of financial contracts in the world's first fully decentralized way.
This technology is just months old, and already it has the promise of allowing a derivatives market that is significantly more secure and orders of magnitude less expensive than the ones we currently have on Wall Street.
Five derivative products are already actively trading on the Bitshares platform.
They are: BitUSD, BitCNY, BitEUR, BitGOLD и BitBTC.
Traders can and are trading in and out of these derivative products on a daily basis.
If confidence grows, and awareness of this technology spreads, then many more derivative products will become available and liquidity in each Bitasset will deepen.
It just may begin to take a bigger and bigger slice of that $700 trillion derivative marketplace.
Even more exciting is the fact that just like Bitcoin and the TCP/IP protocol of the Internet, Bitshares at its heart is a relatively simple open-source protocol. The real magic occurs when entrepreneurs begin to build new and useful products in and around this new paradigm.
Thanks to Google, Facebook, Twitter, Wordpress and millions of other companies, the TCP/IP protocol of the Internet has changed our lives in profound ways.
Thanks to companies like Blockchain, Bitpay, and BitFinex, the Bitcoin protocol is well on its way to doing the same.
So too, with early adaptors and entrepreneurs working on web services built on the Bitshares protocol over the next 10 years, we will see the true power of this amazing technology begin to take shape.
Now, enough with the complicated stuff. In the next chapter we will take a look at what it all means to the end users of bitUSD. I think you will be amazed at how simple it all becomes and just how unique and valuable to the consumer a Bitasset is.
Before we leave this Chapter, I wanted to share with you another video I did with the Satoshi Nakamoto of Bitshares, Dan Larimer. In this video Dan shares his vision for Bitshares. I think you will really appreciate the beautiful world that Bitshares can help create. I find it particularly interesting to hear Dan speak about this thing that he helped build and put into the universe that he no longer has control of.
I think the message of liberty that is the core behind Dan and Bitshares will really resonate with you. Just like Satoshi Nakamoto before him, he has no interest in controlling his fellow man or even his very own creation. Bitshares is a gift to the world, open-source and free for everyone to use if they wish. A tool for every person on the planet to use to contract with each other in a peaceful, private and voluntary way that has never existed before.
Enjoy.