Chapter 3: What is Bitshares?
Bitshares is a DAC.
But what does this DAC do?
It offers a service. The service is matching willing buyers and sellers of financial instruments and assets. In this chapter we will focus on how the Bisthares platform can be used to create and trade a financial instrument called a derivative contract. Just like in the traditional financial sector, these derivatives become assets available for trade in and of themselves.
In the Bitshares world we call these derivative contracts Bitassets.
These Bitassets can be sent from one person to another just like Bitcoin.
This allows for some interesting possibilities that we will explore together in this book.
As we explore these possibilities, I would like you to keep a couple of things in mind. We all know that Bitcoin has some tremendous advantages over all other types of money and payments, but we also know it has some drawbacks.
One of Bitcoin's biggest drawbacks is its volatility. The high volatility of Bitcoin makes it hard for the mainstream user to treat Bitcoin as a currency in a self-contained ecosystem.
It is true that in some markets, specifically the so-called "dark markets" like Silk Road, users have been forced to use Bitcoin as a currency in a self contained ecosystem. But for mainstream businesses, Bitcoin is generally received and then immediately sold into a more stable store of value. For this reason, I see Bitcoin's primary use as a payment system. Its tertiary uses are for speculation and as a store of value. If the number of people using the payment network increases, it is likely that the Bitcoin price will increase as well.
Bitcoin has many uses as a payment network— Internet sales, remittances, micro-payments, and lots more. But for the mainstream user and especially for businesses with small margins, the volatility of Bitcoin is too high. Once a payment is complete, many businesses choose to sell their Bitcoins for a less volatile asset, generally trading into their local fiat currency.
It is true that increased use of Bitcoin as a payment system will result in a higher net demand for Bitcoin at any one instant. It follows therefore that the price of Bitcoin should go up as the number of Bitcoin payments go up.
It is also true that eventually, and at a much larger scale, the volatility of Bitcoin will reduce. In fact it already has. We have noticed the volatility of Bitcoin reducing every year since its creation. That trend will no doubt continue as Bitcoin gains more traction and has larger liquidity pools behind it. But none-the-less, the volatility of Bitcoin is expected to be much higher than that of say the US dollar or gold for many years to come.
So what if we could have all of the benefits of the Bitcoin payment network, plus the price stability of things like gold, silver, the Euro or even the US dollar? If a new crypto currency could achieve that, then we would see people having no need to immediately sell the coins.
They could hold them indefinitely. They could simply save them until the next time they want to use a crypto-coin to make a payment. They could do this without fear of what the value might be at that time.
This is, in my opinion, the holy grail of crypto-currencies.
We should pause for a moment to note that Bitcoin is attempting to solve its volatility problem in many different ways. Several different companies have launched very innovative products that allow users to "lock" the value of their Bitcoins to a number of different options.
I think the best one is a company out of Panama called Coinapult.
This company is funded and supported by some of my favorite Bitcoin ambassadors like Roger Ver and Eric Voorhees.
Coinapult is essentially a hosted wallet, with a very simple interface that allows you to lock the value of your Bitcoin to one of five assets-- gold, silver, USD, Euros or British Pounds.
By "locking" your coins, you are no longer exposed to the Bitcoin price volatility. In the background, Coinapult goes out and actually secures those assets to keep themselves solvent in the case of price swings against them. From the user perspective, however, it is a very simple process. I believe the fee is 1-2% for this service, and there is a cap of $3000 per transaction that you can lock.
Using this product, you can easily lock the value of your Bitcoins. If you deposit $100 worth of Bitcoin and "lock it" to another asset, then next year or next month you can withdraw $100 worth of Bitcoin. It will not matter if the price of Bitcoin has increased or decreased during this time. You will still have $100 worth of Bitcoin.
This is a useful product for Bitcoin users, but it still has some serious drawbacks. By locking your coins, you lose many of the benefits of Bitcoin, such as owning the private keys to your wealth.
There are a plethora of other drawbacks that are mostly the result of this solution being centralized. There is one company that has control over your funds.
As I mentioned earlier, I really like the guys behind this company and have no reason not to trust them. All things being equal, however, I would rather not have to trust anyone at all. I am always looking for a decentralized, fully transparent solution where I don't have to place my trust in any single person or entity.
Just look at some of the things you have to trust when you use Coinapult's locks:
- You have to trust that management is honest.
- You have to trust that management is competent.
- You have to trust their servers don't get hacked.
- You have to trust employees not to run off with your Bitcoin.
- You have to trust their systems are backed up and the records of your deposits are not lost.
- Coinapult interacts with and hold funds in the legacy banking system; therefore, you have to hope there is not a Cyprus-style bail-in with their bank.
- The physical gold and silver backing your Bitcoin is stored somewhere and is subject to confiscation by authorities.
- If you are being sued, going through a divorce, or under an investigation of some sort and a court order compels those companies to confiscate your funds, then your funds will be taken.
The list is nearly endless.
Lest we forget the infamous Goxing incident, during which most of the above risks came to fruition for a company called Mt. Gox in the space of one year. The result? $700 million of wealth was stolen from its customers, who will now be in court for a number of years sorting out exactly how it happened. But the why is very clear: Mt. Gox is a centralized solution.
That is why, in my opinion, decentralized solutions will always win out over centralized solutions.
One of the things Bitshares has achieved is to create a decentralized "locks" solution. The consequence is quite profound. It is a crypto-currency just like Bitcoin, but with the price stability of the US dollar, the Euro, gold, silver, or whatever asset the customer desires.
These crypto-currencies with price stability are called Bitassets. And the first to begin gaining traction is bitUSD. As you might imagine, it functions just like a crypto-currency, but its value is pegged to that of the US dollar. One bitUSD is always worth close to one actual US dollar.
It is important to mention here that the deviation between one bitUSD and one US dollar is already less than 1-2%. This margin will continue to close as the market depth increases.
In addition to bitUSD, there is bitEuro (pegged to the price of the Euro), bitCNY (pegged to the price of the Chinese Yuan), bitGLD (pegged to the price of one ounce of gold), and bitBTC (pegged to the price of one Bitcoin).
If Bitshares achieves a critical a mass of users with any one of these (most likely bitUSD), then perhaps businesses will start accepting it as payment for goods and services, just like they do with Bitcoin.
If bitUSD does reach that critical mass, I think that it could eventually be the dominant payment method for online transactions. If that happens, the owners of Bitshares could make incredible profits.
Making the deal even sweeter for people to buy and hold bitUSD (or any other Bitasset) is the fact that while you hold it, you earn interest on your balance. This is another powerful feature for everyday consumers. While Bitcoin is phenomenal for merchants, its advantages are not quite as strong for consumers. Paying holders of crypto-coins interest on their holdings could be the nudge consumers need to rapidly increase their participation in the crypto-currency revolution.
We will talk more about that in the next chapter when we focus on Bitassets.
To explain this concept creates a chicken and egg situation. To understand Bitassets, one must understand Bitshares, as well as the other way around. They go hand in hand and you need to understand both to make sense of them.
I think it is useful to hold this analogy in your mind as we move forward.
Think of Bitshares as a decentralized company and Bitassets as its products. If you think these products are useful and will be used by lots of people, and you think the Bitshares company can make a profit providing these products to the marketplace, then you might decide to invest in the company by purchasing Bitshares. If your predictions are correct, then the value of the company may increase and your ownership portion of the company may increase in value. If you are wrong, then the value of your shares in Bitshares may decrease in value.
Conversely, you may not be that much into investing and may not have the time to understand how all this technical mumbo jumbo works, but still like the idea of holding your wealth outside of the banks in a stable crypto-currency that earns interest. If that is the case, you could just use one of the products Bitshares offers, called Bitassets.
I will spend the rest of this chapter talking about the business of Bitshares, and in the next chapter I will talk about the product of Bitassets.
So what does Bitshares do? Bitshares is a decentralized platform that allows users to enter into financial agreements with each other. Prior to the invention of the Blockchain, doing this in a decentralized way was impossible.
In the past, you had to have a centralized trusted party to hold collateral and enforce agreements. Now, crypto-currency can be used as collateral and the Blockchain can enforce contracts.
There are lots of different uses for this, but we are going to start by looking at the world of derivatives.
The union of Blockchain smart contract and crypto-currency technology is perfect for derivative markets.
For some, derivative markets have a very negative connotation. There is nothing bad or immoral about these financial assets in principle. However, some argue that in the traditional markets they are under-collateralized and thus dangerous. These arguments may have some merit, but fully collateralized derivative contracts do offer major advantages for business, with little downside.
I will spend just a couple of minutes going through some basics of how derivative markets work.
If you are new to this, you may want to re-read this chapter a few times, but don't worry too much if you don't get it. There are just a couple of main points you need understand, and I will recap them at the end.
A derivative is a contract that derives its value from an underlying asset. As the price of the underlying asset moves, the value of the contract either increases or decreases.
Let's use a real world example to demonstrate.
Let's say I am an American television manufacturer who purchases most of my components from China. My supplier in China prices his goods in Chinese Yuan. Let's say I am bidding to supply a hotel chain with 2,000 televisions. If my bid is accepted, then I need to know that in 6 months time, when I need my components, I can still buy them on budget, despite the price swings of the Chinese Yuan.
I have two options. I could just go and buy the Yuan or the components now, but that would hurt my cash flow. Or, for a small fee, I could enter into a derivative contract to guarantee me the price I could buy the Yuan for in 6 months time. This would help my cash flow considerably.
So let's say the price of the Yuan goes up over the next six months. In this case I would use my contract to buy the Yuan at the agreed-upon price. I would be unaffected by the price increase of Yuan.
If the Yuan goes down, then the person I have the contract with would want to force me to buy the Yuan at the agreed upon price. I would be paying over market price for the Yuan, but I had the peace of mind that I could afford to purchase it and build that price into my television contract with the hotels.
So now let's look at who might enter into that contract with me. The answer is pretty simple. There might be a Chinese manufacturer who uses American parts. They have the same problem in reverse. The Chinese manufacturer wants to lock in a price they can trade in their Yuan for dollars at a future date, in the same way I wanted to lock in a price I could trade my dollars for Yuan at a future date.
You can see how both parties benefit from this agreement.
This particular form of derivative contract would be called a future, as we are locking in the future price of a commodity. In this case, the commodities are the US dollar and the Chinese Yuan.
It is important to note that these are just contracts entered into voluntarily by two parties. They can be any variation of the above example.
A common variation would be that I want the privilege of being able to buy my Yuan for X price, but not the obligation to sell it. For that privilege I will pay you an upfront fee.
There are an infinite number of variations in the way contracts could take shape and lots of different reasons why various parties would enter into these contracts. Speculation is, of course, one of those reasons. Some people just think they know which way the price of a commodity will go and want to profit from that using the derivatives market.
I am going to leave the discussion about derivatives there for our current purposes, but I will mention these four important things.
1
The size of the derivatives markets is estimated to be over $700 Trillion. It is humungous. It is orders of magnitude larger than the entire world's GDP. To say that bringing an efficient innovation to that world may have some upside to investors could be the understatement of the century.
2
If everyone just had a variety of contracts with no commonality between them, they would not be very liquid. Every contract would be unique and not easily transferrable. So, contracts with standard terms have been formed to solve this problem. For example, you might have a market for a gold futures contract maturing on January 1st, another on February 1st, but not on all the days in between. Because everyone in the market has his or her contract maturing on the same day, this allows for a highly liquid market. Traders can trade them minute by minute, as the price of the contract fluctuates. The derivatives themselves become assets. Even better yet, they become fungible assets. That means any contract with the same terms as mine is identical, and thus can be easily exchanged. This is really important, so please remember that. The derivative becomes a fungible asset itself. On December 2nd I can buy a contract to acquire gold at a certain price at a future date and sell that same contract to someone else on December 5th. The high liquidity and fungible nature of these assets make them very useful, as we will see shortly.
3
Contracts are often settled and secured in value only, and not in the actual commodity. For example: I may have a contract to buy 1 ounce of gold from you for $1,200 in 30 days. The current price of gold is $ 1,200 per ounce and so you have a 50-50 chance of making or losing money. You choose to charge me a small fee for this privilege.
But, how do I know that you have the gold to give me? The contract would be most secure if you put either the gold or the dollar amount of the gold in escrow with a trusted third party to cover your obligation to me. That would give me certainty that you can deliver on your promise. But gold, wheat, oil, copper, corn and most other commodities are clumsy and expensive to move around. So, people usually just deposit some dollar amount with a trusted third party as security, without touching the underlying commodity.
So let's examine that a little closer. Let's say the 30 days has elapsed and I have the right to buy gold from you for $1,200 per ounce. But the price of gold has moved to $1,300 per ounce. Now I must put in $1,200, and you must put in $100, for me to get a $1,300 ounce of gold from the market.
You can see in this instance that in order for you to cover your promise to me, you only needed to deposit a fraction of the dollar amount of your promise. In order to guarantee me a price of $1,300, you only had to deposit $100 as security. However, at the start of the transaction, we don't know how much the price would swing or how much you will need to cover. Traditionally, the more stable the commodity, the less the security there needs to be.
But what happens if your security is not enough? Let's say you only deposited $50 as security in the above example. After 15 days or so the price of gold has moved to $1,250 per ounce. I have a promise to buy the gold for $1,200. You have $50 as security. If the price goes up any further, there will not be enough money to cover the position.
At this point, one of two things can happen. One option is for you to put in more security to cover your position. This is known as a margin call. Alternatively, the trusted third party can give me the $50 security now, so I can go and buy a new futures contract for $1250, using my $1200 and your $50. Remember that the price of the derivative contract is derived from the underlying value of the asset. The new derivative contract will cost me $1250, and I am not out of pocket.
The important thing to note here is that access to the underlying commodity is not necessary. The actual physical gold is nowhere to be seen in this transaction. These are financial instruments. As long as value can be transferred, the integrity of the contract is held. The form of that value is not significant; as long as it has value and is (preferably) liquid, the derivative market works.
4
There are lots of people who are a putting up security and offering these contracts. And there are lots of people buying these contracts. For these derivative contracts to be created, the two parties need to be paired up. There needs to be a buyer and a seller. But because these contracts are on standard terms, they are fungible. The parties can be interchangeable. Let's again look at the above example where you had to put in more security on the 15th day or the trusted third party would give me your $50. In reality, as the $50 security is dwindling, the escrow goes to the market and buys back a contract. This can be any contract of the same type because they are all fungible.
So just because the person I was paired up with to create the contract was forced to buy his contract out, does not mean that he must buy his specific contract back from me. In fact he can by any other contract of identical terms. In a contract with me he is the seller at $1200 and in another he is the buyer at $1250. He no longer has any exposure to the price of gold as he has both bought and sold one ounce of gold. I still have my contract for an ounce of gold at $1200 even though he has closed out of his position.
That is the power of fungible contracts.
Once these markets hit significant volume, there are always people who are willing to take a position for profit. These people are called market makers. These speculators, for a price, will always take a position and these derivatives can exist indefinitely.
In a moment we will see why all of these things are important, so if it does not make too much sense at the moment... be patient. I think it will become clear in the next chapter.
What is important for you to understand now is that these derivative markets exist and are functioning.
To ran this $700 trillion derivative market, there are exchanges all over the world, huge buildings are erected, thousands of people are employed, large bureaucracies are paid for by taxpayers to reduce fraud and illegal activity, and huge accounting and auditing firms must be engaged to monitor the flow of funds to stop embezzling and other forms of theft.
The resources spent on running these exchanges are huge. But obviously the fees that these exchanges charge their users to create, buy and sell these derivative contracts are more than enough to cover these enormous costs.
Despite all of these measures, embezzling still takes place, fraud is still rampant, and corruption is rife.
Blockchain technology promises:
- To create a fraud free environment.
- An exchange where we do not have to trust bureaucrats, auditors, politicians, bankers, or anyone else.
- An environment where all of those people are completely cut out.
- An environment where all we have to trust is the mathematics of the Blockchain.
And best of all, a decentralized exchange based on the Blockchain can make all of these improvements while reducing the costs by over 99%.
Bitshares is the first decentralized exchange to be released into the ether and I don't think the world will ever be the same again. Our ability to own part of Bitshares is what this book is all about.
By downloading the free open source software, anyone, anywhere in the world can engage in offering or accepting derivative contracts with anyone else. You do not need any middlemen. You do not need to give up any of your financial privacy. You do not need to trust any other person. You do not even need to trust the person you are in contract with, because the Blockchain will enforce all contracts, no matter what.
Just as derivative contracts become highly liquid assets in traditional markets, Bitshares allows users to create these same contracts on the Blockchain and trade them as assets. Just as we send Bitcoin to one another now, we can also send derivative contracts. As we said earlier, in the world of Bitshares we call them Bitassets.
We will examine just one of those Bitassets (bitUSD) in the next chapter, and I think it will really help your understanding of how it all works.
But before we do, I think it is worth noting even if these Bitassets had no other utility, what we have already learned could send Bitshares skyrocketing in usage as an efficient decentralized exchange in a $700 trillion marketplace.
As amazing and as exciting as that is, that is not the most exciting part about Bitshares and Bitassets. The next two chapters will explain why.
By the way, I know this is tricky stuff. So congratulations for sticking with it so far. If the concepts have not solidified in your mind, sometimes visual aids can be very helpful. I found an excellent video on Youtube that goes through futures contracts step by step. You may find it useful to help you understand exactly how they work.
You can check it out here.