(EDIT: Note this piece is the first of a series I call the BitMarmot Saga. Feel free to read the rest!).
BitShares – which I’d thought for the longest time was vapourware, but which inexplicably has been developed and even had the cojones to launch a $5 million Bitcoin IPO – was brought back into frame today with the news that they’re having a chat with a certain other “2.0” ledger about collaborating.
For those of you who don’t know BitShares, it purportedly works like this:
1) Get some dev funding, crypto style
No VC-friendly business plan? No problem! Issue cryptotokens called BitShares X. Make damn sure you include the X, because everyone knows adding “X” to something makes it edgy and cool. It’s just like any other cryptocurrency, but these are “shares” in a “DAC bank.”
Sell BitShares X to the public. Fail to file a prospectus. Actually call them shares, and pray that the SEC is asleep at the wheel:
2) Drive some hype
BitShares X need a market value like any other cryptocurrency (at time of writing, $ 0.0106). Moon ahoy. Use long-form technobabble. Bonus points if you have a slick website, forums and a wiki. Make claims in sympathetic media…
BitShares X will resolve the problems arising from fractional reserve banking, naked shorting, and high-frequency trading manipulation.
…and hope/expect nobody calls you on it. Or even worse, actually believe what you’re saying is correct.
3) Have a USP…
But unlike any other crypto, these are shares (they’re actually not shares, since ‘decentralised companies’ aren’t actually companies), so they’re valuable on that basis as well! Holders of BitShares X get payments of “dividends” from income of the “BitShares Bank.” Make some representations too, such as:
Exclamation point original.
4) …but remember, it doesn’t need to make sense
Create “BitAssets”, such as BitUSD or BitMarmot, “pegged” assets to be launched some time this month, out of thin air and make these digital assets available to BitShares X holders by way of a loan:
BitShares X can create BitUSD by lending it into existence backed by collateral in the same way that the banking system lends dollars into existence today. Whereas your bank uses your house as collateral, BitShares X uses BTSX as collateral. If the value of the collateral falls relative to BitUSD then BitShares X will automatically cover your loan by selling the BTSX held as collateral for BitUSD and giving the borrower the BTSX is (sic) left over.
In case you don’t think you’re reading that correctly:
Just like real banks, BitShares requires collateral for the loan and the only collateral BitShares has the ability to foreclose upon is its own equity. When you borrow money for a house the bank usually requires at least 20% down to protect the bank in the event your house loses value. In the case of the BitShares DAC the bank requires a 50% downpayment. Someone wishing to borrow $100 dollars from the BitShares DAC must find $200 worth of equity (bitshares) to back the loan. Lets assume they have mined $200 worth of equity, they can mortgage this equity and receive 100 BitUSD in exchange for a lean (sic) on their equity that can only be cleared by paying back 100 BitUSD.
That’s actually a 200% down payment. But who’s counting?
The scenario described is sort of like buying a mortgage that’s secured on itself instead of a house. Except, when you buy this mortgage (the third mortgage) from the originator, you need to deposit two more mortgages on the same home with the originator that also secure themselves as collateral, which you bought and paid for already at par in dollars. After buying the third mortgage, which is actually lent to you, you have to pay the bank for the privilege of holding and trading it.
Put differently: these transactions make no commercial sense.
But that’s OK, because in cryptoland, ceci n’est pas un dollar:
With an effective yield on BitUSD of 20% per year you must compare it against other USD investments, such as lending it to the bank at 3% per year. By performing a net present value calculation you can determine that 1 BitUSD should sell at about $1.14 based upon yield alone. This value must be adjusted based upon any premium paid for the cryptocurrency features and any discount paid for cryptocurrency risks. These premium / discount rates will cause the price to fluctuate between $1.10 and $1.20 and over time that range will narrow as the perceived risks decrease and benefits become clearer.
As a friend of mine puts it, “no convertibility, no parity.” But a synthetic dollar trading 10-20% above par?
I can’t even.
Keep reading. It gets even better.
5) Collateralise. Because if you can call it “200% reserve banking” and say “schelling point” enough everyone will be reassured
In the words of Hunter Thompson,
When the going gets weird, the weird turn pro.
In finance, that roughly translates as “start messing around with derivatives.” Doing derivatives right, however, is not easy, and is best left to qualified professionals. I’m not sure BitSharesX quite makes the grade.
The BitShares Guide explains:
There are no real assets behind BitAssets, i.e., there is no gold in a vault backing BitGold. However, BitGold is backed by an equivalent value of BTSX, so it isn’t like it isn’t backed by anything. If you want BitGold, you need to put up collateral in the form of BTSX.
So BitUSD (or BitGold, BitOil, BitMarmot, BitWhatever) don’t actually exist. BitAssets are, at their core, representations of pools of BTSX collateral. They are, furthermore, the subject matter of contracts on a prediction market which are used to maintain the desired dollar peg in respect of that BTSX collateral.
The loan which constitutes each asset is intended to act as the facilitator for a short sale of the BitAsset vis-a-vis the underlying BTSX:
First, you borrow the [BitAsset], then you sell it at today’s high prices. If all goes well then you can buy it back tomorrow for less than you paid today, pay off your loan, and keep the profit. However, if things go against you then you will have to pay more to buy back the stock than you sold it for in the first place and thus take a loss.
For example, if you want to short 1 BitBTC and the current market price of BTS/BTC is 0.1 (meaning 1 BTC is priced at…10 BTSX) then you need to provide a margin of 2 x 10 = 20 BitShares on this short position. If the price moves unfavorably to the short, then there is a short squeeze wherein the protocol automatically sells these 20 BTSX to cover the short position. The proceeds are paid out as dividends to all the holders of BitBTC.
So not only is a BitAsset a repackaged pool of BitShares, it’s
- a collateralised BTSX derivative
- which in economic substance is worth the losses that will be realised by either counterparty which are drawn from the obscene amounts of BTSX collateral posted thereunder and
- which has a lot more to do with the price movement of BTSX than it does with any characteristic of the label (USD, Marmot, Gold) the BTSX engineers ascribe to it.
Anyone bringing a BitAsset into existence will be betting that BTSX will rise vis a vis the price of that associated asset. The market on the whole is structured to require the amount of BTSX which need to be purchased in order to deal in BitAssets to be a minimum of three times greater than the nominal value of the assets listed thereon, on account of the onerous collateralisation requirements.
Most significantly, anyone who wants to bet against BTSX versus a BitAsset (though it might make more sense to just short it against Bitcoin on, e.g., a third party exchange… whatever, moving on) cannot do so without buying BTSX and posting BTSX as collateral first.
Those who take the opposite side of the trade benefit as a class by way of “dividends” paid from these vast BTSX collateral pools if the price of BTSX falls, and not by dint of the terms of the individual contract they’ve concluded.
Abundance of weird. Absence of pro.
If I haven’t used stronger language to describe this arrangement, it is because I don’t sense any malice in the BitSharesX team/promoters – just ignorance as to how financial contracts work. I’m trying to be polite.
6) But whatever you do, don’t tell the users that it’s actually their own BitShares collateral which backs BitAssets, because that’s liable to piss them off. Tell them it’s “better than a Swiss bank” instead
The problem is that BitAssets are just repackaged exposures to BitSharesX. If the price of BTSX always rises and you’ve gone long BitAsset, no problem – your collateral gains in value as quickly as your exposure rises under the derivative, so you lose nothing. But when price movements in BTSX start going in the wrong direction – i.e., downward –
- the collateral gets burned through extremely quickly,
- maintaining the peg means that losses can exceed the value of the BitAssets themselves, and
- given a significant enough market-wide fall in BTSX value, the BitAssets themselves will get dinged once the collateral pool runs out of firepower and/or the speculative bubble in BTSX pops.
Which isn’t great if you’re running what you purport to be an asset exchange and a bank.
Let’s do a worked example to see just how bad this could get – and how easily it might unfold. Say a real company – GM – sets up a system on the BitShares model (we’ll say the whole ecosystem is BitGM). GM recharacterises a loan equivalent to par value of $100 in GM stock “100 GMDollars” – and requires the party shorting GMDollars (Party A) to post $200 of stock as collateral and the party going long (Party B) to post $100 of stock as collateral. If GM’s stock falls by 50% in the interim, (1) Party A’s collateral falls to $100 in value (reduced by half), (2) Party A has to pay back the full GMDollar loan in the bank (it has no substance apart from the derivative, and thus should not be double-counted), (3) has to apply any remaining balance of its collateral to pay Party B under the derivative ($50). Although Party B is paid the $50 of GM stock it is due under the contract, Party B also has $100 in collateral locked up for its end of the trade – collateral which is also made of GM stock.
All in all, the BitAsset ceases to exist, Party A is out at least $150, Party B just breaks even, and (considering the parties put $300 into the transaction) that means half their dollar investment is wiped out. And hey, would you look at that – this exactly corresponds to the fall in the price of the stock, 50%. Magic.
Perhaps most importantly, Party A loses 300% of what he would have lost totally unhedged, and 50% more than if he had taken $100 USD and burned it.
So I ask: how long does it take for an alt coin to lose 50% of its value? And is this one any different?
Of course, BitShares X has thought of the possibility of rapid downward price moves, saying:
With BitShares X all short positions (those borrowing BitUSD) must start out with enough BTSX as collateral to purchase 2x the USD borrowed. Margin calls are executed when the value of the collateral falls to 1.5x the amount borrowed. This gives the market ample opportunity to cover the short position and pay off the loan before there is insufficient collateral. In the event that the market is forced to execute a margin call, a 5% fee will be assessed. This should encourage participants to be pro-active in maintaining sufficient margin.
Three words: cascading margin calls. Especially when your “assets” are just wrapped BTSX.
The result of this price movement is that some BitUSD will be in circulation without any backing which may or may not impact the market peg of BitUSD to USD. We have two hypothesis (sic) as to the market response in this event: in one case the BitUSD will start trading at a discount proportional to the surplus BitUSD in circulation, in the other case the market expectation of a peg to USD will override any surplus supply and BitUSD will continue trading as before.
So either people will figure out BitAssets are the same thing as BitSharesX, or they won’t.
No word on what happens if the price of BitShares collapses completely, such that every BitAsset is chronically under-collateralised. (Which arguably they are already, as BitShare-based assets are backed by themselves. BitShares’ words here, not mine.)
By now my views on the subject should be pretty clear. But this is crypto, so naturally I’m wrong and BitShares’ promoters are right. New paradigm, this time it’s different, etc. etc.. We are meant to believe that BitSharesX, paired with aforementioned prediction market, a pretty unicorn and a BitSharesX price that never falls, will allow BitUSD to become permanently and securely pegged to USD. The same principle applies, mutatis mutandis, to any other BitAssets the BitShares ecosystem elects to create:
- across all BitAsset classes;
- with BitShares and USD acting as reference assets at the same time; and
- with particular, exchangeable instances of BitAssets being backed by different quantities of BitShares collateral.
8) …it’s still a pig
Require the borrower to repay you with… what else? BitAssets, which are created from/purchased with BitShares! And pay dividends to BitShares holders from the interest repayments and/or losses on short positions. But everyone still wins:
The incentive for savers is that BitAssets pay dividends whereas real-life entities don’t. Put another way, if you hold BitGold for a year, then convert all of that back into physical gold, you’ll end up with more gold than you started with, assuming BitGold tracks Gold prices perfectly.
If you own BitBTC you can earn dividends on your bitcoins… If you have a thousand bitcoins and you convert them to BitBTC, and then you hold it for six months, then you convert the BitBTC plus the dividends you received back to bitcoins, you’ll end up with more bitcoins than you started with.
I still can’t even.
…although it’d be nice to have more marmots running around.
11) But as long as you’ve done all of this, why stop there? Might as well have two other BitShares-labelled cryptos – AngelShares and ProtoShares – on the go at the same time, each of which are structured in a similarly curious fashion, because the only thing better than one altcoin under one roof is three of them.
So on my reading, BitAssets are
- willed into existence by a DAC;
- a liability of the DAC which is somehow secured by BitShares, each of which in fact represents proportional ownership in the DAC itself (check out a balance sheet – last time I checked, a company’s own equity wasn’t an asset of the company, but a claim against it);
- priced by reference to the price of BitShares;
- repaid in BitShares or assets backed by BitShares;
- which in turn are backed by more BitShares, because the BitAssets were created by being lent at a fixed rate of interest to holders of BitShares who are required to post 200% cash collateral – money they actually have at their disposal – in BitShares.
Where I’m left is that this is a month-old cryptocurrency that makes money by issuing redeemable asset-backed promissory notes, a valuable business from which its “equity” – i.e., BitShares – derives value. Those notes – which are in fact derivatives – are then secured by BitShares (which, recall, those notes are supposed to make valuable) to 300%+ of their notional value, which gives the notes value in exchange. Any gain or loss on the transaction is drawn from this collateral. And any hedge the parties attempt by reference to any asset on the BitSharesX exchange – because any such hedge would ultimately be denominated in BitShares – has the effect of increasing their aggregate exposure to BitShares.
Dividends on the downside, asset price growth on the upside – it all seems too good to be true. The high degree of collateralisation and attendant risks participation in the BTSX ecosystem requires means that returns have to be astronomically high to justify such participation, levels of returns really only seen in very limited circumstances. I’m forced to conclude that the only way BitShares makes sense is in the context of asset price speculation on the BitShares themselves.
Me personally, I’d rather just hold onto my hard-earned USD and not buy BitSharesX in the first place. Especially when I’d have to spend $200 to get exposure to $bit100. But then, I’m naturally a cautious fellow; so good luck to you, buyer, but beware.
When the value of the BitShares you post as collateral to obtain these BitAssets falls – these betting contracts have more than just a long and short BitUSD element, you’re not only betting on BitUSD but also on the value of BitShares themselves – your BitUSD will not be sufficiently collateralised to trade at par. To repay your loan the BitShares Bank will automatically execute the margin call and seize your BitShares collateral. You will be left with undercollateralised BitAssets and whatever residual BitShares you’ve managed to get out of escrow.
This self-referential system is now one of the top 10 cryptos by aggregate market cap in the world, and rising.
What could possibly go wrong?