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Update 2014-12-18-What-are-BitShares-Market-Pegged-Assets.md #33

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BitShares market pegged assets are a new type of freely traded digital asset whose value is meant to track the value of a conventional asset such as the U.S. dollar or gold. What makes market pegged assets unique is that they are free from counter party risk. BitShares uses an advanced decentralized consensus ledger that takes some cues from Bitcoin. While Bitcoin has demonstrated many useful properties as a currency, its price volatility makes it risky to hold and difficult to use for everyday pricing and payments. A currency with the properties and advantages of Bitcoin that maintains price parity with a globally adopted currency such as the US dollar has high utility for convenient and censorship resistant commerce. This paper will explain how market pegged assets including "BitUSD" (intended to track the value of the US dollar) achieve price parity while minimizing risk to holders.

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### Price Stability

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 "block chain". 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.
Bitcoin and similar crypto-currencies track transferable 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 "block chain". 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 block chain ledger and the software enforces the market rules. This block chain 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 block chain 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 rules considered thus far do not specifically restrict the internal exchange rate between BitUSD and BTS in a way that ensures it will track the external exchange rate between USD and BTS. A first step toward this goal is to get reliable information about the external exchange rate into the internal market algorithm. It is not immediately obvious how this is accomplished 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 run computers on the BitShares network that check and commit broadcasted transactions to the block chain ledger. The trusted delegates can also be used to input external exchange rates into the block chain 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.
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 transferable 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.

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#### Counterparty risk:

Unlike many attempts to create a digital asset that tracks the dollar, market pegged asset are not an "I owe you" issued by any entity. For this reason, it does not rely on a specific counterparty to honor its value. Although manipulation risk occurs in any market, it is minimized by the open source and auditable nature of the BitShares system and carefully considered market rules. BitAssets stored on an exchange become IOUs and are subject to counter party risk just like storing bitcoin or bitshares on an exchange. This risk is not a property of the BitAssets themselves. We recomend that users never deposit BitAssets on an exchange and instead only use [gateways]({% post_url 2014-12-18-Benefits-of-Being-a-BitShares-Gateway %}) that issue their IOUs onto the BitShares network. This way you can trade your BitUSD against gateway IOUs without exposing your BitUSD to counter party risk while in the order book.
Unlike many attempts to create a digital asset that tracks the dollar, market pegged asset are not an "I owe you" issued by any entity. For this reason, it does not rely on a specific counterparty to honor its value. Although manipulation risk occurs in any market, it is minimized by the open source and auditable nature of the BitShares system and carefully considered market rules. BitAssets stored on an exchange become IOUs and are subject to counter party risk just like storing bitcoin or bitshares on an exchange. This risk is not a property of the BitAssets themselves. We recommend that users never deposit BitAssets on an exchange and instead only use [gateways]({% post_url 2014-12-18-Benefits-of-Being-a-BitShares-Gateway %}) that issue their IOUs onto the BitShares network. This way you can trade your BitUSD against gateway IOUs without exposing your BitUSD to counter party risk while in the order book.

#### Systemic risk:

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