synthetic USD & distributed auditable exchanges without a banking interface

[adam3us]

Hi

It occurred to me that one should be able to bootstrap a synthetic USD (or EUR etc) based only on an authenticated feed for the BTCUSD exchange rate (maybe validated against public order book, ideally with p2p blockchain settlement so you know MtGox et al aren't hacked or manipulating the rate) using conventional synthetic commodity financial mechanisms.

How synthetic commodities work is that it is possible to create eg synthetic gold or synthetic stock index without buying the underlying asset, with a matched option pair with exercise price at the current asset price: sell a call option to give away the rights to any upside, and use the proceeds to buy a put option for downside insurance (plus some commission/spread cost).  There are two types of options: american options (which can be exercised at anytime before expiry) and european options (which can only be exercised on the maturity date).  Other potential building blocks include CFDs (contract for difference).  Synthetic commodities work and are used in the financial world, the cost of creating them over buying the underlying asset is small provided there is a deep, liquid market in the options, and similarly they can track the underlying price closely with the same assumptions.  Now options have expiry dates, however the synthetic can be made ongoing by replacing expired, or exercised (in your disfavor) call options.  You do not actually lose in these events.  Similarly you can sell your synthetic back to bitcoin early at a small cost by reselling the put you bought (if not execised in as part of the sale) and buying back the call you sold.

Anyway read about how synthetic assets are created it in a financial reference tutorial or whatever.

The point for bitcoin is a liquid market in BTC denominated BTCUSD options you can hold BTC, and spend a few basis points/year to convert that into a synthetic USD holding (with enough option liquidity).

Such a liquid options market would have a second beneficial value for BTC in that people argue it would stabilize the BTCUSD exchange rate.

I cant imagine I'm the first to think of this, and I suspect bitshare and maybe mastercoin may be saying the same thing, however their financial terminology was non-standard to the point I couldnt understand if this is what they were saying for sure or not.

I would think smart-contracts can be written for the necessary options, so that the whole affair is digital and block chain settled and hence publicly auditable.  We do need more auditable block chain settled exchanges so that we can audit the BTCUSD order book directly, but that is something that needs to happen anyway.

Once you have a BTC backed synthetic USD with smart-contract options, you can do atomic trades for BTC.  Perhaps once it boot straps a bit you dont even need BTCUSD exchanges, you can p2p atomically and publicly auditably swap BTC for synthetic USD which trade itself can auditably define the exchange rate.

Of course I welcome any real financial wizards (or other) comments.

Adam

[blueadept]

I've been thinking along similar lines in a way...

There's an investment strategy that allows risky bets to be made for "free" not counting inflation and sovereign default risk. For example, if you have $1M, buy $1M face value in Treasuries. Use the remaining money to make your risky bet (like buying bitcoins). If the bet loses money, you get the nominal amount of money back in interest.

In a liquid Bitcoin options or futures market, you may be able to do the same thing synthetically. Hedge the dollar value of your bitcoins, plus interest, in Treasury options/futures and leave the part paid by interest unhedged for potential upside. You may have more counterparty risk at this stage of maturity in the Bitcoin derivatives markets.

This topic might get better answers in the Economics section of the forum.

[justusranvier]

If you're trying to build a cryptocurrency representation of fiat that does not require a banking interface the result is going to look more like LocalBitcoins on steroids than a traditional financial product.

Some entity could issue synthetic digital dollars to individuals on a P2P trading platform who promise to redeem them in the future for traditional dollars. Their performance can be insured by placing an appropriate amount of bitcoins in escrow. Now you have an effectively unregulated swarm of exchange agents who create the interface with the outside world and a digital representation of dollars that could be traded anywhere, including darknet-hosted virtual currency exchanges.

Something like this could almost be built on Ripple, but their trust model has no concept of limited trust - they only allow you to represent indefinite duration revolving loans.

I think it could be built on Open Transactions though, as that platform is a lot more capable.

[adam3us]

If you're trying to build a cryptocurrency representation of fiat that does not require a banking interface the result is going to look more like LocalBitcoins on steroids than a traditional financial product.

No I am interested more in whether you can do it without a banking interface, but fully backed in bitcoins with full public auditability..  It seemed to me that this could work with the sequence of bootstrap via existing exchange for price feed, and then p2p self-contained market trading synthetic USD backed and hedged by BTC and BTC denominated options, the trade itself setting its own price.

Adam

[adam3us]

I am interested more in whether you can do it without a banking interface, but fully backed in bitcoins with full public auditability..  It seemed to me that this could work with the sequence of bootstrap via existing exchange for price feed, and then p2p self-contained market trading synthetic USD backed and hedged by BTC and BTC denominated options, the trade itself setting its own price.

ie once you had a bootstrapped exchange market in BTC with synthetic USD (itself constructed from  BTC denominated synthetic USD futures) the only thing you lose if someone shuts off the conventional exchange is the possibility to do arbitrage between the BTC<->synthetic USD market and the BTC<->USD market?

ie the external cash in and cash out would be missing other than bitcoin OTC, but people with synthetic USD positions (still fairly closely tracking USD modulo missed arbitrage price synchronization) would be able to create new positions and liquidate existing positions and spend BTC and synthetic USD.

Adam

[wiggi]

I would think smart-contracts can be written for the necessary options, so that the whole affair is digital and block chain settled

If vanilla options are needed to create a synthetic USD... I'm pretty sure these are WAY more difficult
to implement with smart-contracts/block chain settled then bets (i.e. binary options) where two transactions go in and one transaction comes out,
which is doable Imho, but not in the way the wiki suggests. (otherwise it would exist already)

[adam3us]

If vanilla options are needed to create a synthetic USD... I'm pretty sure these are WAY more difficult to implement with smart-contracts/block chain settled then bets (i.e. binary options) where two transactions go in and one transaction comes out, which is doable Imho, but not in the way the wiki suggests. (otherwise it would exist already)

For straight odds bet there's a more efficient protocol with no disconnect nor extortion attacks here:

https://bitcointalk.org/index.php?topic=277048.msg3220019#msg3220019

maybe the same trick can be applied to the binary option with reference to an external price feed.

I think partly its that not many people tried to figure out how to write smart-contracts with bitcoin script, though I would think these are exactly the kinds of things Satoshi designed it for (as a smart-contract implementation with knowledge of what smart-contracts are).  So if you buy into the argument that we can with a bit of work find reasonably efficient contracts for the necessary options - I am still more interested in critique of the financial option/market assumptions.

Adam

[adam3us]

ie once you had a bootstrapped exchange market in BTC with synthetic USD (itself constructed from  BTC denominated synthetic USD futures) the only thing you lose if someone shuts off the conventional exchange is the possibility to do arbitrage between the BTC<->synthetic USD market and the BTC<->USD market?

ie the external cash in and cash out would be missing other than bitcoin OTC, but people with synthetic USD positions (still fairly closely tracking USD modulo missed arbitrage price synchronization) would be able to create new positions and liquidate existing positions and spend BTC and synthetic USD.

A third order thing that could be constructed if the second order boot strap of a synthetic USD traded with BTC worked, and a liquid market in auditable block-chain settled BTC <->synthetic USD could emerge to have auditable decentralized price-discovery of the exchange rate would be to create an alt-coin or coloured coin on the same chain, call that mined virtual USD that references the p2p validatable synthetic USD BTC exchange rate to dynamically control a mining function with the exchange rate as input with the objective of mathematically pegging the alt difficulty to keep the price stable. Of course people would be interested for mining to manipulate the price but arbitrage should ensure that would be a losing proposition.

Adam

[nomailing]

I am interested more in whether you can do it without a banking interface, but fully backed in bitcoins with full public auditability..  It seemed to me that this could work with the sequence of bootstrap via existing exchange for price feed, and then p2p self-contained market trading synthetic USD backed and hedged by BTC and BTC denominated options, the trade itself setting its own price.

ie once you had a bootstrapped exchange market in BTC with synthetic USD (itself constructed from  BTC denominated synthetic USD futures) the only thing you lose if someone shuts off the conventional exchange is the possibility to do arbitrage between the BTC<->synthetic USD market and the BTC<->USD market?

ie the external cash in and cash out would be missing other than bitcoin OTC, but people with synthetic USD positions (still fairly closely tracking USD modulo missed arbitrage price synchronization) would be able to create new positions and liquidate existing positions and spend BTC and synthetic USD.

Adam

I think your idea is quite similar to the bitshares proposal.
I am not sure, if you are suggesting that when the price feed is switched off, that the synthetic USD will still be tracking the real USD. There was a similar very long discussion in the bitshare thread a while ago.
I think you cannot be sure how stable the price tracking will continue when the price feed is gone. Actually, after the connection between synthetic USD and real USD is gone, the synthetic USD price will be uncoupled from the real USD and would move up or down depending on how many people think it will go up or down: so in other words, the price of synthetic USD will be freely floating away from the real USD.
You might argue that it will still track the real USD price because of arbitrage traders, but that is a circular argument where you assume that arbitrage traders think it will continue to track the real USD price. Actually some very rich person might make a lot of money by short selling synthetic USD until it is obvious for all arbitrage traders that the synthetic USD will not track the real USD. This could then continue in a downward spiral until sythetic USD is worth nothing.

So, to sum up, I think it will not work if you shutdown the price feed from a conventional exchange. But I hope that it is possible to construct a continuing price feed of USD<->BTC purely within a p2p system itself. I think it should be possible if you implement something like localbitcoins within a p2p-blockchain using the idea of SSL logs to prove payment: https://bitcointalk.org/index.php?topic=173220.0
So you would have a very slow p2p-trading system to convert between real USD and BTC by using bank wires. This would then generate the price feed for additional synthetic USD. Don't know if that makes sense, but I would be happy to hear some feedback on it...

[cunicula]

I think your idea is quite similar to the bitshares proposal.

Bitshares is a ponzi.

https://bitcointalk.org/index.php?topic=297147

A feasible way of doing what you want is described in the above thread.
Key point:
1)maintaining parity of synthetic USD has to be consistent with financial market equilibrium.
2) to prevent implosion there must be a cap on synthetic USD issuance

[wiggi]

For straight odds bet there's a more efficient protocol with no disconnect nor extortion attacks here:

https://bitcointalk.org/index.php?topic=277048.msg3220019#msg3220019

And in this case "the least significant bit of two committed secrets" is indeed reliable data,
i.e. the random miner who includes it in a block can't tamper with it.

This would be different for an authenticated feed for the BTCUSD exchange rate.

Either everything happens within the same p2p blockchain settlement (Ripple system extended to support
vanilla options), or if it's an authenticated but external source someone trustworthy would have to sign the data and include it in the blockchain.