Securing contingent claims

[cunicula]

Ex. I mine a Contingent Block today. The Coins in the Contingent Block become a bitcoin Block on August 1st 0:00 UTC or Block xxxx if difficulty is less than X, and disappear otherwise. In the meantime, I can trade the contingent coins on an electronic exchange similar to bitparking. 

Now note that (barring changes to mining tech) difficulty on August 1st [or block xxxx] proxies for the USD/BTC exchange rate on August 1st. The difficulty price relationship will only become stronger over time, once the mining business is more mature. Thus if I trade some bitcoin for some contingent coins, I could remove a considerable fraction (probably the majority) of the variance in the USD value of my BTC holdings as of August 1st. The insurance relies on a p2p system with block chain integrity as the only counterparty. It would be much, much cheaper to use this system for insurance rather than a traditional market which exposes users to counterparty risk.

Difficulty of regular and contingent Blocks can be pegged so that the total number of coins and contingent coins generated at block time t is fixed in all future states of the world. Fixing the generation rate would make contingent claims a scarce resource, i.e. contingent claims would not affect long-term money supply trends. Relative difficulty for each coin type would be adjusted according to a system of linear equations that related past difficulty levels to current difficulty and which incorporated the constraint that expected total supply generation remained constant (i.e. solution of a system of linear equations)

Alternatively, a p2p contracting system could be implemented which allows bitcoins to be held in escrow by a blockchain and then distributes bitcoins at expiration according to difficulty information in the bitcoin block chain. The block chain would need to be secured using a proof of work system that rewarded individuals performing the work with contract fees. Contracts would need to be standardized (for example you can only contract on ln difficulty >= 0, 0.1, 0.2, .... and only on realization on the first day of each month or week). It is important that each side of the contract could be freely traded to other peers, so that holdings in these contracts would remain liquid.

I am not a programmer, so I don't know which type of system would be easier to implement. Combining everything in one blockchain seems more secure.

Either of these systems would make it much easier for merchants to adopt bitcoin without subjecting themselves to large risks or the considerable expense of exchanging BTC for USD after every transaction. The value of bitcoin is inversely proportional to its velocity. If merchants are constantly exchanging BTC for USD after every transaction, the velocity will be high and BTC value will be low. Instead Merchants could hold BTC and a bundle of BTC contingent claims aka BTC derivatives. If unwilling to bear the residual risks, they could purchase supplementary USD-denominated insurance on futures markets. The value of BTC would still be higher because much of the insurance market could be denominated in BTC.

"Bitcoin is technically sophisticated. As a monetary system, it looks primitive." - The Economist
I think this is a correct assessment. If bitcoin doesn't eventually introduce more sophisticated p2p monetary instruments, some other digital currency will. This currency will be much easier for merchants to adopt. If bitcoin hasn't achieved world domination before this happens, bitcoin will disappear and the new currency will take over.

For a simpler proposal for more basic monetary instruments (bonds), see my post here:
http://forum.bitcoin.org/index.php?topic=18288.0

[bji]

Ex. I mine a Contingent Block today. The Coins in the Contingent Block become a bitcoin Block on August 1st 0:00 UTC or Block xxxx if difficulty is less than X, and disappear otherwise. In the meantime, I can trade the contingent coins on an electronic exchange similar to bitparking. 

Now note that (barring changes to mining tech) difficulty on August 1st [or block xxxx] proxies for the USD/BTC exchange rate on August 1st. The difficulty price relationship will only become stronger over time, once the mining business is more mature. Thus if I trade some bitcoin for some contingent coins, I could remove a considerable fraction (probably the majority) of the variance in the USD value of my BTC holdings as of August 1st. The insurance relies on a p2p system with block chain integrity as the only counterparty. It would be much, much cheaper to use this system for insurance rather than a traditional market which exposes users to counterparty risk.

Difficulty of regular and contingent Blocks can be pegged so that the total number of coins and contingent coins generated at block time t is fixed in all future states of the world. Fixing the generation rate would make contingent claims a scarce resource, i.e. contingent claims would not affect long-term money supply trends. Relative difficulty for each coin type would be adjusted according to a system of linear equations that related past difficulty levels to current difficulty and which incorporated the constraint that expected total supply generation remained constant (i.e. solution of a system of linear equations)

Alternatively, a p2p contracting system could be implemented which allows bitcoins to be held in escrow by a blockchain and then distributes bitcoins at expiration according to difficulty information in the bitcoin block chain. The block chain would need to be secured using a proof of work system that rewarded individuals performing the work with contract fees. Contracts would need to be standardized (for example you can only contract on ln difficulty >= 0, 0.1, 0.2, .... and only on realization on the first day of each month or week). It is important that each side of the contract could be freely traded to other peers, so that holdings in these contracts would remain liquid.

I am not a programmer, so I don't know which type of system would be easier to implement. Combining everything in one blockchain seems more secure.

Either of these systems would make it much easier for merchants to adopt bitcoin without subjecting themselves to large risks or the considerable expense of exchanging BTC for USD after every transaction. The value of bitcoin is inversely proportional to its velocity. If merchants are constantly exchanging BTC for USD after every transaction, the velocity will be high and BTC value will be low. Instead Merchants could hold BTC and a bundle of BTC contingent claims aka BTC derivatives. If unwilling to bear the residual risks, they could purchase supplementary USD-denominated insurance on futures markets. The value of BTC would still be higher because much of the insurance market could be denominated in BTC.

"Bitcoin is technically sophisticated. As a monetary system, it looks primitive." - The Economist
I think this is a correct assessment. If bitcoin doesn't eventually introduce more sophisticated p2p monetary instruments, some other digital currency will. This currency will be much easier for merchants to adopt. If bitcoin hasn't achieved world domination before this happens, bitcoin will disappear and the new currency will take over.

For a simpler proposal for more basic monetary instruments (bonds), see my post here:
http://forum.bitcoin.org/index.php?topic=18288.0

I didn't read the entirety of what you are proposing - I apologize, I will read the whole thing - but just to get some conversation started:

Did you consider the added difficulty of verifying transactions that will result from your proposal?  If your proposal results in transactions that must be followed back to some origin block in order to validate, and that possibly splits along the way, then it will quickly become impossible for bitcoin peers to validate the transaction chain, and the whole system will break down.

Anyone who is proposing any new transaction type in bitcoin needs to understand this factor.  I am not saying that your proposal falls on the wrong side of it, because I have only skimmed it thus far; but after skimming I am inclined to believe that this proposal would result in an unworkable system as the amount of data and operations necessary to validate transactions would be unworkable.

[bji]

"Bitcoin is technically sophisticated. As a monetary system, it looks primitive." - The Economist
I think this is a correct assessment. If bitcoin doesn't eventually introduce more sophisticated p2p monetary instruments, some other digital currency will. This currency will be much easier for merchants to adopt. If bitcoin hasn't achieved world domination before this happens, bitcoin will disappear and the new currency will take over.

I don't think bitcoin itself will ever intrinsically allow the financial instruments you are talking about.  I also don't think that it is possible to build a sustainable currency system with the properties of bitcoin (pseudo-anonymity of parties engaged in transactions, and distributed authority) that also includes the financial instruments you are talking about, because the cost of incorporating those instruments into the system would mean a greater cost to be paid by the 'miners' in that system that validate transactions.  It is possible that such a system could become self-sustaining but if it did, the cost of every transaction would include the cost of the instruments that you mentioned (because the miners would expect a return that gave them a profit even after paying the cost of verifying those complex instruments, which would require either inflation (always fabricating bitcoins to pay miners) or higher transaction fees.

I guess what I'm saying is, you're talking about a system that has higher transaction fees because it includes these instruments.  Actually now that I've thought through this line of reasoning I realize that maybe your system would work - *if* it were possible for miners to attribute the extra cost of the instruments to the transactions that cause them to incur that cost, and *if* the cost wasn't also passed on to future miners who had to do more work to verify those past transactions without getting any benefit of the original transaction fees.

[cunicula]

I'm not a programmer, but I think a few things are relevant. I am thinking of the p2p escrow system rather than the mining system, but the comments are relevant to both.

1) Informational content can be greatly reduced by offering a limited number of standardized contracts. The set could be expanded once information technology improves.
2) If the contracts are tradeable, limited contract variety is not a big deal. (e.g. difficulty drops to a low level on August 1st, the price of a contingent claim paying off on low difficulty Jan 1st will go way up.) So you don't need a large number of maturity dates. Even one contract maturity per year even will accomplish much of the job.
2) Insurance will cost money in this system just like regular insurance. People willing to pay money for insurance will be limited to those dealing in large values of BTC.
Everyone else will prefer to self-insure. This means that the number of transactions will be orders of magnitude smaller than those occurring in the regular bitcoin user base.
3) Because of the different use of these contracts, charging much larger fees for higher data requirements shouldn't be a problem for users.
4) Once contingent claims are transformed into bitcoin the data contained is no longer useful.  I think only outstanding claims would need to be recorded in a block chain. Once these claims were realized (becoming either bitcoin or nothing), data associated with them could be deleted. The ledger would need to contain consistent information on all outstanding claims, but not on claims that had been transformed into bitcoin.

Side note: In the current system, perhaps the txn fee should be indexed so it is inversely proportional to current difficulty rather than adjusted ad hoc.

[cunicula]

I wanted to pointed out that the contingent claims market would allow large businesses adopting bitcoins to capture some of the benefits from entry into the economy.
These business would know that announcement of their try would lead to an increase in the future difficulty level. Therefore they would want to place bets on future difficulty increases before announcing their entry.
Existing business would take the other side of these bet to insure themselves against loss.

[ByteCoin]

These business would know that announcement of their try would lead to an increase in the future difficulty level. Therefore they would want to place bets on future difficulty increases before announcing their entry.
Existing business would take the other side of these bet to insure themselves against loss.

I don't understand what motivation the existing businesses would have to take the other side of the bet.
Could you please explain?

The value of bitcoin is inversely proportional to its velocity. If merchants are constantly exchanging BTC for USD after every transaction, the velocity will be high and BTC value will be low.

You need to define what sort of transactions contribute to velocity. For instance, if I take money out of my safe and put it on the table and then put it back in the safe, even if I do this millions of times a second I'm not decreasing its value. I think you'll find that currency conversions also don't contribute.

Could you also please explain what you're trying to achieve with contingent blocks? It looks like an option based on difficulty. What does it enable?

ByteCoin

[cunicula]

Thanks for responding. Yeah it is just like options. I'm from an economics rather than a finance background so I use different jargon. Centralized option markets aren't likely to emerge until bitcoin grows big. Volumes in markets you see are likely to small to have much use. Options have a huge payoff variance and there is a big risk that people taking the other side of bets will fail to pay your bets (counterparty risk, remember the financial crisis?). A p2p system could get rid of counterparty risk entirely [except for the integrity of the block chain]. Mining for the contingent claims/options would allow a deep markets to be created despite the small size of the economy. Essentially miners would have to hold them or sell them to someone. No one could fail to pay in bitcoin, even though some people might go belly up in USD.
 

I don't understand what motivation the existing businesses would have to take the other side of the bet.
Could you please explain?

Not sure which side of the trade you are asking about.
1) Going Long
Suppose that you are Amazon and you need to decide to accept bitcoin. Accepting bitcoin means either a) bearing risk by holding bitcoin inventories or b) paying a lot of exchange fees. Either of these options is costly, and I doubt that Amazon's savings on credit card processing fees and chargebacks would be large enough to recoup these costs.

Thus, Amazon needs an alternative way of profiting from bitcoin. Imagine there are two possible future states of the world: State 1) bitcoin value and difficulty increase dramatically, State 2) bitcoin value (and difficulty) do not increase dramatically.   

Amazon could just buy up a whole bunch of vanilla bitcoin before announcing its decision and profiting by reselling the bitcoin later at a higher price. However, this is inefficient. By purchasing standard bitcoin, Amazon is acquiring claims to both future states of the world. Since Amazon's choices can dramatically increase the probability of state 1 occuring, Amazon would earn much more by purchasing claims on state 1 than it would by buying up vanilla bitcoin.

2) Hedging Risks/Going Short
Suppose you are an online casino. Accepting bitcoin means that you Americans will start flooding your site with coins. You need to convert their currency into Euros so they can play with other people on your site.
You will also need to pay them out in bitcoins. This means either a) holding a large bitcoin inventory or b) paying a lot of exchange fees. Holding bitcoin inventories puts you at risk of a large loss if bitcoin drops in value. Thus you would likely to want to exchange claims in State 1 for claims on State 2. If bitcoin goes dramatically up in value, you don't enjoy the rewards. In exchange, you shield yourself from some risk.
 

The value of bitcoin is inversely proportional to its velocity. If merchants are constantly exchanging BTC for USD after every transaction, the velocity will be high and BTC value will be low. You need to define what sort of transactions contribute to velocity. For instance, if I take money out of my safe and put it on the table and then put it back in the safe, even if I do this millions of times a second I'm not decreasing its value. I think you'll find that currency conversions also don't contribute.

Standard equation in monetary economics: http://en.wikipedia.org/wiki/Velocity_of_money
Money Supply * Velocity = Currency Price * Real Value of Transactions Per Unit Time

As you can see, velocity is directly proportional to price. Velocity is the rate at which transactions occur per unit time.  Velocity will be high if businesses sell bitcoin as soon as they get it. If businesses are willing to hold bitcoin inventories, some bitcoin is being held of the market and it costs more to acquire bitcoin for exchange purposes.

[marcus_of_augustus]

Hmmm, maybe you need to look into Open Transactions and the financial crypto library that provides for contracts. It can accomodate p2p currencies like bitcoin as a basis.

https://github.com/FellowTraveler/Open-Transactions

Moneychanger could be just what you after.

https://github.com/FellowTraveler/Moneychanger

[iya]

The value of bitcoin is inversely proportional to its velocity. If merchants are constantly exchanging BTC for USD after every transaction, the velocity will be high and BTC value will be low.

Money Supply * Velocity = Currency Price * Real Value of Transactions Per Unit Time

As you can see, velocity is directly proportional to price. Velocity is the rate at which transactions occur per unit time.  Velocity will be high if businesses sell bitcoin as soon as they get it.

So which is it? Of course it's neither proportional nor inversely proportional, at best it's loosely correlated.

But your main proposal seems to have merit. Simply said, there would be several "built in" derivatives, denominated in Bitcoin, which could be traded at different prices.

I just believe the complexity could put people off, as it makes Bitcoin even more difficult to understand. Why buy a financial system, if you want a currency? After all the things gone wrong in the traditional financial system, it would increase suspicions.
Also keeping the money supply predictable will be difficult: If an option might expire worthless based on a future difficulty, will it count towards the final 21 million or not?

[cunicula]

@noone

Still learning about OpenTransactions (looks cool), but I don't think it is really the same thing. Seems to require banking institutions to make markets for claims. Not sure if OT solves the counterparty risk issue, which is major. Think it would be better to build the financial system in lock step within the currency, rather than waiting for entrepreneur's to build a financial system alongside. If you wait for banking institutions to make deep markets for bitcoin options, you might be waiting for a very long time.

But your main proposal seems to have merit. Simply said, there would be several "built in" derivatives, denominated in Bitcoin, which could be traded at different prices.

I just believe the complexity could put people off, as it makes Bitcoin even more difficult to understand. Why buy a financial system, if you want a currency? After all the things gone wrong in the traditional financial system, it would increase suspicions.
Also keeping the money supply predictable will be difficult: If an option might expire worthless based on a future difficulty, will it count towards the final 21 million or not?

Thanks iya. You are right, my proposal is just the creation of several "built in" derivatives. A few comments:

1) no need to increase complexity for the vast majority of end users. They can just use vanilla bitcoin and forget about the financial system, just like they can forget about the mining system. People who are interested in dealing in contigent claims could download a special GUI.

2) keeping money supply growth constant is not difficult. One simple option is as follows:
          a) issue 1/3 vanilla bitcoin [2 vanilla bitcoin bond blocks per hour]
          b) mine 1/3 as bitcoin bonds which become vanilla bitcoin on June 1st of each year.  [2 June 1st bitcoin bond blocks per hour]
                           (allow these bonds to be broken up into several types of mutually exclusive  contingent claims)
          c) mine 1/3 as bitcoin bonds which become vanilla bitcoin on Jan 1st of each year.   [2 Jan 1st bitcoin bond blocks per hour]
                (these can also be broken up into contingent claims)
Growth of the aggregate money supply is the same as before: 6 blocks per hour. it is just divided among more types of monetary instruments.

3) Derivatives might put average people off. Obviously, I don't agree with this. I think it could be overcome through clever marketing and interface design.

As far as your critique of the velocity equation, you are basically correct. I don't want the discussion to go there because that topic leads to flame wars.

[cunicula]

Realizing I screwed up the whole velocity thing. Sorry, please ignore that part; not important to argument.

[ben-abuya]

This is a really neat idea. Bitcoin already has transaction scripting built-in, in fact the regular transactions we know and love are just a special case of this scripting. The thing is, this scripting cannot take the amount of the transaction or things like the difficulty into account. It could, it's just not in the current scripting code. I think adding in some more scripting operations would be all that's needed to make this kind of thing possible. Not hard to code, but a big expansion of how bitcoin works, and that's kind of scary. Again, this could be a variant of bitcoin, like namecoin.

[cunicula]

Thanks ben-abuya. I would be so happy to see someone work on this. I have a small bounty (25 BTC) to share amongst people who make this alternate chain a reality.

I think it is fairly important that miners can choose which maturity of coins to mine for, and accordingly that each maturity has its own difficulty level. Can this be accomplished with scripting?

[ben-abuya]

cunicula, I like the work you're doing here, although I haven't grasped all the details yet. Are you sure you need miners to selectively mine different maturities and for them to have different difficulties? That would really complicate the system.

I have a proposal for a more generalized prediction market based on the bitcoin concept:

http://forum.bitcoin.org/index.php?topic=10011.0

[TierNolan]

Now note that (barring changes to mining tech) difficulty on August 1st [or block xxxx] proxies for the USD/BTC exchange rate on August 1st.

I am not so sure that this is true.  It assumes that cost per hash is constant.  Event without improvements like CPU to GPU hashing, you are going to face the effects of Moore's law.

[cunicula]

@TierNolan

Of course you are completely right. To the extent that Moore's law is perfectly predictable this is not a problem at all. Market participants would factor future difficulty increases when trading.
If there is an unanticipated technological shock (say cheap hashing ASICs appear), then yes it would cause the short-term price-difficulty relationship to change dramatically. On the one hand, the possibility of tech shocks is a downside because they weaken the usefulness of bets on long-run difficulty as insurance against price changes. On the other hand, the development of this market would strengthen incentives for entrepreneurs to build ASICs (see the argument about Amazon). 

@ben-abuya
A fully-backed options/prediction market imposes an implicit tax on transactions in contingent claims. This happens because speculators have to tie up the use of their bitcoin to participate in the market. Accordingly, they have to forgo interest until the predictions are realized. I'll explain in more detail later.

[cunicula]

Okay, here is some more detail. The prediction market is still a wonderful idea, but is not anywhere near as efficient as a system for mining bonds.

Suppose I want to make a 100 bitcoin bet on a prediction realized in one year. To back my bet in the prediction/options market, I would need 100 bitcoin bonds with a one year maturity. In the current system, the bitcoin monetary authority doesn't issue bitcoin bonds. Participants are forced to use bitcoin as a substitute for bonds, but using bitcoins to secure a one year bet requires forgoing one year of interest.

Forgone interest can be assessed using the risk free interest rate. The risk free interest rate can be proxied using the yield on US treasury inflation-protected securities (TIPS), currently around ~0.75% per annum for TIPS maturing in 2 or 3 years http://www.treasurydirect.gov/RI/OFNtebnd]. Using this interest rate, I am giving up ~ 0.75 bitcoin for every 100 bitcoin I invest in backing one-year predictions (a 0.75% tax). Because of this tax, the volumes traded on a prediction market fully backed by bitcoin will be much smaller than they would be on a prediction market fully backed by bitcoin bonds.

Given that current exchange fees on bitparking are around 0.4% (counting both sides of the trade), the size of the forgone interest effect on trading volume might be similar to tripling exchange commissions.

[ben-abuya]

@ben-abuya
A fully-backed options/prediction market imposes an implicit tax on transactions in contingent claims. This happens because speculators have to tie up the use of their bitcoin to participate in the market. Accordingly, they have to forgo interest until the predictions are realized. I'll explain in more detail later.

Yeah that's true. I still don't totally get the contingent claims stuff, and I can't think of any other way to guarantee a bet. I think this is mitigated by a potentially short term of contract and especially because bitcoin is deflationary. Maybe interest isn't as in important when your coin is deflationary instead of inflationary. How much interest do you expect to get on your savings now? What's the devaluation spread between an inflationary dollar and a deflationary bitcoin? Seems like the remaining interest you'd forego, if any, could be worth the utility of the prediction hedging.

[cunicula]

I agree, people will still participate in a prediction market. Even under an implicit tax it is still a good idea. Also I agree that if people expected bitcoin to deflate at the risk-free interest rate + a risk premium, then you would not forgo any interest by holding bitcoin. Remember, however, that inflation/deflation depends on changes in the ratio of volume of bitcoin transactions to the bitcoin money supply. For bitcoin, the serious inflationary risk is a change in transaction volumes/expectations about future transaction volumes, not expansion of the money supply.

[cunicula]

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