Here is a diagram explaining my system for derivatives tracking the USD in value.

https://anonfiles.com/file/69d36074de50b14ec7afa334d9a31da8
[Edit: the diagram captures the basic idea but is outdated. I am travelling now, but will release an updated version when I return
The modifications are simplifications. I.e. no changes to the basic system, but only one type of derivative instead of several and increased automation..]

Feel free to ask questions. I am also working on a text based explanation.
The amount of text is huge, so I figured a diagram is better.

Since the diagram is still arcane and any rigorous text would be much worse...

Here is explanation based on analogy:

Have you ever seen the pyramid of champagne glasses at a wedding? A giant bottle of champagne is poured into the top glass. The top glass overflows into the second tier of glasses. The second tier of glasses overflow into a third tier, and so on. Here is a video if this is completely foreign to you ...
http://www.youtube.com/watch?v=k-wXLnMTiwY

Suppose that we have one bitcoin.

Think of the volume of cheap champagne you can purchase with one bitcoin. This volume fluctuates over time.

Think of the pyramid of glasses. Suppose each glass can hold one USD worth of champagne before it overflows.  In the future, maybe a bitcoin will be worth enough to fill a whole pyramid of glasses  ... or maybe just a single glass  .

Now suppose we commit to buying 1 bitcoin worth of champagne one year from today. We also commit to pouring the champagne we buy into a pyramid of glasses.
The blockchain enforces these commitments as txn rules. There is no trust involved at all.

Now suppose we sell off ownership of each individual glass in the pyramid right now. We won't know exactly how much each glass is worth until next year, but we can still sell them now.

Which glass would you want if you could have your pick? That's right, the top glass. It gets filled with champagne first. As long as 1 bitcoin sells for more than $1 a year from now, this glass will be worth 1 USD.

The top glass is very useful as a medium of exchange. I could agree to pay you ten top glasses next year in exchange for a USB stick. I don't have to worry about overpaying (since they are worth at most 10 USD). You don't have to worry about being short-changed (since they are highly unlikely to be worth less than 10 USD). You can set prices in terms of top glasses and not have to worry about adjusting them.

Under a free market, the glasses will all trade for different prices (all between $0.00 and $1.00).
The bottom glasses will be the cheapest. The top glass the most expensive.

The system I designed allows a bitcoin to be divided into a pyramid of glasses. The top glass always sells for about $1 as long as a bitcoin is worth more than say $10.
Glasses in the second tier also always sell for about $1 as long as a bitcoin is worth more than say $25. The lower tiers of glasses fluctuate wildly in price.

Why is this helpful? The fact that a bitcoin is worth $10 in Feburary and $200 in April and $80 in June is a big problem. It causes trouble/worry for bitcoin-focused businesses, bitcoin users, bitcoin workers, and anyone accepting bitcoin as a means of payment. If we can divide bitcoins into a pyramid of glasses worth up to 1 USD each, then we can solve this problem. Everyday users of bitcoin can exchange the top and second tier glasses only. They won't have to worry about price movements any more than if they were using paypalUSD. Moreover, they still have all the freedom, anonymity, and security from confiscation offered by bitcoin.

Storage of USD value in the blockchain also reduces dependence on the banking system. Speculative trades, for example, do not need to rely on Mt. Gox or banks with their AML/KYC rules. They can be completely decentralized.

High-risk investors can speculate in the enormously volatile bottom glasses. Average investors can just purchase and hold some bitcoin. The expanded functionality will facilitate bitcoin adoption and lead bitcoin to appreciate in value.  

Yikes!   And people call bitshares complicated!

Prediction markets are well understood.  That is all BitShares is.

I am not sure why you think such a convoluted system is required to track the USD price when prediction markets will do it on its own.

I see mention of 8-fold. 4-fold, and 2-fold backing.

If I recall correctly long ago you had been telling us that you need quite a large warchest, certainly more than "100% reserves" to attempt to peg a currency. Is this thing going therefore to take at least 8 times as much reserves (maybe of both sides of a pair) in order to function? Maybe with 7/8ths of it being investment capital from people hoping the scheme as a whole will turn a profit?

-MarkM-

There is a lot of information to digest here. Great work, cunicula! My first question is (forgive me if this is very simplistic) whether you believe implementation of a system like this, at least for experimentation purposes would warrant an alternative digital currency as a vehicle for generating that data? My first thought is how we'd create a system like this, as I think it's unlikely for it to be adopted by Bitcoin development off the bat.

Yes, the real world price enters as the median price submitted by 200 miners over the past 33.3 hours. It lags the real world price by about 1/2 a day.

The miners are assumed to operate via PoS. Major stakeholders have an incentive to produce accurate reports because this increases the currencies usefulness and therefore market value. Minor stakeholders have an incentive to produce reports that mirror the major stakeholders via a prediction market.

The major challenges are:
Generating a reliable, decentralized source of real world data in the blockchain.
Allowing contract outcomes to depend on the data source. (I.e. there is no oracle here. The oracle is the data feed itself.)

Again, I'm extremely skeptical that this can be accomplished using
a) scripting functionality in bitcoin
b) without a complete overhaul of the mining systrm.

I do not think it is semantics at all. M of n implies a set of pre determined authorities. Getting rid of predetermined authorities is the whole point of the project. I don't see any point in continuing with this under that constraint. Colored coins already offer everything you can achieve under m of n.

Who are these authorities? What if they disappear? How do we reallocate authority in response to change?
What if not everyone agrees on who should be part of n (an almost certain outcome in my opinion)?
Do we then end up with segmented markets each with their own dictator or set of dictators? Do we end up with one conensus authority who charges onerous fees and remains in place despite woeful inefficiency?

In either case, we have just reestablished the monopoly/oligoploly markets we see in the real world within the blockchain. Again we have high fees, market inefficiency, and counterparty risk.

Where does the benefit comes from? How is m of n paypal better than 1 of 1 paypal?

Proof of stake implies dynamic random allocation of authority in proportion to ownership.
A median of proof of stake submissions implies the median vote of a random sample of coins.
In my opinion, this is the best possible voting system you could aspire too.

Okay, if you want to have m of n, where n includes every single private key weighted by ownership I'm happy, but that simply isn't feasible. You need a random sample.

My guess is that you will overhaul the scripting system and no one will use any of the functions you enable.

BTW, Dreamweaver, You are welcome to write about this wherever you like. I decided not to keep anything secret.


Yeah, I agree completely.

This is a work in progress. As written, it can preserve units of USD value, but is too complex.
I am revising the system to simplify the design and user experience.

My current revisions are:

1) Use a single 4-fold backing level. (So there is just one type of bitDER and one type of bitUSD)  
2) Automatically reinvest any payoffs back into the system
     a) If I hold only bitDER, then in the future I will also hold only bitDER unless I manually intervene. The amount will fluctuate based on price changes.
     b) If I hold only bitUSD, then in the future I will also hole bitUSD unless I manually intervene. The amount will decline slowly over time via interest payments.


I will refer to the revised system with only 4-fold backed bitUSD in what follows:


Fungibility
One bitUSD is equivalent to another bitUSD and one bitDER is equivalent to another bitDER.
It doesn't matter who I received the bitUSD from any more than it matters who I received a bitcoin from.

Consensus Price
Miners report the current price of a bitcoin in USD within the blockchain.
The consensus price is the median price reported in the last 200 blocks.
It lags the real world price by about a day.

Pairing

bitDER and bitUSD come as a pair. At all times, the total amount of bitDER = the total amount of bitUSD.
Say the conensus price is 1 USD = x bitcoin.
This means that 4x bitcoins are held in escrow to back each (1 bitDER, 1bitUSD) pair.

Issuance and Redemption

If I hold n bitDER inputs and n bitUSD inputs, then I can convert these inputs back into bitcoin without using a market at all.
 
Again, say the consenus price is 1 USD = x bitcoin.

I can issue the following txn (There is likely also a small fee for this but let's ignore that):
n bitDER + n bitUSD -> 4xn bitcion      [Redemption]    (n can be any positive real number)
Likewise, I can convert bitcoin into a bitDER bitUSD pair.
4xn bitcoin -> n bitDER + n bitUSD      [Issuance]        (n can be any positive real number)

Supply and Demand
If there are more bitDER/bitUSD outsanding then the market demands, then redemption  will generate a positive return.
If there are fewer bitDER/bitUSD outsanding then the market demands, then issuance will generate a positive return.

Arbitrage ensures that at all times:

the price of n bitDER + the price of n bitUSD = the price of 4xn bitcoin
 
What are the assets represented by bitDER and bitUSD?

Together, n bitDER and n bitUSD represent joint ownership of 4xn bitcoin.
If the price is stable, n bitUSD trade for n USD and n bitDER trade for 3n USD
When there are price fluctuations that have not been incorporated in the consensus price yet,
these will cause the market price of bitDER to fluctuate. bitUSD should not fluctuate in USD price to any appreciable degree, except if
i) the miners fail to report accurate data
ii) there is an extreme price drop within a short time span

Price Changes
The distinction between bitUSD and bitDER is how they respond to changes in bitcoin price.

Appreciation of bitcion
If x goes down (bitcoin appreciates), then the USD value generated goes entirely to the holder of bitDER as newly issued bitDER.

Say the old price is x and the new price is (0.99x).
Now each bitDER and bitUSD pair has excess bitcoin backing of 4x - 4(0.99)x= 4(0.01)x  
To account for this, (4/3)*(0.01) new bitDER and bitUSD are created for each pair. The (4/3)*(0.01) bitUSD are auctioned off to new buyers to generate (4/3)*(0.01)x bitcoin in additional backing.
The (4/3)*(0.01) bitDER are sent to each holder of a bitDER.

Result: Say Alice starts with 1 bitDER, Bob starts with 1 bitUSD, and Sally (a new buyer of bitUSD) starts with (4/3)*(0.01)(0.99)x bitcoin.

Alice: 1 bitDER -> (1+(4/3)*0.01) bitDER
Bob:   1 bitUSD -> 1 bitUSD
Sally: (4/3)*(0.01)(0.99)x bitcion -> (4/3)*(0.01) bitUSD

You can see that we enter and leave with total bitDER = total bitUSD.
Alice earns a 1.333% return on a 1% appreciation. (You can see that she is leveraged relative to just holding bitcoin.)
Bob is not affected in any way.
Sally's inflow of bitcoin allows the holder of bitDER to be paid entirely in bitDER. If we end up with too much bitUSD/bitDER, it can be converted back.
 
Depreciation of bitcoin
If x goes up (bitcoin depreciation), then the USD value lost is entirely paid for by the holder of bitDER.
The value to recover backing for bitUSD comes from the sale of outstanding bitDER to new buyers.

Say the old price is x and the new price is (1.01)x.
Now each bitDER and bitUSD pairs have a deficit of backing 4x - 4(1.01)x= -4(0.01)x bitcoin .
To fully back the outstanding bitUSD, we need to generate revenue of 4(0.01)x bitcoin. Each bitDER sells for 3 USD, or 3(1.01)x bitcoin.
Therefore, we auction off (4/3)(0.01)/(1.01) bitDER from existing holders to new buyers who pay in bitcoin.

Result: Say Alice starts with 1 bitDER, Bob starts with 1 bitUSD, and Sally (a new buyer of bitDER) starts with 4(0.01)x bitcoin.

Alice: 1 bitDER -> (1-(4/3)(0.01)/(1.01)) bitDER
Bob:   1 bitUSD -> 1 bitUSD
Sally: 4(0.01)x bitcion -> (4/3)(0.01)/(1.01) bitDER

You can see that we enter and leave with total bitDER = total bitUSD.
Alice earns a -1.32% return on a 1% depreciation. (You can see that she is leveraged relative to just holding bitcoin.)
Bob is not affected in any way.
Sally's inflow of bitcoin makes up for the loss of backing due to depreciation.

Automated Markets
You can see that we constantly need to operate two automated markets: a) one for bitcoin / bitDER exchange and b) one for bitcoin / bitUSD exchange
These markets allow for automated conversion of the asset types without intervention from Alice or Bob. Sally manually intervenes in the markets, ensuring
that their prices reflect real world market values.

There is one pair of receiving addresses for each market:
market a) which you can send bitcoin to buy bitDER
market a) which you can send bitDER to buy bitcoin
market b) which you can send bitcoin to buy bitUSD
market b) which you can send bitUSD to buy bitcoin

They receive coins from any source for a fixed interval of say 50 blocks. Once the interval is up, the markets close.
At market closure, all the bitcoin received in market (a) are divided proportionally among all the bitDER in market (a)  [and visa versa]
The ratio of the bitDER received to bitcoin received in market a indicates the market price of bitDER in terms of bitcoin.
At market closure, all the bitcoin received in market (a) are divided proportionally among all the bitUSD in market (b)  [and visa versa]

Transfers from Alice (who holds bitDER) are automated and outside her control. Price changes automatically require bitDER and bitUSD to be put up for sale.
Sally purchase bitDER and bitUSD, so that their market price reflects the real world price. If not, then Sally would have a profitable arbitrage opportunity.

Simple Exchanges of bitDER and bitUSD:

If a txn has only bitDER inputs then it will only have bitDER outputs. A significant fraction of bitDER inputs will be unspendable at any given time as they await conversion in the automated markets. Closing market prices are uncertain so their needs to be a buffer of bitDER held in escrow whenever price changes. Eventually, the markets clear and the bitDER become spendable again.

If a txn has only bitUSD inputs then it will only have bitUSD outputs. The bitUSD are not used as a buffer. Therefore bitUSD are always spendable.

Catastrophic Price Drops:
If the bitcoin price falls by more than 75% over a short period (say less than a day), there may not be enough bitcoin on reserve to pay off bitUSD holders.
In this case, all bitUSD are converted into bitcoin and divided proportionally among bitUSD holders.

Interest:
The holders of bitUSD just have bitUSD in their wallet. These decay over time as the holders of bitUSD pay interest to the holders of bitDER.
Interest is automatically converted into new bitUSD/bitDER issues. bitDER holders receive the interest in the form of newly issued bitDER.
Newly issued bitUSD are auctioned off via automated markets for bitcoin.

Price Link to real world USD:
The automated markets indicate the real world market price of bitUSD in terms of bitcoin. If the real world price is less than the consensus price of a USD in terms of bitcoin, the interest rate on bitUSD is adjusted downwards. If the real world market price of bitUSD is more than the consensus price of a USD in terms of bitcoin, the interest rate on bitUSD is adjusted upwards. The interest rate increases and decreases maintain parity between 1 bitUSD and 1 real world USD in value.

Usability of bitUSD
As long as price doesn't drop by 75% within a day, use of bitUSD is straight forward.
You have bitUSD in your wallet. They are always worth very close to 1 USD each. You can buy and send them just like bitcoin.
The only differences are:
a) The bitUSD decay via demurrage (exactly like freicoin except with a time varying rate). So the balance will drop very slightly every time you sync your wallet.
b) If the very severe 75% price drop within 24 hours occurs (unheard of even in bitcoin land), the bitUSD are automatically converted to bitcoin.
If the bitcoin price keeps dropping, you start to take a USD loss just like any other bitcoin holder.

Usability of bitDER
bitDER are more complicated in that:
a) they are illiquid. You can't spend your entire balance at once.
b) your holding fluctates wildly in response to price changes.

These are intended as investment assets. They do not need to be as user friendly. I don't think anyone would buy goods in bitDER.
They would be even more volatile than bitcoin (1.333 fold more volatile if they have 4-fold backing). Some people will like this however.
If you think that bitcoin is going to the moon in 50 years and you think that bitcoin will never drop in price by 75% within a single day, then you will always be better off holding your long-term bitcoin investment in bitDER rather than bitcoin.

Hope that clears things up.

The point of bitUSD (in my view) is to replace bitcoin as a means of payment. So yes you send 4 bitUSD to buy 4 USD worth of goods. They are much simpler to use than bitcoin because well 1 bitUSD is worth 1 USD and everyone is familiar with that.

Behind the scenes their are insurers holding bitDER that back these bitUSD with bitcoin. Regular people don't need to  uneerstand this part. It might be better to explain things to general audiences as
1) take bitcoin
2) Do some math magic
3) end up with bitUSD ...

From there just explain how useful bitUSD would be. For example, just say that bitUSD provide a way of paying for bitcoin with irreversible units of USD value.

The math, simple as it is, will probably just confuse people. They will finish the article without any idea what bitUSD could be used for.

If you want to explain bitDER and bitUSD, use the following analogy (which is really very accurate).

Take 4 USD worth of bitcoins. Put them in a bottle. Cork the bottle and set it aside until tomorrow morning.

 Sell ownership stakes to the bottle to two different guys.
The first guy gets rignts to the first 1 USD worth of bitcoins that in the bottle. This is the bitUSD.
The second guy gets rights to the remaining bitcoins after removing one USD worth. This is the bitDER.

Every morning open the bottle and check the following:
1) are the bitcoins in the bottle worth less than 1 USD? If yes, break the bottle and give all the bitcoins to the first guy.
2) are the bitcois in the bottle worth more than 4 USD? If yes, remove them until 4 USD worth of bitcoins are left in the bottle. Reseal the bottle and set it aside until tomorrow. Give the bitcoins you removed to the owner of bitDER.
3) are the bitcoins in the bottle worth between 1 and 4 USD? If yes, then confiscate the outstanding bitDER from their current owmers. Sell as much of the confiscated bitDER as you need to in order to refill the bottle up to 4 USD worth of bitcoin. Resaeal the bottle and set it aside. Divide up any remaining confiscated bitDER among the original owners in proportion to their pre-confiscation ownership shares.  Move on to the next day.

Unless (1) occurs, you end the day with a bottle full of 4 USD worth of bitcoins. All bottles are perfectly interchangable (fungible). You can buy and sell them (or portions of them). If (1) occurs, it will break every single bottle (or portion of a bottle) simultaneously.

What is the math magic? Enforce all the checks in a blockchain without human intervention. Np need to trust the bottle creator any more than you trust a bitcoin miner.

Besids (1) is there any other way to break the bottle? Yes, there is one other eay. If one guy purchases all the rights to a bottle (both bitUSD and bitDER), he can break open the bottle and take the bitcoins in it whenever he wants.