Bitcoinica model is flawed

[SgtSpike]

Given that you know what the liquidation threshold is well in advance, why is "speed" a factor?  You could have the order sat on Mt.Gox's books from the moment the position is established.  The market then couldn't move to a "slippage" price without passing through your order.

Let's do a very basic scenario.

Someone is long with a base of $5 and liquidation at $4.

MtGox has open buy orders of $4.50 and $3.50.

The $4.50 buys are filled, and the "price" suddenly drops to $3.50, because there is nothing at $4.00.

The person gone long is liquidated, but zhout has no choice but to liquidate the Bitcoins at $3.50 instead of $4.00, because that is the going market price.

Normally, the spread between bids is very small, so $4 would be liquidated at $3.995 or something, and zhout makes the money off the maintenance fee (if the liquidation is $4.00 to the user, then the "true" liquidation is actually $3.75 or $3.90 or something).  But with large price movements and lots of liquidations in a short period of time, not enough buyers can be found on MtGox to sell all of the liquidations at their liquidation prices, and they slide the price even further beyond the maintenance fee, causing a loss.

Anyone feel free to correct me if I am wrong - this is all just guessing based on the way I would set it up.

I believe you are correct SgtSpike.  realnowhereman is also correct that he could avoid slippage by putting orders in place.  This has it's own issues though since if the user closes or changes their position, the order would need to be updated.  If the market took the order before it could be adjusted, again Zhoutong has loss.

How can you set up a sell order at $4.00 without executing it though?  If the price is $5.00, and the liquidation for a particular long holder is $4.00, you couldn't pre-set a sell order at $4.00 without it being executed.  Unless I am missing something..?

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[Qoheleth]

That is an unsustainable though, those reserves are not infinite.  Travel backward in time, when bitcoins were $0.01 and imagine you had gone long (1:1) with 100 BTC.  That required someone else to go short for $1.  Now BTC are $6 each; and you are worth 200*6 = $1200; at some point that shorter was liquidated, losing their $1; but that leaves us $599 lacking in the fund pool.

Mr. Long buys 100 BTC for $10.
There's no Mr. Short! So Bitcoinica backs this by going to Mt. Gox and physically buying 100BTC with $10 from its reserve.
A year later, Mr. Long cashes out his position of 100 BTC for $6 each - for a total of $600 minus the $10 from the original long position.
Bitcoinica sells those physical 100BTC for $600, passing $590 to Mr. Long and putting the remaining $10 back into its reserve.

The numbers balance.

This is the very definition of the problem.  Bitcoinica has to do exactly this for every long and every short.  The imbalance is not the only thing that needs backing, every position needs backing as the shorts only cover the longs to their margin; and the profit for the long can exceed that margin.

The only problem here is that Bitcoinica doesn't have infinite funds to lend out. Their funds aren't at risk; when all positions liquidate, the reserve is just as big as it was when there were no positions at all. They just don't have the capital to materialize an unlimited number of positions.

I don't think their funds are at risk when people liquidate.  The liquidates are easy.  The problem is the profits.

Ah, I think I comprehend now. You're right about even balanced positions having to be backed; you can't balance longs and shorts without holding the reserve just in case one or the other pulls out first.

But then, it still works. Mr. Long's position is backed by USD from the reserve being traded for BTC. Mr. Short's position is backed by BTC from the reserve being traded for USD.

There's still no risk. There's still no betting against the users or having to foot the bill for profits (since the "buys" and "sells" underlying the longs and shorts are all, at least theoretically, executed on the market). All Bitcoinica is doing is lending money for people to use to make a profit, and collecting whatever they loaned out when the position is liquidated - whether by choice or by force.

What am I still missing here?

[notme]

How can you set up a sell order at $4.00 without executing it though?  If the price is $5.00, and the liquidation for a particular long holder is $4.00, you couldn't pre-set a sell order at $4.00 without it being executed.  Unless I am missing something..?

Doh.  You're right.  MtGox would have to support stop-loss orders for that to work.

[SgtSpike]

How can you set up a sell order at $4.00 without executing it though?  If the price is $5.00, and the liquidation for a particular long holder is $4.00, you couldn't pre-set a sell order at $4.00 without it being executed.  Unless I am missing something..?

Doh.  You're right.  MtGox would have to support stop-loss orders for that to work.

Even if they did, it would only help avoid losses in the case of getting those orders executed in front of other potential orders.  But if there's no one willing to buy between $3.51 and $4.00, then even a stop-loss order at $4.00 isn't going to avoid a loss.

I think there were just far too many liquidations compared to the buy book, and once that snowball started rolling, all the liquidations just couldn't be sold at the price they should have been sold at.

Just my speculation though - I don't know the truth behind why zhout took a loss.

[kronosvl]

realnowhereman I'm quite noob in this matter however I think you forget something
lets say we have 2 positions 1000BTC (long) and -1000BTC(short) open at the same time at price 10$ (I will ignore spread in this example)
price rise at 20$ and the short position is liquidated. Now the system lost the balance. so what does the liquidation mean? I guess that the player with the short position will have the balance at 0 or almost 0. But that's not all. The system should have 1000BTC in it's wallet to cover long position. And it will buy the second it liquidates the short position  at 20$ with the money taken from the player with the short position. So when 1BTC will be 1000$ and long position gets liquidates the system will just sell those BTC on the market.

tl;dr:
without opposing positions market will cover the difference not bitcoinica

[notme]

How can you set up a sell order at $4.00 without executing it though?  If the price is $5.00, and the liquidation for a particular long holder is $4.00, you couldn't pre-set a sell order at $4.00 without it being executed.  Unless I am missing something..?

Doh.  You're right.  MtGox would have to support stop-loss orders for that to work.

Even if they did, it would only help avoid losses in the case of getting those orders executed in front of other potential orders.  But if there's no one willing to buy between $3.51 and $4.00, then even a stop-loss order at $4.00 isn't going to avoid a loss.

I think there were just far too many liquidations compared to the buy book, and once that snowball started rolling, all the liquidations just couldn't be sold at the price they should have been sold at.

Just my speculation though - I don't know the truth behind why zhout took a loss.

Correct.  And like I said earlier, even it it did work optimally, Zhoutong still has to worry about someone changing their position and the order getting filled before he can update it.

Zhoutong said the loss was due to slippage so I would say your speculation is accurate.