What is the BitShares Decentralized Exchange? HD

Chapter 3
What is BitShares? BitShares is a DAC.
But what does this DAC do? It offers a service.
The service is matching willing buyers
and sellers of financial instruments and assets.
In this chapter we will focus on how the BitShares platform can be used to create
and trade a financial instrument called
a derivative contract.
Just like in the traditional financial
sector, these derivatives become
assets available for trade in and of themselves.
In the BitShares world, we call these
derivative contracts BitAssets.
These BitAssets can be sent from
one person to another
just like Bitcoin. This allows for some
really interesting possibilities that we
will explore together in this series.
As we explore these possibilities,
I would like you to keep a couple things
in mind. We all know that Bitcoin has
some tremendous advantages over
all other types of money and payment. But we also know that it has some drawbacks.
One of Bitcoin’s biggest drawbacks is its volatility.
The high volatility of Bitcoin makes it
hard for a mainstream user to treat
Bitcoin as a currency
in a self-contained ecosystem. It is true
that in some markets, specifically
the so-called “dark markets” like Silk Road
users have been forced to use Bitcoin as a currency in a self-contained ecosystem.
But for the mainstream
business, Bitcoin is generally received and
then immediately sold into a more stable store of value.
For this reason, I see Bitcoin’s primary use as
a payment system. Its tertiary uses are for speculation
and as a store of value. If the number of
people using the payment network increases,
it is likely the Bitcoin price will increase as well.
Bitcoin has many uses as a payment network.
Internet sales, remittances, micropayments & lots more.
But for the mainstream user and
especially for businesses with small margins,
the volatility of Bitcoin is too high. Once a payment is complete,
many businesses choose to sell their Bitcoins for a less volatile asset.
Generally trading into their
local fiat currency.
So what if we could have all of the
benefits of the Bitcoin payment network,
plus the price stability of things like
gold, silver, the Euro,
or even the US Dollar. If a new cryptocurrency could achieve that,
then we would see people having no need to immediately sell the coins.
They could hold them indefinitely. They
could simply save them until the next
time I want to use a cryptocoin to
make a payment.
They could do this without fear of what
the value might be at that time.
This is in my opinion, the holy grail of
One of the many things BitShares has achieved, is that cryptocurrency
just like Bitcoin, but with the price
stability of the US Dollar, the Euro,
gold, silver, or whatever asset the
customer desires. These cryptocurrencies
with price stability,
are called BitAssets. And the first to
begin gaining traction
is bitUSD. As you might imagine it
functions just like a cryptocurrency,
but its value is pegged to the US Dollar. One bitUSD
is always worth close to 1 actual US Dollar.
Now it is important to mention here that
the deviation between one bitUSD and
1 US Dollar
is already less than 1 to 2%. Now this
margin will continue to close as the
market depth increases. In addition to bitUSD, there is also bitEUR
that’s pegged to the price of the Euro. There’s bitCNY
and that’s pegged to the price of the Chinese Yuan. There’s bitGLD
pegged to the price of 1 ounce of gold. And bitBTC
pegged to the price of one Bitcoin. If BitShares achieves a critical mass of users with any
one of these, most likely bitUSD, then perhaps businesses will start
accepting it as payment for goods and services
just like they do with Bitcoin. If bitUSD
does reach that critical mass, I think it
could become a significant player in the
world of online payments. It could massively help all cryptocurrencies, including Bitcoin,
grow acceptance. Making the deal even
sweeter for people to buy and hold bitUSD
or any other BitAsset, is the fact that
while you hold it you
earn interest on your balance. This is
another powerful feature for everyday consumers.
While Bitcoin is phenomenal for
merchants, its advantages are not quite
as strong for consumers.
Paying holders of cryptocoins interest on their
holdings could be the nudge consumers
need to rapidly increase their
participation in the cryptocurrency revolution.
We will talk more about that in the next Chapter when we focus on BitAssets.
To explain this concept creates a
chicken-and-egg situation. To understand BitAssets
one must understand BitShares as well as the other way around.
They go hand in hand and you need to
understand both to make sense of them.
I think it is useful to hold this
analogy in your mind
as we move forward. Think of BitShares as a decentralized company
and BitAssets as its products. If you
think these products are useful
and will be used by lots of people and you
think the BitShares company can make a
profit by providing these products to the marketplace, then you might decide to invest in the
company by purchasing BitShares. If your
predictions are correct
then the value of the company may
increase and your ownership portion of
the company may increase in value.
If you are wrong, then the value of your shares in BitShares may decrease in value.
Conversely, you may not be that much into investing
and may not have the time to understand how all this technical mumbo jumbo works.
But still like the idea of holding your
wealth outside of the banks
in a stable cryptocurrency that earns interest. If that is the case,
you could just use one of the products BitShares offers called BitAssets.
I will spend the rest of this Chapter talking about the business of BitShares
and in the next chapter I
will talk about the product BitAssets.
So what does BitShares do? BitShares is a decentralized platform
that allows users to enter into
financial agreements with each other.
Prior to the invention of the blockchain, doing this in a decentralized way was impossible.
In the past, you had to have a
centralized trusted party
to hold collateral and enforce agreements. Now,
cryptocurrency can be used as
collateral and the blockchain can be used
to enforce contracts. There are lots of different uses for this
but we’re going to start by looking at
the world of derivatives. The union of blockchain
smartcontracts and cryptocurrency technology is perfect for derivative markets.
For some, derivative markets have a very negative connotation.
There’s nothing bad or immoral about
these financial assets in principle.
However, some argue that in the traditional markets, they are
under-collateralized and thus dangerous. These arguments may have some merit,
but fully collateralized derivative contracts do offer
major advantages for businesses with little downside. I will spend just a couple of
minutes going through some basics at how derivative markets work.
If you are new to this, you might want to
review this chapter
a few times, but don’t worry too much if
you don’t get it. There is just a couple
of main points you need to understand and I will recap them all
at the end. A derivative is a
contract that derives its value from
underlying asset. As the price of the
underlying asset moves,
the value of the contract either
increases or decreases.
Let’s use a real-world example to
demonstrate. Let’s say I am an American
television manufacturer who purchased most of his components from China. My supplier
in China prices his goods in Chinese Yuan. Let’s say I am bidding to supply a hotel
chain with two thousand televisions.
If my bid is accepted, then I need to
know that in 6 months time
when I need my components I can still
buy them on
the budget despite if there are any price
swings in the Chinese Yuan.
I have 2 options; I could just go and buy
the Chinese Yuan or the components now,
but that would hurt my cashflow. Or, for a
small fee
I could enter into a derivatives
contract to guarantee me the price
I could buy the Yuan for in 6 months time. This would help my cashflow considerably.
So let’s say the price of the Yuan goes
up over the next 6 months.
In this case, I would use my contract to
buy the Yuan at the agreed upon price.
I would be unaffected by the price
increase of the Yuan. If the Yuan goes down,
then the person I have the contract with would want to force me to buy the Yuan at the agreed
upon price. I would be paying over market price for the Yuan, but
I had the peace of mind that I could afford to purchase it and build that price
into my television contract with the
hotels. So now let’s look at who might
enter into the contract with me.
The answer is pretty simple. There might
be a Chinese manufacturer who uses American
parts. They have the same problem in reverse. The Chinese manufacturer wants to lock
in a price they can trade in their Yuan for Dollars at a future date.
In the same way that I want to lock in a price I can trade my Dollars for Yuan.
You can see how both parties benefit
from this agreement. This particular
form of derivative contract will be called
a Future. As we are locking in the future price of a commodity. In this case,
the commodities are the US Dollar and
the Chinese Yuan. It is important to note
that these are just contracts enter into
voluntarily by two parties.
They can be any variation of the above
example. Now I’m gonna leave the
discussion about derivatives there for our current purposes,
but I will mention these 4 important things…
1) The size of the derivatives market is
estimated to be over $700,000,000,000,000.
It is humongous. It is orders of magnitude larger
than the entire world’s GDP. To say that
bringing an efficient innovation to that
world may have some upside to investors
could be the understatement of the century.
2) If everyone just had a variety of
contracts with no commonality between them
they would not be very liquid. Every
contract would be unique
and not easily transferable. So contracts
with standard terms have been formed to solve this
problem. For example, you might have a market for a gold futures contract maturing on
January 1st. And another one maturing on February 1st. But not on all the days in between.
Because everyone in the market has
his or her contract maturing on the same day,
this allows for a highly liquid market. Traders can trade them minute by minute
as the price of the contract fluctuates. The derivatives themselves become
assets. Even better yet, they become
fungible assets.
That means that any contract with the
same terms as mine is identical
and thus can be easily exchanged. This is
really important so please remember that.
The derivative becomes a fungible asset itself.
The high liquidity and fungible nature
of these assets
make them very useful as we’ll see
shortly. Point number 3…
Contracts are often settled and secured
in value only
and not in the actual commodity. For example,
I may have a contract to buy one ounce of gold from you for $1200 in 30 days.
The current price of gold is $1200 per ounce
and so we have a 50-50 chance of making or losing
money. Now, you choose to charge me a small fee for that privilege.
But how do I know that you have the gold to give me? The contract would be most secure
if you put either the gold or the dollar
amount of that gold
in escrow with a trusted third party to
cover your obligation to me.
That would give me certainty
that you can deliver on your promise. But
gold, wheat, oil,
copper, corn and almost all other commodities are clumsy and expensive to move around.
So people usually just deposit some
dollar amount with a trusted third-party
as security without touching the underlying commodity.
So let’s examine that a little closer. Let’s say that 30 days has elapsed,
and I have the right to buy gold from
you for $1200 per ounce,
but the price of gold has moved to $1300 per ounce.
So now I must put in $1200 and you have to put in $100
for me to get a 1300 ounce gold bar from the market.
You can see in this instance, that in
order for you to cover your promise to me,
you only needed to deposit a fraction of
the dollar amount of
your promise. In order to guarantee me a
price of $1300
you only had to deposit $100 as security.
However, at the start of the transaction
we don’t know how much the price would swing
and how much you will need to cover. Traditionally, the more stable the commodity,
the less security there needs to be. But
what happens if your security is not enough?
Let’s say you only deposited $50 as
security in the above example
and after 15 days or so the price of gold
has moved to $12.50 per ounce
I have a promise to you to buy for it $1200
and you have $50 as security. If the
price goes up
any further, there will not be enough to
cover the position.
At this point, one of two things can happen.
One option is for you to put in more
security to cover your position.
This is known as a margin call. Alternatively,
the trusted third-party can give me the $50 security now
so that I can go and buy a new futures
contract for $1250
using my $1200 and your $50. Remember that the price
the derivative contract is derived from
the underlying value of the asset.
The new derivative contract will cost me $1250
and I am not out-of-pocket. The important thing to
note here is that access to the underlying
commodity is not necessary.
The actual physical gold is nowhere to
be seen in this transaction.
These are financial instruments. As long
as a value can be transferred,
the integrity of the contract is held. The form of that value is not significant.
As long as it has value and is perfectly
liquid, the derivative market works.
Point number four… There are lots
of people who are putting up security
and offering these contracts
and there are lots of people buying
these contracts. For these derivative contracts to
be created, the two parties need to be paired up. There needs to be a buyer
and a seller. But because these contracts
are on standard terms,
they are fungible. The parties can be interchanged.
Let’s again look at the above example
where you had to put in more security on the
15th day, or the trusted third party would give me your $50. In reality,
as the $50 security is dwindling, the escrow goes into the market
and buys back the contracts. This can be any contract of the same type because they’re all fungible.
So, just because the person I was
paired up with to create the contract
was forced to buy his contract out
does not mean that he must buy my
specific contract back from me.
In fact, he can buy any other contract of
identical terms. In a contract with me, he
is the seller at $1200
and with another he is the buyer at $1250. He no longer has any exposure
to the price of gold as he has both bought
and sold one ounce of gold. I still have my contract for an ounce of gold at $1200,
even though he is closed out all of his
positions. That is the power
fungible contracts. Once these markets hit significant volume,
there are always people who are willing
to take a position for profit.
These people are called market makers. These speculators, for a price,
will always take a position and these
derivatives can exist indefinitely.
In a moment, we will see why
all of these things are important. So if it doesn’t make too much sense at the moment,
be patient. I think it will become clearer
in the next chapter.
What is important for you to understand now,
is that these derivative markets exist
and are functioning.
To run this $700,000,000,000 derivative market,
there are exchanges all over the world. Huge buildings are erected,
thousands of people employed, large
bureaucracies are paid for by the taxpayers
to reduce fraud and illegal activity and
huge accounting and auditing firms
must be engaged to monitor the flow of funds to stop embezzling
and other forms of theft. The resources spent on running these exchanges
are huge. But obviously, the fees these exchanges charge their users to create,
buy and sell these derivative contracts
are more than enough to cover these enormous
costs. Despite all of these measures embezzling still takes place,
fraud is still rampant and corruption is
rife. Blockchain technology
promises to create a fraud free
environment. An Exchange where
we do not have to trust bureaucrats, auditors, politicians, bankers or anyone
else. An environment where all of those people are completely cut out.
An environment where all we have to
trust is the mathematics of the blockchain.
And best of all, a decentralized exchange
based on the blockchain
can make all of these improvements while
reducing the costs by over 99%.
BitShares is the first to decentralized exchange to be released
into the ether and I don’t think the
world will ever be the same again.
By downloading the free open source software,
anyone, anywhere in the world can engage in offering or accepting derivative contracts
with anyone else. You do not need any
middlemen. You do not need to give up
any in your financial privacy. You do not
need to trust any other person.
You don’t even need to trust the person
that you’re in contract with because
the blockchain will enforce all contracts
no matter what. Just as
derivative contracts become highly
liquid assets in traditional markets,
BitShares allows users to create
these same contracts on the blockchain
and trade them as assets. Just as we send Bitcoin to one another now,
we can also send derivative contracts. As
we said earlier in the world of BitShares, we call
these BitAssets. We’ll examine just one of
those BitAssets,
bitUSD, in the next chapter and I think
it will really help your understanding of
how it all works. But before we do, I think it’s worth noting,
even if these BitAssets had no other utility,
what we have already learned could send BitShares skyrocketing in usage
as an efficient decentralized exchange in
a $700 Trillion marketplace.
As amazing and as exciting as that is, that’s not the most exciting part about BitShares and BitAssets.
The next two chapters will explain why. By the way,
I know this is tricky stuff. So congratulations for sticking with it so far.
I really hope you enjoyed this video in
the BitShares 101 series.
If you want to help BitShares achieve its
mission of securing life, liberty and property for all,
go ahead and give this video a thumbs up. Share it on social media like Facebook and Twitter.
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for future updates. To watch the remainder of this video series, click
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the Getting Started series
that will walk you through downloading your free wallet and creating your free account.
See you in the next video… 🙂


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