A black swan event is a very unlikely, yet possible event. The concept was first introduced by Nicholas Taleb in his book, “The Black Swan: The Impact of the Highly Improbable”. All debts and contracts are vulnerable to sudden and unexpected movements in the market and investors would be unwise to fail to account for these events which are more common than we would like to believe. BitAssets, such as BitUSD and BitGold are no different than any other financial instrument and have limits beyond which they are unable to maintain their market peg. Today I would like to explore what scenarios would cause the peg to fail and how the BitShares network automatically responds to them.
The Highly Improbable
By Wall Street standards, BitShares is extremely conservative in its ‘lending’ policies by only allowing users to borrow up to 33% of the value of their collateral. Most banks consider lending 80% the value of collateral to be conservative and often go almost to 100%. The loan is secure so long as the value of the collateral is greater than the amount borrowed.
In the case of BitShares we assumed the collateral (BTS) could easily be as volatile as Bitcoin on its worst days. On some days Bitcoin has lost 25% or more of its value. Recently Bitcoin lost 42% of its value over just 7 days and along with it so did almost all alt-coins. This level of movement is within the design tolerance of BitAssets, but did result in many short positions being margin called.
In order to break BitUSD the value of BitShares would have to fall by 67% in a market where no one was willing to sell enough BitUSD to allow all existing shorts to cover. For all practical purposes this fall would have to occur over just a few days, in thin markets, with no expectation for a rebound in value. This kind of event is possible and could be triggered by any number of events: most likely bugs, hacked wallets, or government actions.
As much as we would like to pretend these things would never happen, we can be sure they will happen at some point with some BitAssets because even if BTS didn’t lose any value at all the value of gold or silver could grow by 300% while BitShares stays flat. So a Black Swan can occur due to no fault of BitShares or crypto currency in general.
Handling a Black Swan
For BitAssets we define The Black Swan as any time the value of the least collateralized short position is less than the balance due according to the median price feed published by the delegates. Once this happens the network is unable to keep the peg without transferring wealth from shareholders or other shorts. Socializing this risk would punish shorts that were pro-active in maintaining their collateral or shareholders who were not actually party to the speculation. Considering the potential costs of maintaining the peg are unbounded, we opt to settle all BitUSD debts with the available collateral.
Rather than attempting to keep the peg “at all costs” BitShares chooses to define the ability to redeem BitUSD as the minimum value of about $1 or the collateral ratio of the least collateralized short position. It also chooses to define the terms of BitUSD such that it can be automatically converted to BTS at the ratio of the least collateralized short at any time.
Anyone who is holding BitUSD at the moment of a Black Swan will have it instantly converted to BTS. The least collateralized short will get nothing back and all other shorts will get what ever collateral they have left after settling. Everyone settles at the same price.
Impact of Price Feeds
Deciding when a Black Swan has occurred is up to the price feeds of the top 101 delegates. Under normal market conditions almost all trades execute at a price approved by the individuals creating the orders. All shorts and relative orders specify limits that protect them from the delegates arbitrarily moving the price feed. Even margin calls cannot be executed unless the highest bid is below the margin call price and within 10% of the price feed. In effect, delegates can confirm a margin call, but they cannot create one unless the market agrees.
In very thin markets delegates can trigger margin calls, but only by pretending the collateral is worth less than it really is. In the very unlikely event that they were able to manipulate the market and the feed they could trigger the Black Swan liquidation event. If this were to happen then it would be a wind fall to BitUSD holders which would receive BTS that had a real value far in excess of a dollar. This assumes the obvious “attack” didn’t result in BTS price actually falling, in which case it would be a real Black Swan.
In other words, if the price feeds and market were compromised most of the risk of an artificial liquidation event falls on the shorts. Shorts are “super bulls” and thus implicitly trust the system more than those who want the stability of BitUSD.
There is only one way that compromised price feeds could impact BitUSD holders. If a real Black Swan event did occur, the delegates could post-pone/prevent liquidation by failing to publish prices that reflect the new reality. If this were to happen the internal market would continue to operate, but almost all feed-relative bids, asks, and shorts would be canceled (or filled) leaving only BitUSD longs to trade against BTS longs. The trading price would likely hover around the expected liquidation price because most players would expect the feed to eventually be corrected and force everyone to liquidate.
In short, pun intended, the price feeds alone are unable to harm shorts or longs and all market participants can predict with a high degree of confidence how to value BitUSD in any and all market conditions.
What happens to BitUSD Yield
As many of you know, BitUSD is currently paying about 1% APR yield to those who hold it. In the event of a Black Swan all BitUSD will be paid out all of the yield they would have expected over the course of a full year. So if you just purchased $100 a mere 10 seconds prior to a Black Swan event being detected then you would receive the BTS due for a full $101. Any open shorts would immediately pay their full balance including the interest due.
In effect, the yield fund maintained for each BitAsset gives all BitUSD holders one last bit of protection from volatility by giving them an extra 1% (or more) a full year earlier than they had expected. The larger the APR the greater the Black Swan protection. In the grand scheme of things, if BTS has fallen by 67% an additional 1% protection is nice, but probably unable to cover all of your losses.
Status (Jan 2015)
As of this writing a Black Swan event will simply halt the market until the settlement process defined above can be implemented. We expect to have a fully implemented and tested liquidation process by the end of March 2015. Hopefully, there will be no Black Swans between now and then. Even without this liquidation process being fully implemented, the value of BitUSD still carries almost the same guarantee. The only difference is how long you may have to wait for settlement.