tl; dr: Every POLY.10.n bond will have a face value of (X/10)^n BTC, where $X USD is the last trade price of BTC on Mt. Gox, and n is a value specific to the particular bond.Introduction. This instrument emulates BTC/USD margin trading, acting as an alternative to margin trading platforms and as a substitute while they are inactive. Unlike the margin emulation asset
ABSORB, POLY is persistent (in principle the same asset can be used indefinitely) and embodies a much clearer effective leverage, allowing traders to more easily control their position.
Operation. Specific bond offerings will include for example POLY.10.1 and POLY.10.-2. In general, every POLY.10.n will have a face value of (X/10)^n BTC, with $X being the last traded price of BTC on Mt. Gox. Bondholders have the right to sell the bonds back to the issuer at their face value.
Position equivalence. Holding 1 BTC worth of POLY.10.n bonds is locally equivalent to holding (n+1) BTC, in the sense that for small a, an increase of $a in the BTC exchange rate causes an increase of $a*(n+1) in the USD worth of the held bonds. Unlike normal margin trading, holding POLY bonds means profits are immediately reinvested in increasing the position, and losses are immediately liquidated and deduct from the position.
To see this, we first consider some trivial cases. POLY.10.0 bonds always have a face value of 1 BTC, and holding 1 BTC worth of the bonds (1 bond) is equivalent to holding 1 BTC. Investing in such bonds is uninteresting, since one may as well keep the bitcoin.
A POLY.10.-1 bond has a face value of (10/X) BTC, and since each BTC is worth $X, each bond is worth $10 regardless of the BTC price, and thus holding a bond is equivalent to holding no BTC at all. This again is uninteresting because one may as well sell the bitcoin for USD.
A POLY.10.1 bond has a face value of (X/10) BTC. 1 BTC gives you (10/X) such bonds, initially worth $X. If the exchange rate rises to $(X+a), the new face value of the bond is (X+a)/10 BTC, so the value of all (10/X) bonds is 1+a/X BTC, which at $(X+a) per BTC is worth $(X+a)(1+a/X) = $(X+2a+a^2/X) ~ $(X+2a), an increase of $2a, so the position implied by 1 BTC of bonds is indeed 2 BTC (so investing in such bonds is equivalent to taking a long position with 2:1 leverage). With the new price of $(X+a) per BTC, the held bonds are now worth 1+a/X BTC, so the position is now 2+2a/X BTC, meaning that the profits have been reinvested in an even longer position. If the trader wishes to maintain the same position, he will have to sell some excess bonds (or buy new bonds in case of loss).
More generally, a POLY.10.n bond has a face value of (X/10)^n BTC. 1 BTC gives you (10/X)^n such bonds, initially worth $X. If the exchange rate rises to $(X+a), the new face value of the bond is ((X+a)/10)^n BTC, so the value of all (10/X)^n bonds is (1+a/X)^n BTC, which at $(X+a) per BTC is worth $(X+a)(1+a/X)^n = $X(1+a/X)^(n+1) = $X(1+(n+1)a/X+O(a^2)) ~ $(X+(n+1)a), an increase of $(n+1)a.
In particular, holding 1 BTC worth of POLY.10.-2 bonds is equivalent to holding -1 BTC, so starting with USD, buying 1 BTC and using that to buy POLY.10.-2, is equivalent to short selling 1 BTC.
Calling. The issuer has the right to buy back the bonds, at a multiple of the face value which varies according to the specific bond. For POLY.10.1 and POLY.10.-2, the multiple will be 120%.
Termination. If the trade prices from Mt. Gox become terminally unreliable, such as if it ceases operations, the bonds will be bought back for their face value, determined by the agreed upon last meaningful trade price.
Challenges. Assuming, as is likely at this point, that the BTC exchange rate will eventually reach either arbitrarily high or arbitrarily low values, it is easy to see that by buying both a ^1 (long) and a ^(-2) (short) bond, the trader is guaranteed profit, meaning the issuer is guaranteed loss.
This is because of the trader's implicit right to to reinvest all profits in extending his position, regardless of the issuer's ability to hedge the position. Normal margin trading platforms have multiple ways to control this. They can simply refuse to extend the position; they can increase the fee; they can charge interest for taking an unfavorable position, and pay out interest for depositing funds they can use for hedging.
With the way the POLY contract is set up, none of this is possible. The issuer has only two mechanisms to handle this: Calling the bonds when the position becomes intolerable, which is expensive; and using the time value of money to compensate for the future losses. Since there is no way to control interest rates, the effectiveness of this is limited.
Since this is risky for the issuer, the offering price of the bonds will have to include compensation for it. The trader will have to weigh the advantages of an unlimited permission to extend his position (up to the issuer's right to call the bonds at a profit to the trader) against the higher price.
Even so, this is only sustainable with a market maker bot constantly balancing the issuer's position, and with enough trading activity to make sure that increases in the face value of a bond can be matched with traders looking to sell bonds.
Series details. As an initial proof of concept, 200 POLY.10.1 bonds will be offered. POLY.10.-2 should soon follow. The IPO is scheduled for June 14 2012, but bonds will start selling only after the necessary preparations are made.
In the future, higher-leveraged bonds might be offered, and additionally, if the price of BTC changes so that the value of each single bond becomes hard to work with, new series such as POLY.100.n may be offered.
Update: Currently POLY.10.1 and POLY.10.-2 are offered.
POLY.10.1: You can buy at 110%, sell at 106%, target is 400 BTC.
POLY.10.-2: You can buy at 104%, sell at 100%, target is 400 BTC.
