Topic: Securing contingent claims - page 2. (Read 7293 times)

Great question. There is a very close relationship. First off, I am thinking in terms of zero-coupon bonds (bonds which pay all of their interest at maturity rather than gradually over time).
The most common type of bond pays interest periodically and pays back the principal on maturity. This may be throwing you off.

a BTC Bond - a security which becomes a bitcoin upon reaching its maturity date. (The price of a BTC Bond in BTC will always be less than the bond's face value at maturity. The price discrepancy is interest.)
Contingent Claim - a claim on ownership to a bond which is only valid if difficulty falls within a certain range when the bond matures

A BTC bond can be divided into several contingent claims held by several different owners.
A BTC bond can be recreated from contingent claims by buying up claims to ownership over the entire possible range of difficulties at maturity [1, infinity].

Maybe an example will help.

Say I hold 1 bitcoin and 1 BTC bond with a maturity date of Jan 1, 2012.
Right now my wallet reads:
BTC                                       : 1
BTC Bond (maturity Jan 1, 2012) : 1

After Jan 1, 2012, the bond will mature and my wallet will read.
BTC                                      : 2

Let's consider dividing this bond up into two contingent claims. Frank starts with 1 BTC. He sends me 0.3 BTC and I send him a contingent claim on my BTC bond. If difficulty is greater than 5,000,000 Jan, 2012, he gets ownership of the bond; otherwise I get ownership.

My wallet now reads:
BTC                                                                          : 1.3
BTC Bond (maturity Jan 1, 2012; difficulty <= 5 million)      : 1
BTC Bond (maturity Jan 1, 2012; difficulty > 5 million)        : 0

Frank's wallet now reads:

BTC                                                                          : 0.7
BTC Bond (maturity Jan 1, 2012; difficulty <= 5 million)      : 0
BTC Bond (maturity Jan 1, 2012; difficulty > 5 million)        : 1

If on Jan 1, 2012 difficulty > 5 million

my wallet:

BTC : 1.3

Frank's Wallet

BTC : 1.7

If on Jan 1, 2012 difficulty < 5 million

my wallet:

BTC: 2.3

Frank's Wallet:

BTC: 0.7

I see.  That does sound like a better system indeed (especially with the borderless nature of bitcoin).


I'm a bit confused about how your system handles both bonds and 'contingent blocks [aka options/futures]' and the relation between the two (if any).

If you allow margin trades, then you reintroduce counterparty risk. My main goal here was to find a trading system
which eliminated counterparty risk and the need for legal or reputational enforcement.

Anyways, there is still a tax on margin requirements because you can't use bonds to back your trade.
As you point out, however, allowing margin trading does reduce the tax.

But, different brokers will have different margin requirements.  Surely those won't always be 1:1.

One problem with using the existing block chain is that it ties up BTC in escrow. Suppose we want to wager 1 BTC on bitcoin difficulty 1 year in the future. To do this, we would need to hold 1 BTC in escrow for the next year. If on the other hand we loaned out the BTC at a hypothetical risk-free interest rate of 1%, we could earn around 0.01 BTC in interest during this year. Thus, there is something like a 1% annual tax on speculative transactions that use regular bitcoin.

On the other hand, if we a mine a bond that matures in one year, we don't need to forgo any interest to place bets on difficulty when it matures.

A intermediate solution, perhaps the best, is to allow the mining of bonds and then handle the rest using something like open transactions.


I also worry that the system could become unstable (currency generation could balloon or collapse) if everyone made bad guesses. An arrangement that doesn't allow this to happen is described here:


Basically it involves having three difficulty levels, first mining the bonds and then allowing the miners (or anyone else who buys them ) to break them up into contingent claims.
Open Transactions could handle splitting the bonds into contingent claims.

I think it's a great idea.  Seems like an efficient formalization of options/futures rolled into the blockchain itself.  It should help to stabilize price and, as you said, encourage adoption.

EDIT: IIAP and think the contingent block mining would be easier to implement (and it's conceptually simpler).  However, as others have mentioned 'OpenTransactions' already seems to be approaching 'p2p contracts' and that may be objectively better if one is particularly attached to the current blockchain.  IMO, CBM is a bit more elegant (and it allows the miners to get directly involved in predictions and doesn't preclude the additional options/contracts markets from developing around it either).  There is something to be said for leaving a working system alone though and building onto it.

Have you considered what would happen if a significant number of miners enter the contingent market exclusively and guess wrong?  All that hashing power would be lost and the original network would be less secure as a result.  Or are there enough competing interests to balance this out?

BUMP for more comments.

I agree, people will still participate in a prediction market. Even under an implicit tax it is still a good idea. Also I agree that if people expected bitcoin to deflate at the risk-free interest rate + a risk premium, then you would not forgo any interest by holding bitcoin. Remember, however, that inflation/deflation depends on changes in the ratio of volume of bitcoin transactions to the bitcoin money supply. For bitcoin, the serious inflationary risk is a change in transaction volumes/expectations about future transaction volumes, not expansion of the money supply.

Yeah that's true. I still don't totally get the contingent claims stuff, and I can't think of any other way to guarantee a bet. I think this is mitigated by a potentially short term of contract and especially because bitcoin is deflationary. Maybe interest isn't as in important when your coin is deflationary instead of inflationary. How much interest do you expect to get on your savings now? What's the devaluation spread between an inflationary dollar and a deflationary bitcoin? Seems like the remaining interest you'd forego, if any, could be worth the utility of the prediction hedging.

Okay, here is some more detail. The prediction market is still a wonderful idea, but is not anywhere near as efficient as a system for mining bonds.

Suppose I want to make a 100 bitcoin bet on a prediction realized in one year. To back my bet in the prediction/options market, I would need 100 bitcoin bonds with a one year maturity. In the current system, the bitcoin monetary authority doesn't issue bitcoin bonds. Participants are forced to use bitcoin as a substitute for bonds, but using bitcoins to secure a one year bet requires forgoing one year of interest.

Forgone interest can be assessed using the risk free interest rate. The risk free interest rate can be proxied using the yield on US treasury inflation-protected securities (TIPS), currently around ~0.75% per annum for TIPS maturing in 2 or 3 years http://www.treasurydirect.gov/RI/OFNtebnd]. Using this interest rate, I am giving up ~ 0.75 bitcoin for every 100 bitcoin I invest in backing one-year predictions (a 0.75% tax). Because of this tax, the volumes traded on a prediction market fully backed by bitcoin will be much smaller than they would be on a prediction market fully backed by bitcoin bonds.

Given that current exchange fees on bitparking are around 0.4% (counting both sides of the trade), the size of the forgone interest effect on trading volume might be similar to tripling exchange commissions.

@TierNolan

Of course you are completely right. To the extent that Moore's law is perfectly predictable this is not a problem at all. Market participants would factor future difficulty increases when trading.
If there is an unanticipated technological shock (say cheap hashing ASICs appear), then yes it would cause the short-term price-difficulty relationship to change dramatically. On the one hand, the possibility of tech shocks is a downside because they weaken the usefulness of bets on long-run difficulty as insurance against price changes. On the other hand, the development of this market would strengthen incentives for entrepreneurs to build ASICs (see the argument about Amazon). 

@ben-abuya
A fully-backed options/prediction market imposes an implicit tax on transactions in contingent claims. This happens because speculators have to tie up the use of their bitcoin to participate in the market. Accordingly, they have to forgo interest until the predictions are realized. I'll explain in more detail later.

I am not so sure that this is true.  It assumes that cost per hash is constant.  Event without improvements like CPU to GPU hashing, you are going to face the effects of Moore's law.

cunicula, I like the work you're doing here, although I haven't grasped all the details yet. Are you sure you need miners to selectively mine different maturities and for them to have different difficulties? That would really complicate the system.

I have a proposal for a more generalized prediction market based on the bitcoin concept:

http://forum.bitcoin.org/index.php?topic=10011.0

Thanks ben-abuya. I would be so happy to see someone work on this. I have a small bounty (25 BTC) to share amongst people who make this alternate chain a reality.

I think it is fairly important that miners can choose which maturity of coins to mine for, and accordingly that each maturity has its own difficulty level. Can this be accomplished with scripting?

This is a really neat idea. Bitcoin already has transaction scripting built-in, in fact the regular transactions we know and love are just a special case of this scripting. The thing is, this scripting cannot take the amount of the transaction or things like the difficulty into account. It could, it's just not in the current scripting code. I think adding in some more scripting operations would be all that's needed to make this kind of thing possible. Not hard to code, but a big expansion of how bitcoin works, and that's kind of scary. Again, this could be a variant of bitcoin, like namecoin.

Realizing I screwed up the whole velocity thing. Sorry, please ignore that part; not important to argument.

@noone

Still learning about OpenTransactions (looks cool), but I don't think it is really the same thing. Seems to require banking institutions to make markets for claims. Not sure if OT solves the counterparty risk issue, which is major. Think it would be better to build the financial system in lock step within the currency, rather than waiting for entrepreneur's to build a financial system alongside. If you wait for banking institutions to make deep markets for bitcoin options, you might be waiting for a very long time.


Thanks iya. You are right, my proposal is just the creation of several "built in" derivatives. A few comments:

1) no need to increase complexity for the vast majority of end users. They can just use vanilla bitcoin and forget about the financial system, just like they can forget about the mining system. People who are interested in dealing in contigent claims could download a special GUI.

2) keeping money supply growth constant is not difficult. One simple option is as follows:
          a) issue 1/3 vanilla bitcoin [2 vanilla bitcoin bond blocks per hour]
          b) mine 1/3 as bitcoin bonds which become vanilla bitcoin on June 1st of each year.  [2 June 1st bitcoin bond blocks per hour]
                           (allow these bonds to be broken up into several types of mutually exclusive  contingent claims)
          c) mine 1/3 as bitcoin bonds which become vanilla bitcoin on Jan 1st of each year.   [2 Jan 1st bitcoin bond blocks per hour]
                (these can also be broken up into contingent claims)
Growth of the aggregate money supply is the same as before: 6 blocks per hour. it is just divided among more types of monetary instruments.

3) Derivatives might put average people off. Obviously, I don't agree with this. I think it could be overcome through clever marketing and interface design.

As far as your critique of the velocity equation, you are basically correct. I don't want the discussion to go there because that topic leads to flame wars.

So which is it? Of course it's neither proportional nor inversely proportional, at best it's loosely correlated.

But your main proposal seems to have merit. Simply said, there would be several "built in" derivatives, denominated in Bitcoin, which could be traded at different prices.

I just believe the complexity could put people off, as it makes Bitcoin even more difficult to understand. Why buy a financial system, if you want a currency? After all the things gone wrong in the traditional financial system, it would increase suspicions.
Also keeping the money supply predictable will be difficult: If an option might expire worthless based on a future difficulty, will it count towards the final 21 million or not?

Hmmm, maybe you need to look into Open Transactions and the financial crypto library that provides for contracts. It can accomodate p2p currencies like bitcoin as a basis.

https://github.com/FellowTraveler/Open-Transactions

Moneychanger could be just what you after.

https://github.com/FellowTraveler/Moneychanger

Thanks for responding. Yeah it is just like options. I'm from an economics rather than a finance background so I use different jargon. Centralized option markets aren't likely to emerge until bitcoin grows big. Volumes in markets you see are likely to small to have much use. Options have a huge payoff variance and there is a big risk that people taking the other side of bets will fail to pay your bets (counterparty risk, remember the financial crisis?). A p2p system could get rid of counterparty risk entirely [except for the integrity of the block chain]. Mining for the contingent claims/options would allow a deep markets to be created despite the small size of the economy. Essentially miners would have to hold them or sell them to someone. No one could fail to pay in bitcoin, even though some people might go belly up in USD.
 
Not sure which side of the trade you are asking about.
1) Going Long
Suppose that you are Amazon and you need to decide to accept bitcoin. Accepting bitcoin means either a) bearing risk by holding bitcoin inventories or b) paying a lot of exchange fees. Either of these options is costly, and I doubt that Amazon's savings on credit card processing fees and chargebacks would be large enough to recoup these costs.

Thus, Amazon needs an alternative way of profiting from bitcoin. Imagine there are two possible future states of the world: State 1) bitcoin value and difficulty increase dramatically, State 2) bitcoin value (and difficulty) do not increase dramatically.   

Amazon could just buy up a whole bunch of vanilla bitcoin before announcing its decision and profiting by reselling the bitcoin later at a higher price. However, this is inefficient. By purchasing standard bitcoin, Amazon is acquiring claims to both future states of the world. Since Amazon's choices can dramatically increase the probability of state 1 occuring, Amazon would earn much more by purchasing claims on state 1 than it would by buying up vanilla bitcoin.

2) Hedging Risks/Going Short
Suppose you are an online casino. Accepting bitcoin means that you Americans will start flooding your site with coins. You need to convert their currency into Euros so they can play with other people on your site.
You will also need to pay them out in bitcoins. This means either a) holding a large bitcoin inventory or b) paying a lot of exchange fees. Holding bitcoin inventories puts you at risk of a large loss if bitcoin drops in value. Thus you would likely to want to exchange claims in State 1 for claims on State 2. If bitcoin goes dramatically up in value, you don't enjoy the rewards. In exchange, you shield yourself from some risk.
 



Standard equation in monetary economics: http://en.wikipedia.org/wiki/Velocity_of_money
Money Supply * Velocity = Currency Price * Real Value of Transactions Per Unit Time

As you can see, velocity is directly proportional to price. Velocity is the rate at which transactions occur per unit time.  Velocity will be high if businesses sell bitcoin as soon as they get it. If businesses are willing to hold bitcoin inventories, some bitcoin is being held of the market and it costs more to acquire bitcoin for exchange purposes.