If it works, why is the market cap so low?
That is difficult to answer, but from what I can gather there are several reasons:
1. There was a big FUD campaign when Bitshares first came out saying Smartcoins (then named bitAssets) would never work and their value would collapse, and that scared a lot of people away. Google Preston Byrne and bitUSD... his set of three articles were the most quoted "evidence" that bitAssets would collapse. But really those articles were just speculation, and after three years of Bitshares holding its Smartcoin pegs these detractors have pretty much gone silent. I guess they are starting to realize they may have been wrong (if they haven't already).
2. bitUSD had two competitors in the space. Tether and Nubits. Tether and Nubits had much more volume and market depth closer to the $1 pegs than bitUSD. They both put huge buy and sell walls close to the $1 peg. Nubits paid people to do so by use of inflation, and I guess Tether raised investment capital to do so. Up until very recently, there were not many market makers for bitUSD and the spread was much higher than it is today and there was less market depth. Because of the bigger market depth and smaller spreads, Nubits and Tether killed bitUSD as far as usage.
Then Nubits had a big collapse during the summer of 2016 where it went as low as $0.22, and ever since then Nubits has seen much less usage/volume. At this point, Tether is easily the most popular and liquid USD pegged asset. However, recently even Tether is showing some cracks in its armor. There is evidence that they are closely associated with Bitfinex, both of which are having monetary issues. It is showing in Tether's value which is currently $0.968, and has recently gone as low as $0.921. bitUSD has held a tighter peg than Tether for two weeks running. If Tether collapses just like Nubits did, then I think everyone will finally understand that bitUSD is the best solution.
Nubits, Tether, and Bitfinex's issues highlight that they may not be the best solutions, and they are both subject to many issues that bitUSD is not.
Nubits is like a "decentralized" federal reserve, which is still pretty centralized, prone to errors in judgement from Nushare holders, and more vulnerable to exchange default (among other issues.)
Tether is completely centralized, and subject to all of the downfalls that brings... subject to the Tether company not honoring the $1 peg (it is held only by a promise from Tether to do so, and if you read the excerpts from the ToS it is not a promise at all), subject to seizure by governments, and it is also more prone to exchange default (among other things).
bitUSD is completely decentralized and runs on free market principles. Also, recently due to market maker bots being made easier to use (such as
https://btsbots.com/), bitUSD is slowly closing the gap as far as liquidity and market depth. Before market maker bots were only ran by a few individuals who kept the source code private, so there was not much market making going on.
After doing some looking online, I don't understand how it works. According to this video,
https://www.youtube.com/watch?v=YD8i2Py9Paw, a bitUSD is made up of a variable number of bitshares, such that the value will always be $1. But that does not make sense, firstly it is dependent on the viability of bitshares, second, where are the bitshares coming from to insure a constant value?
Instead of typing up a long post of how it works, which I admit is difficult to grasp at first, I think this answer from Bitcoin's Stack Exchange is a good description. There are a ton of articles and videos on it. Bytemaster released this video in 2013 before starting Bitshares explaining how bitUSD would work, and it helped me understand. I still think it is one of the best descriptions:
https://www.youtube.com/watch?v=-8ZJ3xTDwbIIf it's dependent on bitshares, then how is it not centralized?
Bitshares was one of (if not THE) first working smart contracts. The decentralized exchange and shorting/covering/defaulting of Smartcoins like bitUSD is all done autonomously by the Bitshares decentralized network and blockchain.