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Updated on | Posted in Cryptocurrency, Fintech

Colored Coins vs ERC20 Tokens – The future of Futures?

J. R. Willett’s “The Second Bitcoin White paper” describes (among other things) user currencies which track value of a specific assets without being backed by that asset by issuer.

At first this seems to be counter-intuitive… You can’t create digital gold out of nothing.

However, something very similar happens on derivative markets. For example, futures price converges towards spot price by the date of settlement on futures market. This happens according to no-arbitrage condition: difference in price would create an arbitrage opportunity which would level this difference.

If you consider cash-settled futures, exchange operator effectively moves money from pockets of those who have “lost the bet” into pockets of those who won during the settlement. This forced transfer creates potential arbitrage opportunity at the time of settlement, which forces price convergence.

If we can implement something like cash-settles futures on a decentralized market we’ll be able to create  a digital asset with price pegged to physical asset price which won’t be backed by physical asset. Price will be stabilized by speculations.

However, using futures directly would be inconvenient.

J. R. Willett outlined a stabilization approach involving two different assets linked together, let’s call them GoldShares andGoldCoins. Price of GoldCoins is supposed to track price of gold, while GoldShares is very unusual kind of derivative which lets people to bet on demand for GoldCoins. They are linked together in such a way that GoldCoin supply will beable to fluctuate, compensating for changes in demand and making sure that price is more-or-less stable.

However, what paper outlines is a long-term stabilization and I doubt it would work very well. I’ll quote the paper:

  • “Proportional” gain of the PID loop governing value corrections (i.e. “Increase GoldCoin supply by 1% per year for every 2% GoldCoins are below target. Decrease GoldCoin supply by 1% per year for every 3% GoldCoins are above target.”)

  • “Integral” gain of the PID loop governing value corrections (i.e. “Increase GoldCoin supply by 1% per year for every 1% GoldCoins stay below their target value multiplied by the number of years they have been below target. Decrease GoldCoin supply by 1% per year for every 0.5% GoldCoins stay above their target value multiplied by the number of years they have been above target.

I believe there is a more straightforward way to implement this: GoldCoins can be created or destroyed instantly, forcing price to fall into a very narrow corridor. Moreover, this approach is compatible with colored coins which are not as flexible as Ether ERC20 Tokens.

Here’s how we do this: suppose we have separate order books for GoldCoins and GoldShares. Price pegging is implemented by issuer, he defines acceptable price range for GoldCoins, fixing it each day, for example.As long as price is within that range nothing special happens, order are matched like with normal p2p trade.

Now suppose that price range for GoldCoin today is 0.9 .. 1.1 BTC. Somebody puts a bid at 1.2 BTC and it is not matched.

What happens?

The Issuer intervenes and creates new GoldCoins to satisfy this extra demand. To keep things balanced he needs to destroy GoldShares. Effectively oldShares are converted into GoldCoins.

At what rate? Obviously converting 1 GoldShare into 1 GoldCoin ain’t going to work.

I think it works perfectly if we use this formula: one GoldShare creates

   (GoldShare price) / (GoldCoin price) = GoldCoins.

Here’s what it means: if GoldShares are in shortage and their price is high, one GoldShare creates a lot of GoldCoins.When GoldShares are abundant and their price is low, you need many GoldShares to create one GoldCoin.

So supply is going to be very flexible, if demand is high we can create practically unlimited amount of GoldCoins, driving GoldShares ask price higher and higher.

If demand is low and GoldCoin price is falling, we’ll create lots of GoldShares.

However, this scheme isn’t perfect. When there is a massive sell-off of GoldCoins, we are essentially limited to whatever liquidity is on bid side of GoldShares.If bid price goes very low, GoldCoin price will fall below lower threshold, potentially to zero.

As J.R. Willett writes, in that case a reserve fund might help the situation. Issuer gets some money (e.g. Bitcoins) when he sells initial GoldShares. He should use that money to buy them back. However, in colored coin-based protocol we can’t really force issuer to do anything.

So, to summarize, non-backed pegged currency price can be stabilized via a speculative market to a certain degree.However, in case of a catastrophic sell-off we are at mercy of issuer.

Perhaps there is a better way to do it, via futures-like instruments or something like that.

Final thoughts…

I think that I described as Goldcoins and Goldshares is a private case of multiple issuers to the same asset, each of them making a market allowing the buyers and sellers to define the spread between the 2 issuers. An example of this in current market structures are buy side and sell side market makers on exchanges, very common in the US.

I believe a more abstract and free market approach, would be for each issuer to decide if they are also a market maker which means they continuously place either buy or sell orders or both, and enable in p2p trade to define assets like gold which are supported by more than one color.

This translates the risk of the issuer or market maker into the spread between the bid ask, so the exchange rate of gold is as thin as there are more trustable issuers and market makers.

For example i am willing to sell gold at market+100 pips, and buy gold at market-100 pips, as a single issuers the risk of holding the asset depends on trusting that I will always buy/sell in the market. If there are 20 different market makers then the risk is the is lower as all you need as the holder; is to trust that one of them will remain a market maker when you want to sell.

I think we are almost ready to issue Goldcoins backed (partially) by bitcoin or create an ERC20 Token on Ether, who wants to buy some Goldcoins ?

#blockchainbank #tokens #tokenized #etherCfd

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