Fork Futures Appendix -- How Trading Works
Paul Sztorc
October 12, 2017
This uses Robin Hanson’s market scoring rule, but good explanations of it on the Internet basically don’t exist. So I will explain it in detail.
And please contact me if you are a major exchange and you would like free help implementing this.
Benefits:
Financial Requirements:
Technical Requirements:
That’s it! It is really easy! Call me if you need help.
This is quite different from the traditional double-auction order books that everyone is used to. That’s because: the double-auction method is used for assets that have already been issued. In Bitcoin trading, the USD and the BTC both exist outside the exchange. In other words, they have to be xfered in and out. But our case is different – we will have to issue (and destroy) our token dynamically.
So please forget everything that you ‘know’ about how computerized trading works. It will only confuse you.
If we want to conduct trading, we’ll need to talk quantities and prices.
First, the quantities. Recall that there are two markets, and four token-types:
Market 1 : "Futures of 1x" Market 2 : "Futures of 2x"
Short Long Short Long
q1 q3 q5 q7
q2 q4 q6 q8
---------- ------------
"d1" "d3" "d1" "d3"
"d2" "d4" "d2" "d4"
The q values, (q1, q2, q3, … q8), represent the “quantity outstanding” of tokens, across both markets. They will all start at zero (and they’ll all end at zero, as well).
The two markets will be separate, and we do the same trading calculations, per market. So, it is important to note that within each market there are only four tokens. To emphasize this, I have given the d values above. The quantity d3 is equal to q3 if we are in Market 1; but in Market 2 else d3 = q7. The d’s are specific to the market. I label them q1-q8 so that it is easier for me to talk about differences across markets, but from the trading-computer’s perspective there are just two markets that each have a d1-d4. Better notation would be ( q1_1, q2_1, q3_1, q4_1, q1_2, … , q4_2 ) but it is very ugly.
Second, recall that each token is going to have (at any given time) a market value, priced in USD, between $0.00 and $1.00. In this scheme, the “shares outstanding” and the “market price” of each token are, astounding though this may seem, the exactly same quantity – only expressed in different units.
It’s as easy as 1-2-3:
Traders who want to buy or sell, compute what the new score would be. And they then pay the difference in scores. (Or, if they are selling, they pay the difference in d’s, and receive the difference in scores).
Market 1 : “Futures of 1x” Market 2 : “Futures of 2x” Short Long Short Long p1_1 p3_1 p1_2 p3_2 p2_1 p4_1 p2_2 p4_2 Score: s_1 Score: s_2
As promised, here is f(). For all “b” (a parameter we will explain shortly), and e ~= 2.718 (of course), market prices (aka p1, p2, p3, p4) are a function of shares outstanding (d1, d2, d3, d4) given by:
function d:
define z(x):
z(x) = e^(x/b)
SUM = z(d1) + z(d2) + z(d3) + z(d4)
p1 = z(d1) / SUM
p2 = z(d2) / SUM
p3 = z(d3) / SUM
p4 = z(d4) / SUM
return(p1,p2,p3,p4)
Thus, f(d1, d2, de) = (p1, p2, p3, p4)
And g() is given as (using the same b and SUM, above; ln() is the natural log function):
g(d1, d2, d3, d4) = b * ln(SUM)
Imagine further that, in Market 2, (d1,d2,d3,d4) = (4500, 2500, 3300, 0). And the parameter b is 500.
Then:
Token prices are f(4500, 2500, 3300, 0) = ( .902, .017, .082, .000 )
Market expects fork to activate at a likelihood of (.902+.082) = .983
Ie, 98.3% likely. Participants are very confident that the hard fork will manifest itself.
The "expected future price" of SegWit2x Chain is:
IF FORK:
(.082/.983) * 70000 = $5,839.27
fyi: If you don't truncate, it is $ 5,822.088755 .
IF NO FORK:
(.000/.017) * 70000 = $ 0.
Now imagine that someone wants to take $20 and short this market. They don’t know anything about the activation likelihood, they just don’t believe 2x should be worth that much. So they will be buying d1 and d2 ; d1 shorts the market IF FORK, d2 shorts the market IF NO FORK.
By tinkering, I notice that buying 21.75 shares each of d1 and d2 will cost a total of $20. There is an easy formula for this, but I’m too lazy to look it up. But I will go through the normal calculation, going “forwards” from (+21.75, +21.75, +0, +0) to $20.
> Compute The Score As It Is Now
.. SUM = e^(4500/500) + e^(2500/500) + e^(3300/500) + e^(0/500)
.. SUM = 8987.59
.. g(4500,2500,3300,0) = 500 * ln(8987.59)
.. score is 4551.8
..
> Compute the New Score, (+21.75, +21.75, +00.00, +00.00)
.. g(4521.75, 2521.75, 3300.00, 0) = 4571.8
..
> Compute the difference
.. 4571.8 - 4551.8 = 20.0
The purchase of 43.5 total shares (21.75 each of d1 and d2) costs $20.
User pays $20.00 and receives (+21.75, +21.75, +00.00, +00.00). New market-state is (4521.75, 2521.75, 3300.00, 0), the new expected price of SegWit2x is 5594 USD/BTC, down (-$228) from 5822.
The trader has completed the trade. His trade went through instantaneously! He didn’t need to find a rival trader.
The parameter b affects the liquidity of the market. The above market was not quite that liquid…a $20 trade knocked the ‘expected future SegWit2x price’ down by about $230.
Why not make b really really high?
Well, unfortunately, to get this scheme going, the exchange will have to pay the first score, the score where all d’s equal zero. This is equal to b*ln(4) in this case. And exchanges will have to front this money twice, once for Market 1 and again for Market 2. With b=500, exactly $693 must be risked for each market. Without getting bogged down by details of where this money goes and how it might return, I expect the exchange to be able to recover more than half of this money. So, since there are two markets, the total capital required outlay for two b=500 markets will be around $1380, of which 40% (or $552) will probably be lost forever.
As b increases, the market has more liquidity for traders, but more startup-capital is required, and (again) 40% of this will probably be lost forever. At b=2000, a similarly-situated $20 trade^{1} knocks the price down by only about $58 (instead of $228). But the financial loss will probably be $2218 (instead of $552).
But where do we get the startup capital? Who bears the risk and ultimate loss? Well, Ben Davenport once offered to put together a $1,000,000 fund to “resolve the scaling debate”. So we can take that fund and give $693 to Market 1, $693 to Market 2, and then deposit the remaining $998,614 into my personal bank account.
In all seriousness, this is a tiny amount of money. The exchanges should be happy to front some cash (or, more precisely, some of their investor’s cash), for the privilege of providing their customers and potential customers with very liquid markets. And we have lots of BTC early adopters who could chip in.
Or, I would be to provide the $970, to any exchange that can’t afford it. In return, I would like half of all revenues generated from trading fees in this futures market. A win-win.
One could demand, with some justification, that the people who want a fork so badly, be the ones to pony up the cash..in order to demonstrate convincingly that they aren’t going to crash this spacecraft directly into the ground.
In particular, the miners have a very, very, strong interest in figuring out exactly how much more money they might be able to make, if they facilitate an upgrade to WhateverFork that lots of people really like.
Hopfully my description of all the novel features (above) has enticed you into considering this possibility.
There are even cooler possibilities as well. Message me!
I used d=(9700,1200,4900,0), b= 2000. ↩