Will HERO work? Or, can you brute-force the free market?

Several years ago, when Bitshares launched, its founders Dan and Stan Larimer ( @dantheman and @stan, respectively) had a vision of creating price-stable assets which could also provide significant rates of return. The number they repeatedly threw around was 5% annual returns; this led to the term "+5%" becoming a sort of "thumbs-up" in the Bitshares community.

So the Larimers created BitUSD, which has been trading continuously for a while now. BitUSD is a token smart contract which is designed to track the value of the US Dollar very closely. Originally, the Larimers thought they could create a market mechanism which would fund the 5% interest they hoped to pay on BitUSD. Unsurprisingly, this did not work. Why would a market pay 5% when it can get away with less?

Now, @stan and company have decided that because market mechanisms didn't cut it, they'd just brute-force the 5%. Enter HERO. HERO comes from what seemed like a very silly idea: If you can create a smart token that tracks the value of a real-world asset, then you can in principle create a smart token that tracks the value of an imaginary asset as well. So why not "imagine" that an asset grows steadily by 5% annually, and then create a smart token that tracks that imaginary asset?

That's what HERO is. The BTS team imagined that the US Dollar, in 1913, began to appreciate at a rate of 5% annually. This is easy to do; in principle it's just a mathematical function. The following graphic comes from @stan's recent post on HERO:

You should be scratching your head right now

Here's what should be going through your mind: "They just want to create a token that appreciates? Is that allowed?" At first glance, this looks like they're trying to get a free lunch. In real life, you can't typically just tell an asset to be a particular price; price is a function of supply and demand. If you can't control demand (which is typically the situation), then if you want to control price, you have to control supply. If the price of your thing is higher than you want, you have to create more of them - if the price is lower than you want, then you have to buy some and destroy them.

So how does HERO do that?

Bitshares has a built-in mechanism for controlling the price of a smart token. I believe it goes like this: If the price of the token is too high, ordinary people can create new tokens by "borrowing them from the network" with ordinary BTS as collateral. This ensures that there is always something with value (BTS) backing the value of the smart token. Note that this is fundamentally different from how Steem does supply control with SBD, and it's one of the reasons that SBD has a generally less-accurate peg than BitUSD.

So here's how HERO will work:

1. When the price is too high, people who own BTS will lock some of that BTS into collateral and "borrow" new HERO so they can sell it into the market. If the price of HERO crashes, these people are on the hook for it.
2. When the price is too low, people who own HERO can request a "settlement," which means that the bitshares network will take the HERO borrower with the least-collateralized position, close their HERO debt, and give the person who requested settlement an amount of BTS equivalent to the amount of HERO they settled.
3. Alternatively, when the price is too low, people who owe HERO can buy it on the market at a cheap price, use it to pay their "debt," and their collateral will be released back to them.

Point (1) is how new HERO is created when the price is too high, points (2) and (3) are how HERO is destroyed when the price is too low.

You can get more details at the bitshares website.

What will happen when HERO starts trading?

I believe that HERO's algorithmic appreciation will be self-defeating. Here's why:

Suppose that everybody believes that HERO will be what it is supposed to be; i.e., that it will always be worth a 1913 dollar continuously appreciated at 5% annually. Then anybody who would want such a thing will start buying it. I'm a candidate for this; I currently have large balances of BitUSD and USDT because I've been selling off my crypto stashes during this wild crypto craze we've been seeing. A properly-functioning HERO is strictly better than BitUSD, because it appreciates continuously. So I'd likely sell off my BitUSD and buy HERO.

If everybody who wants price stability thinks the same way, this would create a large demand for HERO, pushing its price above the target. When its price is above the target, this will attract more people to borrow it ("short it"), and eventually an equilibrium will be reached. I'd expect this equilibrium to be strictly above the price target. This will be the case unless there is an infinite supply of people willing to short HERO, which there is not. How do I know there isn't an infinite supply of shorters? Because of game theory: some shorters will read this article (or reason through this themselves) and will realize that HERO must trade above its price target.

What does it mean for the equilibrium price to be above the price target? It means that HERO will be an asset that is worth a constant offset more than an index that appreciates at 5% annually. This is not the same thing as an asset that appreciates at 5% annually. The larger the price offset, the lower the effective annual appreciation.

Thus, I predict that HERO will not appreciate at 5% annually; rather, it will appreciate at a lower effective rate.

Essentially, what we'll see is that you can't outsmart the market. HERO's appreciation will be, must be, self-defeating. If HERO actually can offer 5% with no downside, then people will rush to buy it, which will drive its price up to a point where it's offering an effective interest rate below 5%.

This is, once again, an example of the Bitshares team not understanding (or at least pretending that they don't understand) game theory. Stan used the phrase "the markets behaving rationally" in his post on HERO. But there is no such thing as a rational market. There are only rational individuals, and rational individuals should trade HERO above the price target.

Nonetheless, I think HERO is an adorably cute idea and I'm looking forward to see how it actually plays out.

Here is a link with more technical information: http://hero.global/

If you want to trade HERO when it launches, sign up with my referral link: https://bitshares.openledger.info?r=zebulon