Steem dollar SBD is a way for blockchain-based social network Steem to get investment. By form, this way of investment on the Steem platform is similar to conventional convertible notes.
In business world, convertible notes are a way to fund startup ventures and small business acquisitions. Because stability is important to any business project, including Steemit, it created Steem Dollars as a way to bring more stability to the Steem network.
The mechanism that creates SBDs on the network is also similar to the way businesses and individuals create convertible notes. A convertible note is pegged in value to some currency or commodity. The terms of a convertible note specify how its owner can convert the note to the currency or a commodity. Usually, this can be done with a short notice, hence the word “convertible” in the name.
For these reasons, together with the creation of Steem Dollars, the Steem network also created a reliable price feed and rules to prevent abuse of the feed.
On the Steem network, holders of Steem Power (SP), a vested version of the Steem currency STEEM that exists on the network together with Steem Dollars SBD, elect witnesses. Witnesses can then publish price feeds. To do so, they get paid by the Steem network.
The idea behind the process is that SP holders both have a vested interest in the future of the network because of their vested investment and trust the witnesses they elect. Because witnesses get paid, there is free market competition among those who want to become witnesses. If a witness publishes false information in a feed, others will notice, demote the witness and the witness will stop getting paid. This is why witnesses are interested in publishing true information and preventing fraud from happening on the network.
The price for conversion of Steem Dollars then becomes a median of the witness feeds.
A median of a set of odd number of elements is the middle element. For example, if there is a set of 7 prices and these prices are 2, 2, 7, 4, 6, 5, 1, then to find a median you would first arrange these numbers in order and get 1, 2, 2, 4, 5, 6, 7. The median is doing to be the number in the middle, 4. In a set with an even number of elements, the median is an average of two middle numbers. To find the average, you will need to add the numbers and then divide them by two. For example, if the range of prices contains eight elements and they are 2, 2, 7, 4, 6, 5, 1, 8, then to find the median for the set you would first arrange the elements in order and get 1, 2, 2, 4, 5, 6, 7, 8. The two elements in the middle are 4 and 5. The average of 4 and 5 is (4+5)/2= 4.5, which is the median for the set.
Looking at the median instead of the whole range when it comes to price feeds on the Steem network is important because this way the network doesn’t take into consideration the outliers. If a malicious witness increases or decreases the price of his or her feed in a way that is very different from what is happening with other witnesses on the network (which is the only way to manipulate the prices in a way that could have an impact), the price won’t change significantly (because the network looks at the median of all the value and not individual values), yet network members will still notice the behavior. This means that witnesses don’t have much to gain if they try to manipulate a price, yet they still have a lot to lose.
The network samples price feeds every hour. It then takes a median price of the samples over 3.5 days. This is done to prevent short-term market manipulation that may occur even if all witnesses are honest, yet the network has to deal with events or circumstances that are beyond its control.
In the event of a feed corruption, the members of the network can vote corrupt members out before the actions of corrupt members have an impact on the price.
Another issue the Steem network had to solve with Steem Dollars SBD was a possibility of a timing attack. The timing attack is an attack in which hackers try to compromise a system by tweaking its ways to obtain timely measurements of certain parameters of the system. With Steem network and Steem Dollars SBD, market participants have access to the information that the network uses to create 3.5 day averages before the system actually creates the averages. At the same time, there’s an automatic delay of 3.5 days for all conversion requests of SBD. This means that while traders have access to the information and can use the information to help the network prevent attacks, they can’t use the information for personal gain, such as observing the trends and then selling at a high and quickly buying again at a low. Also, the network only allows members to exchange Steem Dollars SBD to STEEM. Converting STEEM to SBD is impossible.
The Steem blockchain decides when to create SBD and who the recipient is going to be. This allows the network to add SBD to the circulation in a controlled predictable way and to prevent potential abuses of the system.
Fundamentally, Steem Dollars SBD are not a currency, but a form of debt. Just like with any other debt, having too much debt as compared to ownership could be very dangerous.
It is dangerous when a person has debt that is much higher that the person’s salary. It is also dangerous when a person uses all the debt available to him or her. This is why credit score bureaus look at the total available credit and compare it to used credit when calculating a credit score. This is also why in many real estate markets a landlord would only rent an apartment to a person who with an annual salary that is forty times the rent, which means that rent expenses for a person should be around or less than 30% of the income.
On the Steem network, rapid changes of debt to ownership ratio can also cause all kinds of issues. One of the issues is that a rapid conversion of a large number of debt notes, which is what Steem Dollars SBD are in essence, can cause the entire ecosystem of the network and its currency STEEM become unstable.
This scenario is exactly what happened in the world during the financial crisis of 2008/2009 and what led to the creation of Bitcoin by Satoshi Nakamoto. Before and during the crisis, many of banks and insurance companies, such as Bear Sterns, Lehman Brothers and Citigroup in the United States, Kaupthing Bank, Landsbanki, and Glitnir Bank in Iceland, Royal Bank of Scotland, Bradford & Bingley, Fortis, Hypo and Alliance & Leicester in the United Kingdom, have made a lot of bad investment decisions. The governments then decided to bail them out, fundamentally transferring the responsibility for mistakes of a few players to the entire taxpayer base.
Left unchecked, a system with an unhealthy ratio of debt to ownership can collapse and make the ownership worthless. Finally, the higher the ratio of debt to ownership in any financial system, the less likely new investors are to invest in the system, be it a business, a country or a blockchain network.
To prevent all these issues from occurring on the Steem network, the network automatically starts to reduce the levels of STEEM currency obtained via SBD conversions so that the level of debt doesn’t surpass the 10% mark.
SBD interest rates
Because SBD is similar to a convertible note, it pays interest to its holders. The rate is set by the same witnesses that are elected by SP holders. This way, the interest rate fluctuates with market conditions.
In economics, there is a principle of the Impossible Trinity. The principle states that the following three things can’t happen at the same time: free movement of capital, fixed exchange rate and independent monetary regulations.
For the Steem network, it is important that the Steem Dollar has a stable conversion rate to the US Dollar. It is also important to the network to have free movement of capital, which means that the need for a monetary policy. Here’s how the policy works: the network stops payments of interest when 1 SBD trades above 1 USD. If the value of SBD goes below 1 USD, the network increases interest rates.
If the Steem network keeps growing, then the STEEM currency will be growing faster than the network is creating SBD and the debt-to-ownership ratio will stay at a healthy level, offering benefits to everyone, including the platform, the STEEM currency holders and the SBD holders. Fundamentally, what happens on the network is that witnesses who become feed producers create the monetary policy of the network with the main goal of pegging SBD to USD. If the witnesses were to stop accomplishing this goal, they would lose the trust from the SP holders, who would vote the witnesses off their status.