A mathematician and a software engineer have garnered venture capital funding for a decentralized cryptocurrency and financial derivatives trading system. Called BitShares, the project will be officially unveiled in October.

BitShares is the brainchild of Invictus Innovations. It will consist of a protocol and a piece of software called Hydra, which will offer three separate services: a decentralized identity management system called BitNames, a secure chat and messaging system codenamed BitCom, and a peer to peer trading exchange.

Both the protocol and the software will be open source, said Charles Hoskinson, who is co-founder of the project.

Hoskinson has a track record – he is the director of the Bitcoin Education Project and a mathematician with a strong cryptography background. He also heads the education committee for the Bitcoin Foundation.

His co-founder Daniel Larimer is a software engineer with a background in networked C++ applications. They secured “mid-six figure” funding from Chinese private equity firm BitFund.PE, which is focused on funding bitcoin-related projects. BitFund founder Li Xiaoli is a director of Invictus.

Like bitcoin, the protocol is designed to be decentralized and trustless, and to provide at least as much privacy and security as the Bitcoin protocol. The founders also want it to be as easy as using email, and scalable.

The BitShares project is particularly ambitious, encompassing not only a peer-to-peer network, but also a cryptocurrency that will be used as the basis for sophisticated online trades.

Invictus wants to enable common investment actions on the trading exchange, such as shorts, and options. There are two main components of this trading system: a cryptocurrency called BitShares, and a new type of financial derivative called BitAssets.

BitShares aren’t designed to be spent with merchants in the same way that bitcoins are. Instead, they act as a form of collateral to back BitAssets. BitAssets in turn represent ‘real world’ assets such as gold, silver, dollars, and other currencies. Each BitAsset is a pairing of BitShares with one of these other assets, and it is used to hedge the value of BitShares against that asset.

Specific BitAssets include BitUSD (BitShares to US dollars), and BitGold. BitAssets will also be created for bitcoin using the BitBTC BitAsset, and the team is considering other cryptocurrencies.

BitShares are mined at a gradually reducing rate, reaching zero in twelve years (at which point, mining rewards will come from transaction fees). This maximizes mining rewards early on, which the team hopes will encourage adoption.

BitShares have value in their own right. Their use as collateral gives them value, but they were also pay dividends, based on a share of the mining reward and transaction fees proportional to the number of BitShares owned. Because BitShares back BitAssets, BitAssets also pay those dividends.

“If you own BitBTC you can earn dividends on your bitcoins,” said Larimer. “If you have a thousand bitcoins and you convert them to BitBTC, and then you hold it for six months, then you convert the BitBTC plus the dividends you received back to bitcoins, you’ll end up with more bitcoins than you started with.”

Any scheme that suggests you’ll always come out ahead on your investment will raise eyebrows. Someone always has to lose if someone else wins. So how does all this work?

How BitShares and BitAssets trading works

The BitShares world is divided into two types of users, which Larimer calls ‘speculators’ and ‘savers’. Similar to conventional markets, the speculators try to make as much money as they can and stand to lose everything, whereas the savers concentrate on low risk and relatively steady returns.

In this system, speculators gamble on the value of assets (such as gold, dollars, and bitcoins), as related to BitShares. They do this by creating BitAssets, such as BitBTC or BitUSD, backing them with BitShares as collateral. This enables them to take short or long positions on the assets, betting that they will go down or up in value. BitAssets, then, are financial derivatives: they’re agreements between two parties, designed to represent the value of an underlying asset.

“They are a completely new type of derivative, which is why we have named them Polymorphic Digital Assets,” said Hoskinson.

Conversely, the savers simply buy the BitAssets and sell them at a later date, making money from the dividends. They can do this without buying or mining BitShares, by paying for the BitAssets using real-world assets such as gold, dollars, or bitcoin.

The base exchange rate between BitAssets and the real-world asset it represents is supposed to be relatively stable, because Invictus wants the value of one to be market-pegged to the other. One BitUSD will always be worth around one dollar, say the founders, just as one BitBTC will be worth around one bitcoin. It’s the amount of BitShares needed to buy one BitUSD or one BitBTC that will change. That amount is reflected in BitAssets, and speculators who create those BitAssets take that risk.

The key word here is ‘market’. Invictus is relying on market consensus to keep the prices pegged rather than setting any prices itself. It does this by forcing a speculator to close their position when a trade moves against them by a certain amount, in a move that financial traders call a ‘margin call’. This constantly renews the capital coming into a BitAsset, and means that the crowd regulates the price. That’s the hope, anyway.

There is a caveat to this market-pegged pricing. People may impose a price premium on BitAssets. Someone might sell a BitBTC for more than 1 bitcoin, on the basis that the risk-reward ratio is favourable, especially if the dividends are good. If the dividend return ends up falling short of that premium, the buyer could still end up down on the deal.

The block chain(s)

Dividends will vary in part because of the block chain. All of these transactions will be stored in a block chain called a BitShares Exchange. It will support multiple assets, such as cryptocurrencies, company stocks, or commodities, and Invictus will initially launch with BitAssets for gold, silver, bitcoin, and the 15 top fiat currencies.

Larimer also hopes that independent entities will launch their own such block chains, which he likens to exchanges such as the Dow and the Nasdaq. Miners can mine on multiple block chains, and Invictus envisages inter-chain arbitrage. Different BitGold assets might exist on multiple chains, he says. However, the dividends for each chain will vary, based on factors such as the number of BitShares that existed in that chain, and the number of BitShares held.

The BitShares Exchange block chain is different from the bitcoin block chain in several ways. Firstly, it automatically moves transaction outputs forward after a set period, imposing a 5% transaction fee for the privilege (although this can be avoided if you have old outputs in the block chain by simply running your client at least once a year). This enables transactions to be deleted from the block, limiting its size to an arbitrary figure. This should avoid block chain bloat, Hoskinson said.

“You don’t need to keep an internal record of everything that has been done to have everyone’s accounts settled. We recognized a solution that would keep everyone’s block chain relatively lean,” he added.

Block chains will also include different information than bitcoin’s. To support trading of multiple assets, with sophisticated investment features such as shorts and options, transactions between two parties will contain information such as bid/ask prices for a particular asset and the number of BitShares backing a BitAsset.

When a block is mined, miners pair all of the compatible bids and asks in the network, so that all bids for which there are compatible asks can be traded. If a trade doesn’t have a suitable counterparty, and it leaves a short position beyond a certain threshold, the miner automatically exercises a margin call. If a trade moves too far against a trader, the miner will automatically sell his BitAsset to cover his position, charging him a 5% transaction fee in the process. This motivates people to manage their own margins.

Proof of work

Significantly, the Invictus Project uses a different proof of work to the two incumbent ones (Bitcoin’s SHA-256, and Litecoin’s Scrypt). The former rewards ASIC miners, while the latter rewards GPUs. The Invictus one will focus on general purpose CPUs, keeping them 32-64 times faster than a GPU for mining. To do this, it has a high RAM requirement, and also relies on sequential data processing.

The Invictus team hopes that this will keep mining relatively decentralized. Larimer worries that mining in bitcoin is becoming increasingly centralized, especially with the creation of large ASIC-based pools.

“The reason why it’s a problem is that if mining is collectively controlled by three companies, they can collectively block any transaction that isn’t approved by the government,” he said.

Core bitcoin developer Jeff Garzik has argued the opposite, however. “It is trivial for a mining hardware owner to switch mining pools and that helps keep individual mining pools from gaining power,” he has told CoinDesk. “Also, the ASIC market is very decentralized.”

Getting funds into the system

The biggest challenge for Invictus may be getting funds in and out of the system. BitShares can be mined, which is great for speculators, but the “savers” Larimer talks about need to get their funds in and out from elsewhere to buy BitAssets.

There are four ways to achieve this. The first involves physical BitAsset exchanges, Satoshi Square-style. The second involves hooking up with conventional bitcoin exchanges. “This could be used with exchanges and let them plug into it and link together through our ecosystem,” says Hoskinson, pointing to Mt Gox’s problems with getting US dollars to customers. If the exchange supported the Invictus protocol, that issue would go away, he explains. “You could use us to move USD to another exchange and then withdraw.”

The other system involves escrow transactions. One person could buy a BitAsset from another by wiring them money using a conventional system. An escrow agent would ensure that the money arrived, releasing the BitAsset afterwards.

Escrow agents are anonymous. The agent collects a fee for every transaction that references their service. Either party in a transaction can post another transaction freezing the funds until the escrow agent makes a decision. The idea is that there is no profit motive for cheating the system, because neither party can collude with an anonymous escrow agent.

The final bridge involves having the Hydra software talk to a bitcoin client like Bitcoin QT. Bitcoin will probably be the primary gateway into the BitShares exchange initially, Larimer says.

ID management and secure communication

That Hydra software would also provide the two other functions originally mentioned: ID management, via a naming system, and secure communication.

The naming system will be similar to the DNS alternative used by Namecoin. Just as Namecoin users can claim .bit addresses, so the BitName naming system will allow people to claim identities (although they won’t have to buy them using BitShares – they will be free). The block chain will allow for 1 billion IDs from the start, but it will be expandable, Hoskinson says.

There will be two classes of names: individual user names (using the BitName BitID system), which are trivial to create, and business names (using the BitName BitDNS system). The latter ones must be created and then auctioned to the highest bidder, giving businesses a chance to claim their own business names.

The identity system will also form the basis for the BitCom encrypted communication network, which will be accessible from within the Hydra software. In BitCom, chat and asynchronous messaging will require a proof of work to send, which will discourage spammers. Encryption keys won’t be stored centrally.

The communications function will mirror the existing BitMessage system in some ways, Hoskinson says, in that it will be broadcast based. Messages sent to a single person are received by all nodes, and everyone tries to decrypt it, but only the recipient succeeds. That masks their identity, along with the contents of the message. That way, the NSA can’t come knocking on your door asking you to decrypt a message because it found out that you were sending the message to a particular person by reading its metadata.

Where BitCom differs from BitMessage is that it will use the unique, human-readable address generated using BitName when sending.

“So unlike Bitmessage, where you have to remember some hideous address, you could just send it to ‘dannybradbury’, and the corresponding public key will be in the block chain, just like bitcoin,” he explauned. (If you’re using it for secure anonymous communication, though, you’d be well advised to claim a random nickname rather than using your own).

The team will work to build gateways to insecure regular communication systems, to make migration easier. Those sending from Gmail to Yahoo mail won’t be any more secure by putting this system in the middle, but that isn’t the point. Invictus is playing a long game. “Our conjecture is that if we make it as easy to use as traditional mail, and bundle VoIP and chat, then people will start it over Gmail and outlook.com and traditional email services,” says Hoskinson.

That will no doubt please the owners of sites like Groklaw, the long-standing law blog, famed for its insightful and controversial legal discussions, which is shutting down. Owner Pamela Jones argues that there is no way to run Groklaw without secure email.

“They tell us that if you send or receive an email from outside the US, it will be read. If it’s encrypted, they keep it for five years, presumably in the hopes of tech advancing to be able to decrypt it against your will and without your knowledge. Groklaw has readers all over the world,” she said in a final post.

One step at a time

Invictus is a long way from taking over email yet, or ID management or derivatives markets, for that matter. It has big ambitions, and a lot to prove. It’ll start with an official unveiling at the C3 conference in Atlanta in early October. It will go into beta the following month, when mining will begin (it won’t be premined). It will start offering bitcoin bounties, potentially into the hundreds of bitcoins, for improvements in security and efficiency.

One of the reasons it can offer bounties is because it has backing from BitFund, which will also enable it to hire good penetration testers to security test the software. Another is because the whole thing is open source. This is an issue which has dogged Ripple founder OpenCoin, which keeps promising to open up its code base.

The open source element will allow third-party developers to build their own modules on top of the system and charge for them if they wish.

“If they charge, then they’re charging in BitShares, and we get a percentage,” says Hoskinson, who adds that Invictus, a private, for-profit company, will also be mining BitShares from day one. When it releases mobile clients, it will also charge transaction fees for those, adding to its revenues, although it won’t be charging for transactions made from Hydra.

So, there is a lot to look out for. All eyes will be on Atlanta in the fall. In the meantime, check out the white paper here.