How Are Steem Dollars "Backed" by the Steem Network?

Most of you likely know that the Steem Dollar is a token that is "pegged" to the US Dollar, though most probably don't know exactly how it works. The Steem Dollar is "backed" by a smart contract which you can execute at any time. The smart contract used to be available on the Steemit.com wallet but was removed due to confusion. Today you can execute it in the CLI wallet using the convert_sbd command, and there are also web tools available which I won't link here.

What You May Think The SBD Contract Is

"After 3 and a half days, you get $1 worth of Steem for each 1 SBD converted" - WRONG

When discussing the Steem Dollar contract, it's often simplified to say that the contract gives you $1 worth of Steem per 1 SBD converted, but if you're going to use the contract it's important that you know that's a simplification. It's not precisely how it works, you CAN LOSE MONEY depending on various factors. If you're going to use the convert_sbd function you should know how it really works, so you can make an educated decision to use it or not.

What the SBD Contract Actually Is

When you excecute the Steem Dollar contract, what you're really doing is making a bet. The bet is as follows: after 84 hours, the Steem price feed will be lower than the real Steem price I can sell it for.

Reveal spoiler

This is the Steem price feed. You can see it at any time on steemd.com

The Steem price feed is based on witness reports on what the price of Steem is on the markets. It's a median of all reported prices during the last few days. In the image above you can see the feed price is $0.86. But if you check an exchange right now, you'll see that the real price of Steem, what you can sell it for at this time, is $0.95. That's 10% different!

There are a number of reasons the price feed can be different from the real price.

It's a median price in a volatile market. 99% of the time, this is why the feed won't match the real price, which is not a median and can potentially change every minute.
Witness price feeds can be inaccurate due to bad data. This is likely rare, but can happen if witnesses are taking in data from exchanges that are reporting a false price. For example, BitHumb today trades Steem for almost $4, but you will not truly get $4 if you deposit 1 Steem on that exchange. Witness feeds are generally robust to this, but it's still possible for feeds to be corrupted in this way, especially if witnesses are using the same methods to report price.
Witness price feeds are inaccurate due to dishonesty. Thankfully this is very unlikely, because of #1. We use a median price because it is robust to cheating, but it also means the feed will almost always be somewhat inaccurate.

Here's a case of where you win due to the volatility factor:

The red line represents the median price during the period. You win because the price at which you sell at the end ($0.96) is higher than the rate that the Steem blockchain gives. In other words, you get more than $1 worth of Steem per SBD.

Here's another case where you would lose. The price at the end is $0.80 but you're given Steem at a higher rate, which means you get less than a dollar's worth per SBD.

But what if Steem Dollars are below $1?

If you buy SBD for less than $1, it doesn't change the fact that using the conversion option is a gamble. What it effectively gives you is an edge. Gambling with an edge in your favor becomes reasonable as long as you make many bets. An edge is a great advantage if you make hundreds or thousands of bets, but only a small thing for any particular bet. You can still lose with a 5% edge. Here are the two above bets with an edge for buying at $0.95 factored in:

Finally, there is another edge which may work against you

Steem Dollars are typically only below $1 during a bear market. The nature of a bear market is that prices tend to be lower as time goes on. Therefore, you should expect some bias for prices to be higher at the start of your conversion process than at the end when you get the payout. How large this bias is, is something you need to work out for yourself before doing a conversion.