Who might be willing to short it into existence?

If BTS is rising in price, the shorters may make a profit from obtaining back their sold HEROs at a cheaper price (denoted in BTS) later.

Who pays the interest?

The shorters do! Those that are willing to lock BTS away as collateral for the HERO need to ensure that the value of their collateral grows by more than 5% every year. Since the minimum collateral ratio is 175%, most shorters speculate on the value of BTS to grow by at least 2.5% after a year which would covers their obligation to top up the collateral sufficiently.

Of course, the BTS token will still be volatile! Basically, by shorting HERO with 175% collateral and issuing a new token with face-value (together with margin calls and settlements) establishes a system in equilibrium.

One the one side, there is 175% of the volatility, while on the other side, there is none. This is the general concept behind market-pegged assets, or smartcoins. Those on the short side experience the volatility and epxect the collateral to rise in price, while those on the long side enjoy the stability of their token.

The HERO does the same, except that it forces the shorters to also hand over a fixed +5% interest per year to the long side of the trades. Independent of the shorters making profit at all, they will need to provide the +5% interest to the long position.

Thus, the HERO represents a Peer-2-peer free currency where shorts and longs are provided by individual traders across the planet with no central entity having control over the issuance process.

Why is the collateral not bitUSD?

BitShares has an asset that tracks the value of USD precisely - it is called bitUSD. So, given that HERO is supposed to track a USD with +5% interest a year, why is the collateral not USD as well? The reasons are liquidity and leverage. Since bitUSD are market pegged assets aswell, they need their own collateral (currently 175%. as of 2017-05). This means in order to provide $100 worth of HERO, there needs to be at least $350 worth of collateral for USD and HERO. Due to this, the intermediate step of going through USD has been removed. Note that HERO can still be traded against any other asset, but the underlying collateral is BTS.

When is interest paid out?

As you can read in detail in the interest section of this documentation, interest is actually never paid. Instead, the valuation of the HERO grows constantly. This means that if you hold HERO for one year, the HERO will be valued at 5% more, but the actual number of HEROs you own stays constant. For tax, this results in capital gains and not in additional income as if there where dividends or tokens paid as interest.

As a consquence, HERO pays no compound interest!