Building a Better Crypto Price Index for Institutions and Regulated Investment Products

There are many existing pricing indices for spot cryptocurrencies. These are primarily based on executed transaction data from retail crypto exchanges. In recent months, multiple analyses from credible sources have cast significant doubt on the veracity of such data, particularly regarding reported trading volumes. While the OTC market is opaque and the size of the market is difficult to quantify, a deep analysis by the TABB Group shows that the Over The Counter spot market for cryptocurrencies is three to four times the size of the global retail exchange market.[1] Because of this, it is essential that pricing indices used by institutional investors incorporates data from the OTC markets.

As stated in the IOSCO Principles for Financial Benchmarks, The design of the Benchmark should seek to achieve, and result in an accurate and reliable representation of the economic realities of the Interest it seeks measure, and eliminate factors that might result in a distortion of the price, rate, index, or value of the Benchmark.[2]

One can think about achieving this goal through the lens of the following factors:

1. Accuracy
2. Manipulability

Accuracy

A good definition of an accurate institutional index or reference price is one that is representative of the level at which institutional size liquidity can be realized in the market.

To analyze the accuracy of retail prices versus OTC prices, we looked at bid-offer spreads for a given typical institutional sized trade. The typical minimum OTC trade size ranges from $75,000 to $150,000 in notional value; for our analysis, we set the trade size as 100 BTC (approximately $800,000 at current prices).

For retail exchanges, we looked at slippage, or the width between the bid level in the order book which represents 100 BTC cumulative volume from the best bid level, and vice versa for the offer side of the book. On the OTC side of the analysis, we looked at the bid-offer width that market makers are willing to quote to institutional customers when asked for two-way quotes.

For retail exchange markets on June 6, 2019 across 5 major retail exchanges, we see 100 BTC bid-offer width (slippage) ranging from 0.85% to 1.82%.[3] For the same period in the OTC markets, we see significantly tighter 100 BTC bid-offer width ranging from 0.05% to 0.54%.[4]

This large difference in bid-offer width together with the fact that the OTC market is significantly larger than the retail market show that indices based solely on retail data are potentially misleading.

Manipulability

A critical component of the methodology for any financial index is its resistance to manipulation. This resistance (or lack thereof) can come both from the index algorithm itself, as well as from the providers or venues from which raw data is sourced.

Although there are some retail exchange-based indices which have algorithmic manipulation resistance or mitigation, many such indices are simply volume weighted average prices across their constituent exchanges. This lack of structural manipulation mitigation means that malicious or false trading activity can flow directly into the index itself.

Even for those retail exchange based indices which have algorithmic manipulation prevention, the fact that most exchanges have little to no effective market surveillance[5] and malicious trading prevention means that these types of indices are susceptible to misleading trading activity.

In contrast, we have seen little evidence of malicious activity or manipulative practices in the OTC cryptocurrency markets. This is due to two main factors:

• OTC market makers are far more receptive to strong oversight by the index administrators to whom they contribute. Moreover, index administrators have greater visibility into the true source of these prices than in the fully anonymous data provided by retail exchanges.
• The community that OTC market makers trade with (institutions and high / ultra-high net worth individuals) is much more sophisticated than retail traders. Manipulative behavior is much more likely to be detected among this professional community.

Institutional investors and service providers who are evaluating cryptocurrency pricing sources should look at those indices which are comprised wholly or significantly from OTC market maker data. Further, they should seek out those index administrators who implement very strong algorithmic manipulation prevention and mitigation.

trueDIGITAL is a digital asset and blockchain focused financial technology and markets company. It produces OTC Reference Rates for Bitcoin and Ethereum designed for institutional market participants. For more information, contact index@truedgtl.com.

Robert Emerson isHead of Quantitative Analysis attrueDigital