Preventing Manipulation in Cryptocurrency Derivatives

29. October 2017.

Cryptocurrency derivatives boast daily trading volumes that regularly exceed $1 billion in notional value. As the attention around bitcoin, Ethereum, and other digital assets continues to rise, so does the need to manage the risk associated with futures and options. The high volatility of these markets often leads to suspicious price action, leaving many traders to wonder if the markets are being manipulated.

In order to address these concerns, it is essential to create a cryptocurrency derivatives exchange that focuses on two prominent tools: a comprehensive, robust index that properly represents the broader span of the underlying spot market, and dynamic trading bands that reject order executions outside of a certain range from the index.

In order to create the most efficient leveraged Ether futures contract of ETH/USD, using Ether as collateral, one must develop a fair settlement price. In order to achieve this, an index that considers the spot markets of the leading high-volume exchanges must be created. The ETH/USD index should represent the median price of the five largest volume spot exchanges as components. The median is far more robust against volume-weighted indexes and is thus able to absorb volatile swings in single outliers.

In addition, there must always be sufficient spot component inputs to ensure that any one exchange does not have excessive influence. This addresses the issue that many crypto traders have with futures exchanges that use either a simple average or an index that contains too few inputs.

To ensure that price manipulation is not feasible, an exchange can only permit trading within a dynamic trading band around the index price. For example, a futures contract that expires within a week would not trade in a range outside of, for example, 1% above and below the index. This prevents large traders from trying to push up the price, nor engage in accommodation trading during low liquidity.

The comprehensive index and dynamic trading band represent an effort to address a common grievance among traders: that futures prices are not closely enough connected to spot prices. Additionally, the bulk of regulations created by governments to ensure fair markets are focused on price integrity. The Leverj index and dynamic trading band are designed to meet high-quality of standards seen even in legacy markets. When a system ensures that price cannot move without explanation in swings that would subsequently trigger liquidation of trader positions, then only real market moves will affect the derivative mark price.

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