Many people visit popular cryptocurrency websites such as CoinMarketCap and CryptoCompare to view cryptocurrency prices. These websites display USD prices for over 2,000 crypto assets. However, the prices can differ significantly from one website to the next due to differences in data sources and methodology. In this article we take a look at how these prices are calculated, and what is required to create a high-quality "reference rate."
The reference rate
The "reference rate" represents a universal price at which one can expect to buy or sell a cryptocurrency at any given time, and is typically shown in USD. Having an accurate and reliable reference rate is critical for price discovery, portfolio monitoring and valuation, and real-time trading applications. It also provides a benchmark against rates at crypto exchanges and OTC trading desks. The reference rate is calculated by aggregating the latest transaction data from global crypto exchanges. Because cryptocurrencies trade on dozens of exchanges around the globe, and market prices can depend on local market conditions or liquidity at individual exchanges, prices can differ significantly across exchanges for even the largest cryptocurrencies. At the time of this writing, a review of the popular BTC/USD rate revealed a high/low difference of $120 among the top 10 exchanges by volume, or over 3% of the average BTC/USD rate.
There are several different aspects to developing a reliable and accurate reference rate, also referred to as a price index. First, it is important to include trade data from only reputable exchanges. Ideally, the included exchanges abide by KYC/AML rules and do not use wash trades to inflate trade volume (see report by The Blockchain Transparency Institute). Second, it is important to have a fast and reliable data feed from the included exchanges. We will discuss this in detail in the next section. Third, it is important to be able to identify and remove any outliers from the data, as we have no control over what data the exchange might send, including erroneous data. Fourth, only the most recent transactions should be included in the reference rate calculation. At BlockMarkets, we utilize a time decay factor to reduce the weight of an exchange’s last transaction until it reaches zero weight after a period of 5 minutes. This ensures that interruptions at the exchange or from the data feed do not influence the rate. Finally, it is important to factor in liquidity by assigning a weighting to each asset based on the exchange's trade volume. The 24-hour volume traded amount is commonly used for this purpose.
Timeliness and latency
The public cryptocurrency exchanges, including Binance, Coinbase, Kraken, Poloniex, and others, all have public APIs available to publish their live order books and trades. Those with knowledge of APIs and programming can develop an application to retrieve this data and find the latest transaction price for a digital asset at a particular exchange. However, to do this across multiple exchanges around the globe requires high-performance computing resources and large-scale data storage capable of handling high-frequency updates. At BlockMarkets, we regularly process over 20 million trades from the leading cryptocurrency exchanges each day. To build a low-latency system, i.e. one that can deliver prices in milliseconds as opposed to seconds, is a non-trivial exercise. One must be able to retrieve the data from the exchanges, remove outliers, calculate a reference rate, and then distribute the data to clients, all in under a second. At present, the major cryptocurrency websites, which are focused on retail investors, lag behind what we would consider “institutional grade” for real-time pricing data. Timeliness is particularly important for automated trading strategies and real-time decision making.
Arbitrage opportunities and the ‘Kimchi Premium’
As there are multiple exchanges across the globe trading digital assets, arbitrage opportunities do exist. However, it is not always so straightforward in crypto markets, as fees and registration requirements vary across exchanges, and financial regulations and anti-money laundering laws can make transferring assets across borders difficult. Decentralized exchanges might allow investors to circumvent this, but do not currently have enough liquidity to handle meaningful transactions. Additionally, it can sometimes take up to 20 minutes or longer to transfer assets between exchanges, making an arbitrage opportunity less than guaranteed in volatile markets. Late last year, the price of Bitcoin was over 40% higher on South Korean cryptocurrency exchanges than on US exchanges. This became known as the ‘Kimchi Premium’, and led to many cryptocurrency websites removing Korean exchanges from their reference rate calculations (popular site CoinMarketCap controversially did this without informing users and was blamed for causing a $100 billion market selloff). However, as South Korea had banned foreigners from opening accounts at Korean exchanges, it was almost impossible to take advantage of this premium without traveling to Seoul with a digital wallet full of Bitcoin and trying to sell it on the street.
The ‘Kimchi Premium’ has since all but disappeared, and with increased liquidity and global trading venues there are fewer arbitrage opportunities for the major assets today. Still, if you are running automated trading strategies or hold significant assets, it is important to monitor overseas exchanges as they indicate price direction. Like forex markets, crypto markets never close, so when volumes go down in the evening on US exchanges, they pick up in the morning on Asian exchanges. It is therefore important to monitor price movements across regions and during weekends and overnight periods.
The future of crypto asset data
Bitcoin turned 10 years old on October 31st. The first decade of growth was fueled by cypherpunks, libertarians, black markets, ICOs, a massive bubble (and burst), and promising new technologies in the form of blockchain and decentralized applications. The next 10 years of growth will likely be driven by regulation, institutional investment, widespread adoption of cryptocurrency for payments, and the transformational use of blockchain technology in everything from digital identity and supply chain management to online voting and property ownership records. As crypto assets continue to evolve, it will be more important than ever to provide users with transparent, accurate, and timely market data.