Preventing Market Manipulation in Cryptocurrency Derivatives Trading
Bitcoin futures are a powerful tool that enable traders to access high leverage through counterparty exchange risk management. However, when a mere 1% move in price can liquidate a trader, it’s natural for people to wonder: how do we know this isn’t rigged?
Anyone who has traded high-leverage derivatives has experienced an inexplicable move in price deviating heavily from spot, similar to this:
After eating enough losses from the quick liquidations that can result from these volatile moves, some traders become convinced that the exchange is trading against them and manipulating the price. In order to address these concerns, as a cryptocurrency derivatives exchange, we focus on two main tools:
- Comprehensive, robust index that properly represents the broader span of the underlying spot market
- Dynamic trading band that rejects order executions outside of a certain range from the index
Robust Spot Index
At Leverj, our first leveraged product is going to be ETH/USD inverse futures. This means the contract settles on the USD value of Ether. In order to assume a fair settlement price, we must compile an index for this product that considers the spot markets of the leading high-volume exchanges. As such, LEV_ETHUSDX, our ETH/USD index, will contain components of the following high-volume Ether spot exchanges:
- Kraken
- Bitstamp
- GDAX
- Bitfinex
- Gemini
The index will pick the median of this bundle of exchanges:
LEV_ETHUSDX = median(Kraken, Bitstamp,GDAX,Bitfinex,Gemini)
This has an advantage over simply taking the average of the five exchanges as outliers will not have an influence. There are enough exchange inputs to ensure that any one component does not have excessive influence. This addresses the issue that some traders have with exchanges that use an index containing too few inputs.
Dynamic Trading Band
Using the above index, Leverj has crafted a Dynamic Trading Band (DTB) which ensures that manipulation does not occur in the market.
For example, a futures contract expiring within a week, would not trade in a range outside of, say, 1% above and below the Index:
TB_lower = (1-r)*LEV_ETHUSDX
TB_upper = LEV_ETHUSDX*(1+r)
where r=0.01q ; assume q=1 in this example, or the determined percentage of the index’s reasonable range
Any trades attempting to be filled below TB_lower or above TB_upper are rejected. The parameter q is a function of other variables which may influence the price to reasonably deviate away from spot, such as volatility in the market and sentiment from other exchanges. The DTB utilized in the Leverj ETH/USD index ensures that a large trader can not simply come into the orderbook and aggressively bid the price well outside of a reasonable price range of the underlying spot market.
Benefits
The Index and DTB are an effort to address a common grievance amongst traders that futures prices are not closely enough connected to spot. Many of these traders have lost significant sums of money due to large swings in derivatives prices that trigger stops and liquidations. This effort will benefit traders sensitive to this issue the most.
Additionally, a bulk of the regulations that governments create to ensure fair markets are focused on price integrity. Our index and DTB are designed to meet the highest quality of standards seen even in legacy markets. When the system ensures that price cannot move without explanation and trigger the liquidations of trader positions, then only real market moves will affect the derivatives mark price. DTB also helps compliance with laws against accommodation trading.
Downsides
The anti-manipulation DTB serves a valuable purpose to bringing confidence and stability to cryptocurrency derivatives traded on Leverj. When traders are highly levered in a position, it is imperative that the market is not manipulated by players who are trying to game the system.
Some may hold the view that derivatives should be in a free market and that the free market should be tradable anywhere, allowing for the price to move freely. Taking this into account, it is important to understand that the only thing our anti-manipulation DTB prevents is opening positions, maintaining that no trader be trapped in a position that they can’t exit.
Conclusion
An exchange has to maintain a balance between allowing the market to discover the price organically and ensuring a stable window of exchange for traders. Leverj will offer high leverage to traders and this necessitates the implementation of safeguards to ensure the market isn’t abused.
