As investor interest returns to crypto the provenance of prices is crucial

A major obstacle to the mainstream adoption of crypto assets has been on-ramping from fiat currency into crypto. However, in 2019, this once laborious process has become near-seamless. Retail investors now have many professional crypto on-ramping services to choose from. Coinbase, Circle, Square in the US, and Vimba in the UK and New Zealand make the process of buying and selling crypto an easy app-based experience.

The CFD platforms

A similarly trusted provider has not yet emerged for retail traders. However, recently there has been an increase in the number of contracts-for-difference (CFD) platforms. These platforms offer cryptocurrency products that currently provide the easiest and quickest route from fiat to crypto.

A CFD is a derivative product, usually on shares, fiat currencies or indices, which allows traders to leverage their position and bet on the direction of price. The contracts are traded on margin with an agreement between the parties on either side of the trade to pay the difference in price movement; a very similar mechanism to spread-betting. They should never be used for long-term investments.

The sponsorship of football jerseys is common practice among gambling and bookmaker companies to reach the betting public.

These platforms also share the same marketing tack as spread-betting companies. Some of the most prominent CFD platforms E-Toro, CMC Markets, Plus500, and newcomer Skilling all advertise to the betting public through sponsorships on professional football and rugby jerseys.

However, CFDs are at risk of being outlawed in the few countries they are legal, which means that a trader is compounding their risk in an already volatile asset class when trading with CFDs providers. According to their data, 74%-89% of traders on CFD platforms lose money.

Retail crypto investing interest is picking up

Retail traders from the legacy markets that are used to seamless UX/UI platforms are often put off trading on crypto-native exchanges due to their clunkiness, relative complexity and the risk of price manipulation by ‘whales’.

This gap in the market has been filled by CFD platforms, which offer cryptocurrency pairs and even indices with low fees and tight spreads. They can do so because, as market-makers, they provide the liquidity and reference pricing for all assets and are also the counterparty to customer trades which creates obvious conflicts of interest.

Worldwide Google Trends searches for Bitcoin have been in a steady uptrend since Q2 2019. Google trends is used as a proxy for new retail interest in crypto markets.

The rekindled interest in crypto due to central bank machinations is an opportunity for brokers that don’t operate on a CFD/market-making model to front-foot customer demand for digital assets. These financial service providers care about their reputation and will only move into crypto if they can offer customers fair and accurate global prices set by a third party as Standard & Poor and MSCI do in the legacy financial markets.

For brokers: A gap in the market

While price discovery is in such an early stage, crypto assets are known for having large price disparity across crypto exchanges (although this is becoming less pronounced). While this offers arbitrage opportunities it makes it difficult for the average trader and even traditional brokers to find the true price of an asset.

CFD market-making platform can add further opacity to the crypto pricing. CMC’s terms and conditions as a market-maker states that they can essentially make up the prices:

Although the prices generated by the Platform will take into account current exchange and market data from various sources, they may not be taken from any source. This means that our price may be different to any curernt exchange or market price, or another financial product provider’s price, for the relevant underlying

The growing demand for retail traders seeking to trade both crypto and traditional markets on one platform has so far been filled by these platforms. These market-making platforms have a contentious business model and regulators in France have called for a blanket ban on CFDs and the UK is moving to ban crypto derivative products.

The share price of CMC markets is down from ~300 to ~90GBP in just over two years.

The market-maker business model is under pressure from regulators and competitors and this is telling in the share price of CMC Markets, listed on the London Stock Exchange is down nearly 70% from its all-time high in 2016. This pressure to return profits to shareholders is an added risk that customers take when entering into trades with a market-maker.

CFDs are illegal in the US and the crypto-derivative exchange Bitmex (which uses more exotic terminology than ‘CFD’ for its derivatives) is currently being probed by US regulators for allowing US citizens to trade on its platform.

There’s a large gap in the market for non-market-making brokers to offer cryptocurrencies along with their traditional range of products. What is needed is a trusted third-party price source to calculate a fair global price for assets while reporting legitimate trading activity only. Trusted by Nasdaq, the BNC liquid indices, or LX series is an enterprise-grade crypto asset data solution. Data is collected using order book depth and volume from executed trades on the six most reliable digital asset exchanges.These are reviewed on a quarterly basis.

Self-pricing platforms: A conflict of customer interest

A major volatility concern for crypto retail traders is that prices often gap through stop losses and run down their account. Some platforms offer stop loss guarantees (ensuring they are stopped even in the event of a price gap through the stop-loss but this can only be offered by market-makers.)

In its Terms of Business, CMC Markets states:

We, or our Associates, may have an interest or relationshi which cnflicts with your interst or our duties to you.

It also reserves the right to:

“amend any margin, spread between the Bid Price and Ask Price for a product, attributes prices and rates, including those relevant to your trades and/or orders”

The conflicts of interest on market-making platforms can range from:

(i) Self-pricing and indexing – Increases the chance of internal manipulation of single asset spot prices and volumes as the exchange sets the reference price provides the liquidity

(ii) Hunting stop losses – as the exchange keeps all orders on its books it knows the price areas traders have their stop losses and have the ability to move price past that level

(iii) Self-indexing products using their own reference prices – raises concerns around transparency, manipulation and fairness in customer disputes

Given crypto markets are prone to bouts of wild volatility retail traders using a CFD platform that derives its spot price from its own reference prices (from its own order book) compounds their counterparty risk, leaving them exposed to both external and internal manipulation.

Market making platforms also have the option of hedging customer CFD positions with an opposite position in the underlying markets. These match with other trader positions or go unhedged but there are better ways to mitigate against this risk of manipulation to the benefit of retail traders, brokers, and fund/money managers.

Mitigating manipulation for customer and broker

Recently, Ethereum experienced a flash crash across exchanges caused by an outsized order on the Bitstamp exchange. The price dumped from ~$270 to $190 in a matter of minutes, wiping out customer positions not just on Bitstamp but also on the major exchanges Bitmex, Kraken, Gemini and Coinbase.

Using independent, third-party indices verified by EU Benchmarks Regulation and IOSOC (International Organisation of Securities Commissions) could be a part of the solution to fairer and more stable pricing of single assets to the benefit of exchanges and customers.

The difference in prices drops during a flash crash in Ether between five exchanges compared to an aggregate liquid index of the most trusted exchanges

Using a Liquid Indices price for Ethereum, the ELX would have protected trader’s stop losses when the large sell order on the exchange Bitstamp dumped the price of ETH, particularly on Bitmex and Bitstamp.

The trend of ETF providers is to create their own indices to cut down on third-party costs and offer cheaper fees. However, this benchmark-setting has raised conflict of interest concerns by EU regulators, ranging from front running index changes or tampering with an ETF’s net asset value. Self-indexed crypto products are also now being offered on certain CFD exchanges.

Preferably, retail investors seeking crypto and traditional products would use a platform which processes their orders straight to the global markets and use an independent price and index provider but these platforms are less well known (not the main sponsors on football and rugby jerseys) and don’t offer the same breadth of trading products or tools.

For brokers, using third party (and IOSCO consistent) indices can support them in response to “price challenges” by customers – for example, if a CFD client disputes a price or settlement rate that has been applied to their position or trade, the CFD provider can say “at the time that price was struck we were using XYZ index, which gave the price of 123”. If the party requires further investigation, the index provider should be able to point to their methodology and published prices as the prevailing rate at the relevant time.

For fund/money managers: Volatility belies risk

The perceived risk in bitcoin and cryptoassets is always attributed to their high volatility. As the finance world bases risk on retrospective VAR (Value at Risk) metrics, which equates high volatility with high risk, cryptoassets are off most fund managers’ radars. Is this a false negative?

Bitmex’s Historical volatility index (BVOL) in blue has jumped 48% YTD, while the S&P implied volatility index (VIX) has fallen almost the same amount and is just above historic lows.

Shorting the VIX has been the most popular trade of the decade, with dedicated ETFs even catering to retail traders – this has artificially suppressed the VIX and it sits 13.9 and is over two standard deviations below its long-term average 18.3. However, this low volatility may belie risk. Hyman Minsky’s financial instability hypothesis that “stability can be destabilizing” – economic agents observing a low risk are induced to increase risk-taking, which in turn may lead to a financial crisis – was recently empirically backed up by the London School of Economicsresearch which concluded:

“The level of volatility is not a good indicator of a crisis, but that relatively high or low volatility is. Low volatility increases the probability a banking crisis, both high and low volatility matter for stock market crises, whereas volatility–in any form–does not seem to explain currency crises.”

Cryptos are undeniably a more volatile asset class than stocks (common for markets with relatively thin liquidity) but this might not underline any imminent market capitulation, unlike the share market which is built upon corporate debt and share buybacks.

Conclusion

Crypto has been an opportunity for retail-targeted CFD trading platforms to revive a constrained business model and they have consistently updated their crypto product range. Traders should be aware of the added risk of trading a new volatile asset class with a market-maker that has publicly listed shares as its shareholders’ interests are in direct conflict with customers.

Regulators are justified in their concern about crypto derivatives being offered to the general public and this scrutiny will only continue to hamper the CFD industry.

The crypto-native exchange landscape is highly complex compared to traditional markets, fractured, relatively clunky, and at risk of hacks. The demand is there for crypto to be traded alongside traditional assets and there remains a gap in the market for a trusted provider that can stand by the provenance of its reference pricing.