Benchmark risks

Financial index data help drive the revenues of many stock and futures exchanges. But calculating an index from market inputs, apparently a straightforward activity, can still be a risky one.

Last week a rapidly growing cryptocurrency exchange, Deribit, suffered a Halloween flash crash that dented its reputation and forced it to reimburse affected clients.

Deribit, based in Amsterdam, specialises in leveraged bets on cryptocurrencies like bitcoin and ethereum. It recently claimed to have 10 percent of the market for unregulated crypto derivatives.

Crypto derivatives are big business for those involved. In July Deribit processed over $1bn in daily volumes, generating anything up to $750k in revenues for the exchange, which is run by 20 people and apparently co-owned by just four.

One of the creators of another unregulated bitcoin derivatives exchange, BitMEX, was last year revealed as the UK’s youngest-ever self-made billionaire.

Deribit’s Halloween flash crash

The Deribit flash crash, which briefly took the exchange’s bitcoin quotation down from $9,150 to $7,720, occurred when two of the exchanges used by Deribit as price sources for its bitcoin index went offline at the same time.

Deribit says on its website that its index takes market inputs from seven cryptocurrency exchanges, Bitstamp, Gemini, Bitfinex, Bittrex, Itbit, Coinbase and Kraken.

Three weeks before the crash Deribit said in a tweet that it was adding two other exchanges, LMAX and Coinbase Pro (formerly GDAX), to the list of its index price sources.

Deribit’s bitcoin index is calculated by discarding the highest and lowest bitcoin prices from this group of exchanges, then taking the median of those remaining.

It was the two recently added exchanges that were the cause of Deribit’s index calculation problems, according to Marius Jansen, the exchange’s COO.

At 9pm UK time on 31 October, LMAX took a planned five-minute break from bitcoin quotations. Coinbase Pro’s bitcoin price feed then also disappeared, this time without warning.

Deribit’s COO explained what happened next.

“When LMAX went into maintenance mode they sent a zero value (outlier) followed by Coinbase sending wrong values at the same time (second outlier), which was not removed,” Jansen told New Money Review.

“The bug [was in] treating LMAX’s zero value as an outlier, when it was simply announced maintenance,” said Jansen.

“We don’t know the exact reason for the Coinbase issues,” Jansen went on.

The Deribit COO says his firm is taking steps to remove the risk of a similar mishap reoccurring.

“We are going to change this to adjust outliers [in the index calculation] to, for example, 1% from median if they are further than 1% from the median,” Jansen told New Money Review.

Who compensates the traders?

The exchange moved quickly to head off a potentially severe reputational blow.

Deribit’s co-founders, Marius and John Jansen, said in a November 1 blog post that they had already credited traders whose positions had been wrongly liquidated.

“Equity levels of all these accounts have been effectively brought back to pre-crash levels. A total amount of more than 150 BTC or $1.3 million got reimbursed this morning,” the brothers said.

Part of the reimbursement came from the exchange’s insurance fund, which is created from fees levied on past liquidated trades.

Deribit said it had decided to compensate clients with money, rather than reversing trades, which could have caused broader problems.

“Crypto markets are highly connected, and most market makers and arbitrageurs are following strategies that require hedging their positions on other platforms. The rollback of trades could have been even more damaging and would have taken additional time,” the Jansen brothers said in their blog.

“Some negative account balances were covered by the insurance fund up to a zero equity point,” Marius Jansen told New Money Review.

“However the Deribit company has further compensated traders’ equity levels back to the pre-incident level.”

Deribit’s most popular contract, and that of many less-regulated cryptocurrency derivatives exchanges, is a perpetual bitcoin swap, which comes with up to 100 times leverage and therefore carries a high risk of automatic closure.

If the market moves against exchange clients and their funds are depleted, as it did to long bitcoin position-holders last week, their positions are automatically liquidated by the exchange.

This automatic liquidation procedure is supposed to protect the exchange and other clients against the losses of losing traders.

If a losing trader’s funds are exhausted, the insurance fund is supposed to cover any extra shortfall. If the insurance fund is exhausted, winning traders then all give up a portion of their gains.

This risk-sharing model differs radically from that on traditional, regulated derivatives exchanges, where a central counterparty acts to guarantee the performance of all trades.

Making the index robust

Sui Chung, CEO at CF Benchmarks, which produces a competing bitcoin benchmark, the Bitcoin Reference Rate (BRR), said his firm had managed to survive the glitch at Coinbase Pro, which CF Benchmarks also uses as a price source.

The BRR is used by the Chicago Mercantile Exchange for its bitcoin futures contract.

“Coinbase Pro is one of our constituent exchanges and we saw the issues that its bitcoin/dollar order book exhibited,” Chung told New Money Review.

“They were excluded from our index calculation for about 40 minutes as they failed three of our index validity rules,” Chung said.

But Chung sought to distinguish Deribit’s problems from the wider bitcoin and index market.

“Markets are one thing but indices are another. The S&P 500 index doesn’t drop 200 points because of bad implementation of code.” said Chung.

“But this wasn’t a market flash crash. In this case the index rules may have been fine, but the implementation didn’t reflect the rules. And Deribit has done the right thing in recompensing clients,” he said.

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