What is cryptocurrency?
Cryptocurrencies use the concept of decentralized control with the help of a distributed ledger technology, also widely known as ‘blockchain’ that acts as a database for all the financial transactions made. The first cryptocurrency (Bitcoin) started gaining traction in the mid-2010s and, over the years, has eventually gained a huge audience.
Blockchain was created by a person/group of people (the identity is yet unknown) named Satoshi Nakamoto in 2008 to act as a ledger for all the public transactions of Bitcoin. The creation of the blockchain for bitcoin resolved the double-spending difficulty without the necessity of centralized control, making it the first such virtual currency. Bitcoin's design has proved inspirational in the formulation of other applications and also facilitated the use of blockchains that are readable by the public to be used in the creation of cryptocurrencies. Blockchain is also regarded to be a payment rail.
Since Bitcoin's inception, more than 4000 alternative cryptocurrencies have been released, also commonly known as altcoins. “Altcoin” is an amalgamation of the words: “alt” and “coin”; alt indicating ‘alternative’ and coin indicating ‘cryptocurrency.’ Thus the word “altcoin” implies a cryptocurrency that is an alternative to Bitcoin that represents the cryptocurrencies released after Bitcoin to replicate the boom. Many of the altcoins are based on the same configuration as Bitcoin but are constantly trying to overcome any restrictions that Bitcoin has and come up with better versions of the same.
Even with the fact that many of the features of the various altcoins coincide, they still vary widely from each other. Altcoins differentiate themselves from bitcoin based on a range of variations. Examples of altcoins include Litecoin, Dogecoin, Ethereum, Namecoin, Ripple, Gridcoin, Nxt, Primecoin, Peercoin, etc.; Ethereum is the 2nd most valuable cryptocurrency after Bitcoin. Bitcoin was the first cryptocurrency and is still the most widely known among all; however, it is only one out of hundreds of cryptocurrencies today.
What is a cryptocurrency price index?
A cryptocurrency price index is a medium that helps measure the growth in the daily and long-term movements in the cryptocurrency markets. Cryptocurrency price indexes act as an integral part of the cryptocurrency industry.
Due to the extensive number of cryptocurrencies available today, investors need a platform to view the options at such a point a price index acts as an essential tool for investors to study and compare the various cryptocurrencies to help investors analyze their current investment or decide on their future investments in the cryptocurrency markets.
Some price indexes cater to only a specific cryptocurrency, for example, bitcoinaverage.com only gives information regarding bitcoin, and some indexes provide insight on only the top 30/50 cryptocurrencies. However, most major cryptocurrency price indexes tend to list the majority of cryptocurrencies available. These Major Cryptocurrency price indexes act as a one-stop-shop for investors to keep track of the cryptocurrency market.
Some major cryptocurrency price indexes are CoinMarketCap, WorldCoinIndex, and CryptoCompare.These sites are mainly popular because they provide investors/traders with instant price information on multiple cryptocurrencies and prove to be a good source of information to benchmark, analyze, study, and compare the growth of the various cryptocurrency assets.
How is a Cryptocurrency Price Index Different from a Traditional Stock Market Index?
A stock market index and a cryptocurrency price index function similarly. Both provide information about the financial industry, market movements, prices, and conditions. However, the clear difference between a cryptocurrency price index and a stock market index is that a stock market index gives information about company shares. In contrast, a cryptocurrency price index lists information about cryptocurrencies.
Another difference is that cryptocurrency price indexes are not segmented into different categories like the normal stock market. For example, there isn’t a separate index for Utility tokens or cryptocurrencies. Instead, all are listed under one index itself. However, in the stock markets, there are different price indexes for different market segments. For example, The Indian equity benchmark index – Nifty, consists of 50 stocks that are the most actively traded among 12 sectors of the Indian economy. And the London Stock Exchange has the FTSE techMARK 100 index, which tracks only the top 100 technology companies listed on the London Stock Exchange.
While the Dow Jones Industrial Average (DJIA) (the Dow Jones Index is owned and managed by Dow Jones & Company) is one of the oldest and most renowned stock market indexes. It measures the daily price movements of 30 of the largest publicly owned companies in the United States listed on the New York Stock Exchange and NASDAQ. Also, the FTSE100 or Financial Times Stock Exchange 100 is comprised of 100 companies listed on the London Stock Exchange that is the largest based on their market capitalization.
A segmented cryptocurrency price index has not yet been established. However, various systems, such as the HOLD10, which tracks the ten largest cryptocurrencies according to their market capitalization, have been propounded for the bifurcation of the cryptocurrency industry, thus making it seem inevitable that some of these systems might be adopted shortly.
What are the Sources of information for cryptocurrency price indexes?
A cryptocurrency exchange is the primary source of information for a cryptocurrency price index. A cryptocurrency exchange or a DCE – Digital currency exchange is a platform that allows customers to trade cryptocurrencies for other digital currencies or other assets, such as conventional money.
A cryptocurrency exchange can be a medium that typically takes the spreads as a commission on the transactions carried out for its service or simply charges fees as a platform for matching the cryptocurrency traders.
As per a survey conducted in 2018 by Bloomberg News, as per the data collected by CoinMarketCap, the largest three cryptocurrency exchanges are Binance, Huobi, and OKEX. Cryptocurrency exchanges are where the majority of trading of cryptocurrencies is carried out. Just like a normal stock market index, these cryptocurrency exchanges help establish the prices of the cryptocurrencies with the help of the basic buying and selling statistics of the traders, thus helping achieve a precise rendition of the prices and therefore prove to be an excellent hub for the cryptocurrency price indexes to attain information from.
As there are several cryptocurrencies, each one is traded in various fiat currencies (USD, EUR, INR, GBP, etc.); thus, the prices of the cryptocurrencies may vary from one exchange to another. Thus the cryptocurrency price indexes generally accumulate data from many exchanges to attain the most precise price of the cryptocurrencies.
Essentially, a cryptocurrency price index tracks the cryptocurrency's last traded price, how much someone paid for that particular cryptocurrency the last time it was purchased, etc. The exchanges communicate this data to the cryptocurrency price indexes.
The information on which exchanges the price index has attained the information is freely available for the traders to check by clicking on the specific cryptocurrency and checking the markets on which it is traded. The cryptocurrency price indexes collect the data required by them through open Application Programming Interface, also called as APIs, which are made available by cryptocurrency exchanges to help ease the flow of data to the price indexes. An API is a channel through which different software can transfer data in a systematic pattern.
What information does a cryptocurrency price index provide?
The information available on a cryptocurrency price index depends on what type of information the index wants to provide its users with. The investor’s main focus is on the price of the cryptocurrencies and the information regarding the trading process. Thus, information such as the trade price, the number of trades, and the amounts of each specific transaction are usually provided.
Along with this, the current market price of each cryptocurrency, along with its market capitalization, is also provided. The market capitalization is calculated by multiplying the current Price by the circulating supply of the cryptocurrency and the 24-hour volume, which is the total trading volume of that specific cryptocurrency across the different markets in the past 24 hours.
Generally, the option to click on an individual cryptocurrency to find more detailed information, like its features, for example, a security token or a utility token, etc., is also available at most major price indexes. This could include the present circulation of that particular cryptocurrency and the maximum supply available.
A cryptocurrency price index also offers a medium to analyze cryptocurrencies using graphs that track the performance of the cryptocurrency based on price. A list of all the markets (exchanges) on which the cryptocurrency can be traded is also available for the investor’s ease.
Although this is some of the standard information made available for the investors, every platform varies from its counterpart and tends to provide different information, contingent on its user base. For example, suppose a particular cryptocurrency price index focuses on day traders.
In that case, it may display the highest and lowest price a cryptocurrency has achieved over the last 24 hours. In contrast, another price index that caters to the needs of a majority of long-term investors might provide data on specific features of the cryptocurrency, like whether it is a proof-of-stake (PoS) cryptocurrency or focussed on remittance or growth of assets, etc.
What data does the cryptocurrency price index accumulate and display?
1. Coin IDs:
Coin IDs are unique cryptocurrency symbols identifying various coins/cryptocurrencies such as BTC, ETH, LTC, etc.
2. Trade IDs:
Trade IDs are unique trade identifiers used to attain each cryptocurrency's trade volumes.
A Timestamp records the exact time a trade transaction took place. A timestamp is used for various purposes, such as real-time pricing information, to attain accurate opening-high low-closing data, and to determine precise 24-hour trading volumes.
4. Exchange rates:
A price index also accumulates and uses up-to-date exchange rates between BTC/USD and LTC/USD to ease trading activities for investors/traders.
5. Trade Price:
A price index also collects and displays the last traded price of a particular cryptocurrency on the stock exchanges. This helps investors analyze stocks based on the latest market conditions.
6. Transaction Volume:
The price indexes provide the traders/investors with the trade volumes of the cryptocurrencies, be it the transaction volume in the last 24 hours, the last week, last month, or even the entire year. This assists the traders/investors in considering the market trends in trading/investing.
Is the information on cryptocurrency price indexes reliable?
Generally, the data on all major cryptocurrency price indexes is reliable as most of these price indexes connect directly to all major cryptocurrency exchanges via an API – Application Programming Interface, thus helping send the data from the exchange to the price indexes instantly.
Most price indexes aggregate the data from multiple exchanges, and smoothen any small differences between the crypto exchanges. But although the cryptocurrency price indexes provide a good description of the overall crypto market conditions and positions.
Often, the same cryptocurrency is listed at a different price on different indexes. This is because most major cryptocurrency price indexes will collect data from a wide number of individual cryptocurrency exchanges. However, small indexes only track data from a single exchange. Therefore A slight change in the price of a cryptocurrency on one exchange might be reflected in that particular small price index but may not be seen on other exchanges.
The information of a certain cryptocurrency available on a cryptocurrency price index may also be less accurate when the volume of that particular cryptocurrency is low. For example, a cryptocurrency like Bitcoin or Ethereum is traded across hundreds of different exchanges, so the data available will be highly accurate. Similarly, all the data of all major cryptocurrencies can be easily aggregated due to their large trade volumes. However, the data of other small cryptocurrencies, such as SelfKey (KEY), which have a small trade volume, are only available on a small number of exchanges, thus making it difficult for the data to be sufficiently accurate.
Also, each exchange trades in various markets against fiat currencies such as INR, USD, EUR, GBP, JPY, etc. Each crypto price index uses various aspects to calculate each cryptocurrency's price. Like the contingency on the markets, the volume of trade, the liquidity of a cryptocurrency, what settlement fees/matching fees the exchange charge, and how many times the API – Application Programming.
Interface appeals and transmits data, i.e., every 2 seconds, 5 seconds, or 10 seconds, will all affect the price calculation on the various cryptocurrency price indexes. To determine the exact value of a certain cryptocurrency at any one moment in all the markets it trades in would thus be a very difficult task; neither would it rather be essential, as long as the traders/investors know that the price of the cryptocurrency exchange that they are trading on is right for that particular market.
What is the method for calculating the prices of the cryptocurrencies used by the price indexes?
In the various aspects of finance, several methods are used to obtain the most optimum and real price for that particular finance branch. Similarly, the 24-hour volume-weighted average price (VWAP) is widely used to measure the average price of a traded stock over the stipulated period.
The cryptocurrency markets never close, contrary to the normal stock markets. This means the price indexes will need to track cryptocurrency prices constantly. Thus the cryptocurrency price indexes use this method to generate and display constantly updated prices by keeping a rolling 24-hour stipulated period. This results in the average price of the cryptocurrencies traded being constantly up to date. The main aim of using a VWAP is to ensure that the prices are by the market volume.
What are the risks associated with cryptocurrency price indexes?
Cryptocurrencies have only recently set foot into the financial world. Thus, the various types of risk associated with the cryptocurrency market should be conveyed to the traders/investors.
The main risks are:
1. The highly volatile nature of the prices and liquidity of cryptocurrencies.
As the supply of many cryptocurrencies is uncertain and due to the unpredictable changes in their highly speculative demand prices, the volatility of most cryptocurrencies cannot be measured or calculated efficiently. Bitcoin’s volatility has a stable nature due to its fixed quantity availability. Just as in the normal stock market, the changes in demand for Bitcoin are by the variation in its price.
When demand plunges, there is no possibility for a decrease in the quantity available to suppress the effects of the price fall. When the demand increases, there is no increase in supply, thus creating stable volatility. However, the supply of many other cryptocurrencies is not fixed, due to which the problem of uncertain volatility arises. Also, the lack of liquidity intensifies the problem of fixed supply. Such issues with liquidity and volatility can lead to price imbalance. They may also lead to a scenario where investors may not even be able to open or close a position.
2. Uncertainty in the regulatory/legal framework surrounding cryptocurrencies.
Another major risk of cryptocurrencies is the uncertainty in government involvement and regulation. Today each country has a separate view and legal regulation concerning Bitcoin and other cryptocurrencies. While many countries have allowed the free circulation of cryptocurrencies, many countries have not yet given a legal perspective or altogether banned the circulation of such cryptocurrencies completely.
Such legal uncertainties may also affect the prices of various cryptocurrencies. For example, when the Chinese regulators recently banned initial coin offerings (ICOs) by stating that trading/investing in them was an unsanctioned and unlawful activity for public financing, the price of Bitcoin plunged by $700 in less than a day from the announcement.
3. Other Risks
There is also a risk of misinformation due to not optimized data by the price indexes. Thus, a potential challenge for the cryptocurrency price indexes is to eradicate any errors in the information that may affect the pricing of the cryptocurrencies.
These risks are faced by any index trying to duplicate any of the cryptocurrency price indexes currently available. Thus these risks should be considered by the investors/traders before venturing into the cryptocurrency markets.