David Sol
In recent years investors have sought data tools to navigate the digital asset universe. Our clients tell us of their desire for indices that screen this market with a transparent, rules-based methodology, apply a broad range of criteria to both assets and exchanges, and encourage the development of best practices in the market.
Our recent paper sets out our approach to digital asset index governance and to inclusion of exchanges in the FTSE Global Digital Asset Index Series, which provides a starting investment universe of the digital asset market, and is intended to filter out questionable platforms, assets and trade information.
The fundamentals of index construction are strong data management processes that deliver accurate and reliable input data: expertise to balance real-time reflections of the market with investability and turnover criteria, and of course a comprehensive governance framework that meets evolving regulations.
Digital assets have some major differences from other traditional investments. They were not conceived through the traditional financial innovation path, where banks, institutional investors and others cooperate on an idea. There is less regulatory involvement than has traditionally been the case, although some proponents see this as an advantage).
There are also major differences between digital asset exchanges and more established equivalents in the equity world. Trading hours are without end. Trades are captured on a blockchain, and they are not processed by clearing houses.
These differences pose challenges for index design. Which price should be used for the index calculation? Where should it be sourced? For our digital asset indices, including the flagship FTSE Global Digital Asset Index Series, we took the view that it’s best to address these questions by setting both quantitative and qualitative requirements for the exchanges where trading takes place, given that there are few regulatory barriers to entry in this space, we wanted to ensure that the governance of the digital assets indices is sound.
We have developed a methodology to determine what data sources we can use for high-quality index pricing and which assets are robust enough for consideration by institutional investors. This vetting of digital asset exchanges and of the underlying assets helps meet investors’ needs for accurate price discovery, transparency, and consistency. In our digital asset indices, we have incorporated data screens to elevate their quality and usability.
FTSE Russell’s digital asset and exchange vetting methodology aims to identify which of the greater than 400 identified digital asset exchanges meet critical baseline standards, including “Know Your Customer” (KYC) and “Anti Money Laundering” (AML) requirements, in addition to 21 other qualifying criteria.
Some digital asset exchanges may be prone to manipulative activity, including the posting of fictitious trade volumes, ‘spoofing’ and other attempts to artificially influence an asset’s price or the behaviour of the markets, so we have used data science as a tool to detect anomalous patterns.
In Figure 1, we compare what appears to be artificially smooth trading activity from a digital asset exchange that failed our vetting test with the trading data from another exchange that passed our test.
Figure 1. Suspicious and expected trading activity (from exchanges BW and Gemini, respectively)
Source: FTSE Russell and Source: Digital Asset Research: BW – is an exchange that failed our vetting criteria and Gemini is a Participating Exchange that passed our vetting criteria. Past performance is no guarantee to future results. Please see the end for important disclosures.
Some of the approach is in common with conventional index governance processes. As Figure 2 shows, we will vet digital asset exchanges each quarter to determine their eligibility. And the vetting process consists of two screens depending on whether the asset is on a watchlist for inclusion or is a participant in the index.
Figure 2: Vetting exchanges and digital assets
Source: FTSE DAR Guide to the Vetting of Digital Assets and Digital Asset Exchanges. Benchmark Asset Vetting includes the criteria for Tier 1 pricing. Past performance is no guarantee to future results. Please see the end for important disclosures.
In our role as a regulated benchmark administrator, we adhere to stringent regulations and requirements. In response to obligations under IOSCO, UK and EU BMR and other systems with which we must comply, we have established a robust yet agile governance framework.
As with any FTSE Russell index, our governance structure extends to the digital asset indices, including the FTSE Russell external committees. This is to ensure that our indices reflect the underlying market and the experiences of market practitioners, and incorporate oversight through technical, operational, structural, and executive level committees.
Digital assets are novel, and investors continue to debate their utility, while the markets will set their value. Our role as an index provider is to provide investors with transparent and robust tools, which track those prices. In digital assets this means meeting the asset and exchange vetting standards established through our robust governance process.
For more on digital assets, see our FTSE Global Digital Asset Index Series report.
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