Everything is relative and open to comparison. Comparison to a benchmark is a vital part of the evaluation of most companies’ operations. Generally speaking and simplifying a bit, a benchmark is an index that represents a certain market and is used for comparing one’s own performance to the performance of a peer group or similar entity. The use of benchmarks is not limited to the financial industry. Examples can be found in key performance indicators (KPIs) for controlling purposes or indices that compare the living standards of various cities around the globe. In order for a benchmark to be reliable and therefore useful it has to be transparent and rules based.
Considering the traditional financial markets, there exist numerous benchmarks that vary by the currency in which they are denominated, the geographical market(s) they cover, the asset class and/or industry on which they are focused, and so forth. The most famous ones are the S&P 500 Index — a market-capitalization-weighted index of the 500 largest publicly listed U.S. companies, the Dow Jones Industrial Average (DJIA) — calculated as the sum of the prices of 30 externally chosen companies, the FTSE 100, and the NASDAQ Composite. Among more specialized benchmarks are the Barclay Hedge Fund Index, the Credit Suisse AllHedge Index, and many others that aggregate the performance of different hedge fund styles. The list of indices can be extended, but the point here is that for each specific need there is a specific index. For example, it would probably be wrong to use the DJIA to evaluate the performance of a manager trading only small-cap companies, so a more appropriate benchmark should be applied.
This is just one of the examples of how and when a benchmark can and should be used, but let’s consider the most common uses for benchmarks in more detail. The design of a benchmark may vary significantly from application to application, leaving a high degree of freedom regarding the specific design to the entity developing it. We identify three main purposes of benchmarks:
- Fund performance evaluation
- Market efficiency assessment and improvement
- Pricing of systematic risks
The first purpose is pretty straightforward: imagine a portfolio manager who claims she was able to generate, say, a minus 5% return in 2008 by trading large-cap U.S. companies following a long-only active strategy. Was that good? Or was it actually really bad? Looking at her performance figure in isolation, one might say the performance was not great at all; in fact it was a loss. However, the return of the DJIA for 2008 was minus 33.84% (the S&P 500 lost 37% over the same period). It becomes obvious that the manager did a pretty good job via active trading and performed far better than the market. The next year her return was 20%. Sounds good, huh? Well, not really, since the S&P 500 gained more than 26% that year. The effort of active trading by the manager generated less wealth than did a simple passively held market portfolio that can now easily be purchased via ETFs.
Secondly, benchmarks and indices can be used to assess the state of the markets and also can provide insights on their efficiency. Usage of indices allows to price the market (systematic) risk which cannot be eliminated by means of diversification. But not only do the indices help with evaluation, they also improve the functioning of markets by aggregating a lot of information and making it available to the public in an easily digestible manner. Investors can thereby make better-informed decisions.
Lastly, but not going into too much detail, an index can be used to proxy the performance of the overall market. CAPM (one of the most popular models derived from Portfolio Theory), which was developed to explain equilibrium asset prices, explains a single asset’s return by relating it to the overall market return. Hence, benchmark returns are largely used in calculations of required returns that in turn are used in the evaluation process of investment attractiveness and asset evaluation.
Challenges of Benchmarking the Market for Cryptographic Assets
So far, we have seen that there is a need for benchmarking in the traditional financial sector and other industries. The market for cryptographic assets (“crypto” hereafter) is no different in its need for evaluation and comparison, although we have to clearly admit that the factors driving its prices have to be distinguished from those of traditional asset classes such as equity. The main peculiarity of crypto at the moment is that it is not yet well defined and developed; hence, there are not as many players and entities that have entered the space. The market for crypto assets and the trading infrastructure is still in the active development stage and rather immature. This causes several issues for someone desiring to create an index or benchmark for this particular market:
- Pricing — From which exchange(s) shall the prices be taken? Shall the index be constructed in fiat currencies (traditional currencies, such as USD, EUR, etc.) or in bitcoin (BTC)?
- Volatility — It is not newsworthy that the market for crypto is highly volatile and daily changes of 5%+ of large-cap assets are no surprise. How should this be addressed?
- Choice of coins — As of now the popular platform for tracking crypto prices, Coinmarketcap, provides data for more than 1,700 assets, and the number is not expected to significantly decline in the near future. Together with the already-mentioned high volatility, more challenges arise: Which coins shall be included, and how often should the benchmark be reallocated in order to represent the market correctly?
- Dynamic environment — It has happened several times. A disagreement within a certain community has resulted in a fork, a situation when a blockchain splits, resulting in the sudden creation of additional assets (i.e., ETH and ETC, BTC and BCH). How should these crypto-specific events be dealt with in an index?
Unfortunately, at the moment the available crypto indices do not solve these issues and hence do not provide a solution suitable for institutional and professional investors. The challenges outlined have boosted the introduction of the LIMEYARD Crypto Assets Index (LYCAI) benchmark.
The index can easily be reached via Yahoo! Finance service here.
How LYCAI Solves the Outlined Shortcomings
The index we are focusing on in this article is LYCAI, developed by LIMEYARD and Decentriq, Swiss-based companies with solid expertise in benchmarking and distributed ledger technologies (DLT). The index has been distributed since July 2018 (USD: CH0418626138, BTC: CH0418625346) by the Vienna Stock Exchange.
As stated in LIMEYARD’s methodology, the benchmark aims to be representative of, i.e., aims to capture most of the dynamics of, the total market for crypto assets and comprises the 20 largest assets by market capitalisation. Together with liquidity constraints, the index aims toward investability by institutional investors. The review of the included tokens is done once a month at a fixed time to provide updates while avoiding excessive changes and fluctuations.
The index value is updated every 15 seconds, 24 hours a day, 7 days a week to provide reliable and highly granular information for investors. The index is calculated in two reference currencies: USD and BTC. The price of an asset within the index is calculated as the smoothed average of the prices from 8 trusted exchanges that satisfy strict requirements on volume, transparency of trading activity, and — last but not least — legal compliance.
The issue of volatility and excessive asset turnover is addressed via use of the exponential moving average of the daily market capitalisation, which allows to avoid the selection of coins with a spike in market capitalisation just before the review.
Treatment of forks in LYCAI does not involve any specific regulation. Since the index includes only the 20 top coins traded in at least 2 of the 8 top exchanges for the last 90 days, once the fork is done the new coin might be included for at least 90 days after, provided it reaches the top 20 again and satisfies all the standard requirements.
The methodology described tackles the crypto-specific problems identified before and is a robust and reliable representation of the market.
Outlook for LYCAI
We have discussed the importance of benchmarks and indices and outlined the main indices designed to meet the needs of the traditional financial industry and the three main purposes we see for financial benchmarks. Then we have mentioned the equivalent importance of the usage of benchmarks and indices for crypto assets and the potential issues associated with designing such indices. Lastly, we have discussed LYCAI, an index developed by LIMEYARD & Decentriq that is able to overcome the issues and provide a reliable source of information for all investors and players, both in USD and BTC terms.
This index solution is a crucial step toward making the whole market for crypto assets more professional. LYCAI is currently the most reliable product available in the market, and we strongly believe it has the potential to become the S&P 500 of crypto assets.
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If you would like to discuss these ideas or ask any questions, we would love to talk with you! Just reach us via email at firstname.lastname@example.org.
Because no central entity lasts forever, we develop, apply, and invest in decentralized technologies. We don’t want history to repeat itself, nor to let our future be determined solely by central powers. From anonymity preservation to zero knowledge, we shape answers that last.
Visit our website at https://www.decentriq.ch/.