Decentralized price discovery using Microtick

Microtick is a new mechanism for decentralized price discovery that decouples price discovery from trade order flow and solves the problems with price discovery mentioned on the last page.  It can be used for any asset currently being traded, or even for assets that can’t be traded but can be conceptually identified such as groups of assets.

In the diagram below the actors are not taking long or short positions anymore. Instead, they submit a price estimate for an asset (in this case let's assume the asset is around $100 USD). With each quote, the actors include an estimate for the price range over a given time duration, such as +/- $1 USD for a 5-minute window of time.

The actors also provide an amount of token value attached to each quote, known as backing and indicated by the Bitcoin symbol in the figure. Backing does not have to be actual Bitcoin, any blockchain-based crypto asset would work as well.

For the top actor, the price estimate of $100 USD +/- $1 USD gives a range or $99 on the low side to $101 on the high side.

Decentralized price discovery for a 5-minute time window

Notice that the price range gives an indication of confidence the actor has in the quoted price, with the tighter ranges generally indicating a higher confidence in the price estimate. The price range attached to a quote is highly dependent on the time window chosen. Larger time windows will be associated with generally higher ranges because the volatility of the underlying asset has to be taken into account. Microtick standardizes time windows for quote markets and on the test net we use 5-minute, 15-minute, 1-hour, 4-hour and 12-hour windows for trading.

In addition to tighter price ranges, generally higher amounts of token backing also indicate a higher degree of confidence in the quote as well. Microtick uses the ratio of backing / range to create an artificial "quantity" for quotes placed on the market. This quantity is used for trading as will be described later.

A "Consensus Spot" price is created by combining all the quotes place on the network into a single weighted average, with the spot price for each quote weighted with the artificial quantity calculation described above.

The resulting system no longer has a spread between bids and asks as with legacy centralized price discovery. In addition, the system is more stable - with generally higher quantities of quotes towards the center of the range of estimates. The system is not tightly coupled to trading activity (although there is a correspondence we will discuss later). Finally, because we can account for block timing uncertainty as well as information propagation times in the premiums for the quotes, we can deploy the system on a global scale to arrive at a mutually agreed upon price estimate that is valid regardless of geographic location. (This works best in blockchain systems with fast finality such as Cosmos / Tendermint).

Microtick quotes as options

A quote placed by a market maker on Microtick is actually an offer to sell either a call or put, with a strike price at the current consensus price and the time duration specified by the time window the quote was place for. The buyer of the option (the trader) can choose whether the quote will be traded as a call or a put. In the diagram below, notice that the fair value for an at-the-money call or put changes as the consensus price (the option's strike price) moves in relation to the quoted spot price.

As the consensus price moves away from a quote's spot price, Microtick automatically adjusts the ask premiums according to a linear approximation to theoretical fair value as shown in the diagram. Notice that the linear approximation is always slightly below theoretical fair value at all points except the point where it is at-the-money. This acts as an incentive for market makers to keep their quotes updated - if the consensus price moves far enough away from the quoted spot, there is a point where it becomes a free option - which represents a riskless trade for the option buyer.

In the diagram the quoted spot price of $100 lies below the current global consensus price of $100.15. Because the market maker originally quoted $0.20 for the option's premium, the price of a call with a strike at $100.15 is currently $0.12 and the price of a put is about $0.28. Think of it like this: if the trader agrees with the market maker that the consensus price is too high, the trader will buy the put and the market maker is rewarded and will receive slightly more than the ask premium. If the trader disagrees with the market maker and thinks the consensus price will be moving up, the market maker will be punished and receive only $0.12 instead of the original ask of $0.20.

The backing originally attached to the quote is now moved into the trade contract and is used to settle the trade after the time window has elapsed, for any price movement in favor of the buyer. After settlement, any remaining backing will be refunded to the market maker.