Bitcoin has seen amazing performance over the past year, and the cryptocurrency has found its way into the collective consciousness in ways that many would have considered to be impossible just months ago. The advent of bitcoin futures has opened up the market to a wide range of new investors, including major financial institutions, that sought a way to take positions in bitcoin without dealing with the specific challenges and risks of actually owning the cryptocurrency outright.

One key to the smooth functioning of bitcoin futures is the establishment of reliable pricing metrics. With different exchanges having different prices, it's critical to have a benchmark against which futures markets can weigh their performance. Although the first-moving Cboe Global Markets (NYSEMKT:CBOE) bitcoin futures contract uses an auction rate to set settlement prices for its investors, the newer CME Group (NASDAQ:CME) bitcoin futures use what's called the bitcoin reference rate to determine pricing. Here's what you need to know about the bitcoin reference rate, and what it could mean not just to bitcoin futures traders but also for those who follow bitcoin more broadly.

3D mosaic of bitcoin symbol in yellow, with gray background mosaics.

Image source: Getty Images.

What purpose the bitcoin reference rate serves

The CME needed to come up with a transparent and readily available way to determine the price of bitcoin for its futures contract customers. Yet the problem it faced was that there are numerous exchanges on which one can buy and sell bitcoin, and the prices of bitcoin can differ greatly from exchange to exchange. These disparities persist in part because moving bitcoin from exchange to exchange isn't as simple as moving cash from one bank account to another, and in part because the decentralized nature of bitcoin makes the reputation of each exchange extremely important in determining the value of what's bought and sold there.

In particular, futures contracts need a daily settlement price for traders to even up their accounts. The CME wanted to use reputable pricing information to come up with its once-daily reference rate. That's where the concept of the bitcoin reference rate came from.

How the bitcoin reference rate is calculated

The CME worked with partner Crypto Facilities, a London-based crypto futures trading platform, to engineer the bitcoin reference rate. The rate takes the trade flow from major bitcoin exchanges during specific time windows and combines that pricing information into a single rate. The rules for calculation, which were developed using industry principles for financial benchmarks, are intended to maximize transparency and real-time replicability for spot market use as well.

The bitcoin reference rate comes from a four-step process:

  • Take all transactions between 3 p.m. and 4 p.m. London time from constituent exchanges and make a list of size and trade price for each transaction.
  • Break the list into 12 pieces, reflecting five-minute intervals of trades.
  • Calculate the volume-weighted median price for each five-minute interval.
  • Take the average of the 12 resulting median prices.

The methodology also has numerous contingencies in case the method above doesn't work. If no trading occurs during a five-minute interval, then that interval can be disregarded for determining averages. If a complete failure of the reference rate determination process occurs, then the previous day's bitcoin reference rate gets used, and the failure is reported to a committee overseeing the rate.

Currently, the constituent exchanges are Bitstamp, GDAX, itBit, and Kraken. The fact that CME has recognized these markets as worthy of contributing to bitcoin futures pricing should be a vote of confidence that direct bitcoin investors might well consider in deciding where to take their bitcoin trading business in the future.

Keep an eye on bitcoin

The bitcoin reference rate currently has its primary use in the futures markets, but there are other applications for which it could become useful. For instance, in evaluating how efficient a particular bitcoin market is, the discrepancy between that market's pricing and the moves in the bitcoin reference rate could serve as a measure of liquidity and volatility. That could better inform bitcoin traders how a particular market is likely to trade in response to certain conditions.

Bitcoin will likely keep seeing volatile movements in both directions for the foreseeable future, and that makes it all the more vital to have as much information as you can about the market. The bitcoin reference rate can show you overall bitcoin moves without being dependent on a specific exchange, and that's useful information as trading picks up across all the exchanges that currently trade bitcoin.

Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool recommends Cboe Global Markets and CME Group. The Motley Fool has a disclosure policy.