In a recent post, my teammate Jennifer Xia outlined our motivation and initial direction for tracking XRP liquidity in support of RippleNet’s On-Demand Liquidity (ODL) service. ODL leverages the digital asset XRP to facilitate cross-border payments by sourcing destination currencies right at the time of payment. Jennifer’s post introduces the concept of order books and defines the implied FX rate or the FX rate implied by a pair of trades bridged through XRP.
As we scaled the service, comparing rates was not enough. Our team often wanted to understand why implied FX rates differ from spot FX rates. As defined, the implied FX rate mixes the order book effects of price competitiveness and capacity, as well as the relative liquidity efficiencies of the originating and destination exchanges. Moreover, it assumes all ODL payments involve pairs of source and destination trades, which limits flexibility of leveraging other sources of XRP.
We wanted a way to tease apart these distinct effects, so we decoupled our analysis in terms of dislocation and depth of liquidity at exchanges. In this post, we introduce the dislocation metric.
Recall that liquidity is the ability to buy and sell desired quantities of an asset without impacting the price significantly. But with multiple exchanges and fiat currencies, how do we define the price across these assets? That is, how should we compare the price of XRP in MXN to that of XRP in USD, PHP and beyond?
To do so, we need some global perspective on XRP price, then a way to map that price to a price for each XRP-fiat pair. Determining a global price is a common problem in trading and finance, and is nicely solved using a price index, such as CryptoCompare’s CCCAGG index.
Once you’ve selected an index price for XRP, say in US dollars, you can get the XRP reference price in any other fiat currency using the traditional spot FX rate. For example, a reference XRP-MXN price comes from multiplying the XRP-USD index price and the USD/MXN FX rate.
Dislocation is then the competitiveness of an exchange’s XRP-fiat price to the XRP reference price in that fiat. Dislocation is the zero-order model of the price quality of an exchange, ignoring the structural details of the order book and the size of the payment.
From a purely economic standpoint (but ignoring fees/costs), non-zero dislocations should not persist because they represent an opportunity to buy or sell XRP at a discount or premium to the index price. Any persistent dislocation is a sign of some structural issue–perhaps an exchange’s deposit or withdrawal processing is paused, or there is an imbalance of supply and demand for that fiat pair. Likewise, any change in typical dislocation at an exchange is worth investigating to understand its impact on ODL rates.
In the next post in the liquidity series, we’ll introduce the depth metric and a combined visualization for assessing liquidity performance.
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