By Dr. Vassilios G. Papavassiliou, Assistant Professor of Finance, University College Dublin
Cryptocurrencies are digital assets that have become quite popular in recent years; however, their basic features are still considered a “black box” to academics and practitioners. In 2017, the cryptocurrency market exhibited record-breaking growth rates in terms of market capitalization and transactional activity. As of January 2018, the total market capitalization of the cryptocurrency market was $630 billion. There is a growing list of businesses worldwide that have begun accepting cryptocurrencies as legal tender. The leading cryptocurrency by market value is bitcoin, the ownership of which is recorded on an electronic ledger called blockchain, which is not encrypted.
The purpose of bitcoin is to allow peer-to-peer electronic transactions between counterparties without the intervention of any intermediary. Trading is conducted on cryptocurrency exchanges and is based on market forces similar to the trading of stocks or bonds. A distinct feature of a cryptocurrency exchange is that it acts as a central counterparty (CCP) clearing house to both buyers and sellers, offering greater transparency, lower transaction costs and greater investor protection in cases of default by a participant. Bitcoin is traded on different cryptocurrency exchanges, and its price may differ across trading venues due to differences in supply and demand.
Bitcoin’s basic features differ from those of conventional currencies. First, bitcoin is fully decentralized and is not controlled by any central bank. Second, it is secure, as the blockchain “distributed ledger technology” ensures transactions can never be altered (there are some fundamental privacy challenges in the blockchain industry that need to be addressed). Third, bitcoin is fully digitalized, allowing for zero transportation costs and near-zero transaction costs.
The growth of the cryptocurrency market has triggered the interest of portfolio managers who seek alternative investments that can add diversification to a portfolio and help mitigate risk and increase returns. In the analysis that follows, I summarize the latest findings from academic research on bitcoin’s main characteristics and its usefulness as an investment or speculative asset.
Bitcoin is very volatile, mainly due to the lack of a regulatory framework, very thin order books and no intrinsic value (fundamental value). The lack of fundamentals in the bitcoin market has not allowed market participants to fully identify the main market factors that can affect bitcoin prices over time. In fact, bitcoin exhibits much higher volatility than conventional currencies, stocks and even gold. High volatility increases investment risk for risk-averse investors, who are still sceptical of investing in that market. Volatility is expected to gradually subside when a solid regulatory framework is put in place. Figure 1, which follows, illustrates bitcoin closing prices obtained from CryptoCompare, a cryptocurrency-market data provider, for the period October 1, 2018, to October 1, 2019. It is apparent that bitcoin prices exhibit high volatility throughout the sample period.
Bitcoin bubbles and speculation
Bitcoin is mainly held by investors as a speculative asset due to its high volatility expressed by bubbles and crashes. These bubbles can be either short-lived or more persistent over time and may even lead to the collapse of a bitcoin exchange (Baur et al., 2018). This casts doubts on bitcoin’s viability in the longer-term.
Evidence on bitcoin’s value as a diversification instrument is mixed. On the one hand, it has been shown that bitcoin offers significant diversification benefits to investors, especially for short-term investment horizons, as it exhibits very low correlation with other assets such as stocks, bonds and commodities and qualifies for inclusion in a well-diversified multi-asset portfolio. Bitcoin’s independent behaviour relative to conventional assets is manifested during both calm and turbulent periods. Moreover, the portfolio’s risk-adjusted returns are improved significantly when bitcoin is added to the portfolio (Platanakis and Urquhart, 2019). On the other hand, there is evidence showing that bitcoin is susceptible to the same factors as traditional assets, such as interest rates, implied stock-market volatility, treasury yields and market sentiment (Koutmos, 2019). This serves as a cautionary note regarding bitcoin’s usefulness as a diversification tool.
Bitcoin’s specific relationship with gold has also been a matter of debate. Gold has been termed a “safe haven” to investors during periods of stress. It has been shown that bitcoin shares similar hedging abilities as gold and can effectively minimize market-specific risk (Dyhrberg, 2016). Another report states that bitcoin possesses no stable hedging abilities as it correlates strongly and positively with downward markets—that is, it cannot be regarded as a “safe haven” asset (Klein et al., 2018).
The bitcoin market is not weakly efficient. Weak form efficiency supports the idea that past price movements do not affect an asset’s price and cannot be used to predict its future direction. That is, asset prices follow a “random walk”, and it is not possible to detect price patterns that can be exploited by investors. It seems that price momentum does exist in the bitcoin market as price movements are not entirely independent of each other. One observed property of bitcoin prices is that they appear to display “long memory” characteristics (Phillip et al., 2018). Bitcoin prices should be thought to have long memory when their past values are related to their future values. This means that the effect of shocks on bitcoin prices takes a very long time to disappear. The fact that bitcoin prices exhibit long-memory features suggests the existence of strong market inefficiency. Market inefficiency is expected to be resolved in the future when the bitcoin market becomes more transparent.
The future of bitcoin as legal tender and as an investment asset will depend on a number of factors. Clearly, the establishment of a solid regulatory framework will create a more transparent market. If the bitcoin market allows more legal protection to investors, and more enforcement of market-specific laws and less corruption, more investors will be attracted to the market. This will enhance confidence in the cryptocurrency market and lead to greater pricing efficiency. The tax treatment of capital gains from investments in bitcoin and other cryptocurrencies will also play a catalytic role in the further development of the market. Lastly, confidence in the bitcoin market will be improved if two disadvantages of distributed ledgers are properly addressed—namely, complexity and insecurity. Specifically, it has been noted that confidentiality of transactions [as described, for instance, in the Markets in Financial Instruments Directive (MiFID) legislation on investor protection] may be breached with the use of blockchains (Mainelli and Smith, 2015). Moreover, distributed ledgers promote speculation among participants, which is often associated with economic bubbles.
References: Baur, D.G., Hong, K., Lee, A.D. (2018). “Bitcoin: Medium of exchange or speculative assets?”, Journal of International Financial Markets, Institutions and Money, 54, 177-189.  Dyhrberg, A.H. (2016). “Hedging capabilities of Bitcoin. Is it the virtual gold?”, Finance Research Letters, 16, 139-144.  Klein, T., Thu, H.P., Walther, T. (2018). “Bitcoin is not the New Gold – A comparison of volatility, correlation, and portfolio performance”, International Review of Financial Analysis, 59, 105-116.  Koutmos, D. (2019). “Market risk and Bitcoin returns”, Annals of Operations Research, In Press.  Mainelli, M., Smith, M. (2015). “Sharing ledgers for sharing economies: an exploration of mutual distributed ledgers (aka blockchain technology)”, The Journal of Financial Perspectives: FinTech, EY Global Financial Services Institute.  Phillip, A., Chan, J.S.K., Peiris, S. (2018). “A new look at Cryptocurrencies”, Economics Letters, 163, 6-9.  Platanakis, E., Urquhart, A. (2019). “Should investors include Bitcoin in their portfolios? A portfolio theory approach”, The British Accounting Review, In Press.