© The Author(s) 2018
Sarah Swammy, Richard Thompson and Marvin LohCrypto Uncoveredhttps://doi.org/10.1007/978-3-030-00135-3_4

4. Crypto Currency: What Do We Know About Investment Performance and Risk?

Sarah Swammy1  , Richard Thompson2   and Marvin Loh3  
(1)
State Street Global Market, LLC, New York, NY, USA
(2)
Digital Air Technologies, New York, NY, USA
(3)
Bank of New York Mellon, New York, NY, USA
 
 
Sarah Swammy (Corresponding author)
Email: sas377@nyu.edu
 
Richard Thompson
Email: rthompson@digitalairtech.com
 
Marvin Loh

Keywords

EthereumBlockchain technologyDigital payment systemFinancial performanceFinancial markets

Introduction

Crypto currency originated in Nakamoto (2008), which described a digital payment system that did not require a third party, but instead a network of participants. The underlying technology, known as blockchain, has allowed for the growth of crypto currency. Bitcoin and more recently other crypto currencies serve as tokens used in blockchain systems.

Although Bitcoin has been traded 24 hours per day, 7 days per week, since 2010, rival crypto currencies started to appear in 2014. Since 2015, there have been competing coins, including Ethereum, which operates on the Ethereum network. Ethereum has a current market capitalization of $47.8 billion as of July 24, 2018, which is exceeded only by Bitcoin’s $140.1 billion market capitalization on July 24, 2018.1 Ethereum coins, like Bitcoins, are created through a mining network. However, Ethereum’s network operates independently of Bitcoin’s blockchain. To pay other computers on the network to complete tasks, Ethereum is used as the payment mechanism.

Ethereum is becoming important as it is designed to execute contracts that involve complicated financial transactions. A traditional financial transaction, such as settling a stock option or futures contract, involves two parties utilizing a third party, such as an organized financial exchange or a bank (for over-the-counter transactions) to conduct the transaction. However, in the traditional financial transaction, the two parties are paying fees to that third party. Ethereum views itself as a mechanism through which the two parties can engage in transactions on a shared network with reduced transactions costs, no restrictions placed by third-party middlemen, and completely security.2 The Ethereum network with its promise of decentralized smart contracts has become of interest for established information technology and financial services firms, such as J.P. Morgan Chase3 and IBM,4 which are interested in using blockchain networks as alternatives to traditional financial exchanges and banks acting as middlemen. In 2017, the non-profit Ethereum Enterprise Alliance was established to bring large companies, representatives of academia, and technology companies to build on Ethereum’s smart contract blockchain technology.5

In addition to Ethereum, other coins have appeared over the last three years because of “initial coin offerings.” For a startup, coin offerings are an alternative to funding via issuing stock or through venture capital financing. In effect, programmers raise money by creating and selling their own crypto currency that uses a framework like Bitcoin. Typically, the newly issued coins can only be used on a computing platform that the issuers are building.

Table 4.1 displays a ranking of market capitalizations of crypto currencies that have market capitalizations of at least $1 billion. As of July 24, 2018, 20 crypto currencies met this criterion.6
Table 4.1

Crypto currencies with market capitalization of $1 billion or greater as of July 24, 2018, 10:59 AM, EST

Rank

Coin

Market capitalization ($ billion)

1

Bitcoin

140.1

2

Ethereum

47.7

3

Ripple

17.6

4

Bitcoin Cash

14.6

5

EOS

8.4

6

Stellar

5.6

7

Litecoin

5.0

8

Cardano

4.5

9

Tronix

3.7

10

Iota

2.7

11

Tether

2.5

12

Binance Coin

2.3

13

Monero

2.3

14

Neo

2.2

15

Dash

2.1

16

Project Pai

2.0

17

Ethereum Classic

1.7

18

Huobi Token

1.7

19

NEM

1.6

20

0x

1.1

Source: www.​cryptocompare.​com, accessed July 24, 2018, 10:59 AM

Over the remainder of this chapter, we survey prior literature on crypto currency pricing and returns; compare Bitcoin returns and risks with established financial assets; and compare returns and risk of alternative crypto currencies. We also discuss the implications of the establishment of crypto currency exchange-traded funds, as well as options and future contracts with crypto currency as the underlying financial asset. Finally, we conclude with suggested directions in future research.

Prior Empirical Literature on Crypto Currency Pricing and Returns

Since 2015, there has been an extensive literature on crypto currency pricing and returns. This research has focused on whether Bitcoin and other crypto currencies can serve as a hedge against other more established financial assets, such as stocks and foreign currency. In addition, financial researchers have focused on whether Bitcoin and other crypto currency assets are characterized by efficiency, that is, whether the prices of the asset reflect all relevant information.

Dyhrberg (2016) demonstrated that Bitcoin can be a hedge against the stock market and the US dollar, which makes Bitcoin extremely useful for portfolio diversification. Urquhart (2016) suggests that the Bitcoin market is inefficient but started moving toward efficiency from August 1, 2013, to and July 31, 2016. Nadarajah and Chu (2017) also show that the Bitcoin market is not efficient. Alvarez-Ramirez et al. (2018) found periods of efficiency that were followed by periods of inefficiency in the Bitcoin market.

Cheah and Fry (2016) show that over the period from July 2010 to November 2013, Bitcoin exhibited speculative bubbles and that speculative bubbles are a major component of Bitcoin prices. Hence, Cheah and Fry suggest that the fundamental value of Bitcoin is zero.

Bouri et al. (2017) demonstrate that Bitcoin is a hedge against economic uncertainty, as measured by the volatility indexes of 14 developing and developing world stock markets. Corbett et al. (2018) find evidence of price and volatility linkages between the crypto currencies Bitcoin, Ripple, and litecoin. However, the price and volatility of the three crypto currencies are unrelated to bond, gold, foreign exchange, and stocks markets. Demir et al. (2018) show that Bitcoin returns are positively related to economic policy uncertainty.

Lastly, Griffin and Shams (2018) and Gandal et al. (2017) investigate trading activity in Bitcoin. Gandal et al. investigated trading on the Mt. Gox Bitcoin Exchange between February and November 2013 and found two distinct periods in which approximately 600,000 Bitcoins (BTCs) valued at $188 million were acquired by agents who did not pay for the Bitcoins. During the second period, the USD-BTC exchange rate rose by an average of $20 at Mt. Gox on days when suspicious trades took place, compared to a slight decline on days without suspicious activity. Gandal et al. conclude that the suspicious trading activity caused Bitcoin to jump from around $150 to more than $1000 in two months.

Griffin and Shams used algorithms to analyze crypto currency data and found that purchases with Tether, a crypto currency backed by dollar reserves, are timed following market downturns and result in sizable increases in Bitcoin prices. Less than 1% of hours with heavy Tether transactions are associated with 50% of the meteoric rise in Bitcoin and 64% of the rise of other top crypto currencies. They argue that Tether is used to provide price support and manipulate crypto currency prices.

Bitcoin Returns and Risks Relative to Established Financial Assets

We compare Bitcoin returns and risks, as expressed by the volatility of returns, with the returns and risk of stocks, bonds, and gold. First, we examine Bitcoin.

Bitcoin’s daily close prices were obtained from CryptoCompare, www.​cryptocompare.​com, for the period from July 19, 2010, through June 29, 2018. Figure 4.1 displays a plot of Bitcoin daily close prices over time. Figure 4.2 displays a plot of Bitcoin logarithmic daily returns. Note the large spike in the volatility of the daily returns in early 2014, which reflects Mt. Gox Exchange’s problems at that time. Note that Mt. Gox handled nearly 70% of all trades in early 2014.
../images/465002_1_En_4_Chapter/465002_1_En_4_Fig1_HTML.png
Fig. 4.1

Bitcoin daily closing price, July 19, 2010, through June 29, 2018

../images/465002_1_En_4_Chapter/465002_1_En_4_Fig2_HTML.png
Fig. 4.2

Bitcoin daily logarithmic returns, July 19, 2010, through June 29, 2018

The Mt. Gox Exchange was hacked in June 2011 and 25,000 Bitcoins were stolen.7 Bitcoin’s price dropped from $17.50 to $0.01 in one hour after the stolen coins were then dumped on the market. On February 24, 2014, the Mt. Gox site was shut down after 850,000 Bitcoins went “missing.”8

To compare Bitcoin returns with the returns of stocks, bonds, and gold, the following daily data over the period from July 19, 2010, to June 29, 2018, were obtained from the Federal Reserve Bank of St. Louis FRED database:

  • The Bank of America Merrill Lynch US Corporate Master Total Return Value Index;

  • The Gold Fixing Price in Dollars in the London Bullion Market; and

  • The Wilshire 5000 Total Return Index.

Table 4.2 displays summary statistics for logarithmic daily returns of Bitcoin and the three financial market indexes. Table 4.2 displays the logarithmic daily returns over the full sample period as well as subsample periods from July 19, 2010, to January 31, 2014, and February 1, 2014, through June 29, 2018. For both the overall sample and the subsample periods, the mean and median return statistics indicate that Bitcoin outperformed stocks, gold, and bonds. The standard deviation in logarithmic daily returns was substantially higher than the standard deviation in logarithmic daily returns for stocks, gold, and bonds. Although higher average daily returns could be earned holding Bitcoin, relative to the other asset classes, the risk was substantially higher.
Table 4.2

Summary statistics on daily logarithmic returns

July 19, 2010–June 29, 2018

Asset class

Mean

Median

Standard deviation

Skewness

Kurtosis

Bitcoin

0.0054952

0.0021542

0.0770317

2.783746

80.15076

Gold

−0.0000672

0.0001341

0.0098664

−0.7379136

10.47102

Equities

0.0005398

0.0007128

0.0092757

−0.5682937

8.285075

Bonds

0.0001636

0.0003162

0.0026274

−0.405708

4.525791

July 19, 2010–January 31, 2014

Asset class

Mean

Median

Standard deviation

Skewness

Kurtosis

Bitcoin

0.0102524

0.0036697

0.0828311

0.1327075

10.44171

Gold

−0.0000531

0.0006971

0.0118165

−1.040465

10.33724

Equities

0.0006647

0.0008644

0.0106603

−0.5213826

8.269166

Bonds

0.0002164

0.0003948

0.0029071

−0.4718331

4.539512

February 1, 2014–June 29, 2018

Asset class

Mean

Median

Standard deviation

Skewness

Kurtosis

Bitcoin

0.0016651

0.0018637

0.0051599

5.984047

177.8209

Gold

−0.0000786

−0.0001889

0.0079671

0.1921139

4.302291

Equities

0.0004399

0.0006334

0.0080014

−0.6376245

6.1505

Bonds

0.0001211

0.0002349

0.0023789

−0.3206363

4.051528

Table 4.3 displays correlations between the daily logarithmic returns of Bitcoin, stocks, gold, and bonds over the full sample period. As is apparent from the low correlations between Bitcoin and the three asset classes, not only is Bitcoin more volatile than the other asset classes, but its daily returns are not closely related to the returns of the other asset classes. Table 4.3 is consistent with the literature reviewed in section “Bitcoin Returns and Risks Relative to Established Financial Assets ” of this chapter as the low correlations of Bitcoin returns with other assets confirms that the addition of Bitcoin to a portfolio that contains conventional financial assets can provide the benefits of further diversification.
Table 4.3

Correlations between daily logarithmic returns: Bitcoin, equity, bonds, and gold, July 19, 2010–June 29, 2018

 

Bitcoin

Equity

Bonds

Gold

Bitcoin

1.0000

   

Equity

0.0389

1.0000

  

Bonds

−0.0062

−0.3181

1.0000

 

Gold

0.0504

0.0155

0.0459

1.0000

Comparative Financial Performance of Alternative Crypto Currencies

To compare the financial performance of alternative crypto currencies, a sample of crypto currencies was drawn from crypto currencies with market capitalizations of $1 billion or more, as shown in Table 4.1. The final sample also included crypto currencies for which there was daily price data from August 7, 2015, through June 29, 2018. The final sample consisted of daily closing prices obtained from CryptoCompare, www.​cryptocompare.​com, for the following crypto currencies with ticker symbol in parentheses: Bitcoin (BTC), Ethereum (ETH), Ripple (XRP), and Litecoin (LTC).

Figures 4.3, 4.4, and 4.5 display line plots of BTC, ETH, XRP, and LTC prices over the sample period. Visual inspection of Figs. 4.3, 4.4, and 4.5, particularly as prices of the four crypto currencies began a rapid rise in 2017, suggests that the prices of the four crypto currencies moved together over time.
../images/465002_1_En_4_Chapter/465002_1_En_4_Fig3_HTML.png
Fig. 4.3

Bitcoin price, August 7, 2015–June 29, 2018

../images/465002_1_En_4_Chapter/465002_1_En_4_Fig4_HTML.png
Fig. 4.4

Ethereum and Litecoin prices, August 7, 2015–June 29, 2018

../images/465002_1_En_4_Chapter/465002_1_En_4_Fig5_HTML.png
Fig. 4.5

Ripple price, August 7, 2015–June 29, 2018

The line plots in Fig. 4.6 are used to display relative performance data for each of the four crypto currencies The line plots in Fig. 4.6 consist of the transformation of the daily data for each data series where each data series’ value is divided by that series’ value on August 7, 2015. This allows us to examine how equal dollar investments in each crypto currency performed over the entire sample period. As shown in Fig. 4.6, even with price declines from their peak in early January 2018, crypto currencies have had rapid price appreciation over the entire sample period. From August 7, 2015, to June 29, 2018, $1.00 invested in ETH was worth $145.08 on June 29, 2018, and $1.00 invested in XRP was worth $56.63. A $1.00 invested in BTC was worth $22.32 on June 29, 2018, and $1.00 invested in LTC was worth $19.28 on June 29, 2018.
../images/465002_1_En_4_Chapter/465002_1_En_4_Fig6_HTML.png
Fig. 4.6

Value of equal $1.00 investments in Bitcoin (BTC), Ethereum (ETH), Ripple (XRP), Litecoin (LTC), and cci30 Index, August 7, 2015–June 29, 2018

Table 4.4 displays summary statistics for the logarithmic daily returns for each of the crypto currencies. The mean and median returns confirm what is shown in line plots of Fig. 4.6 as a ranking of average returns based on both mean and median returns indicated that ETH and XRP had the highest average daily logarithmic returns and BTC and LTC the lowest. The standard deviations of daily logarithmic returns also suggested that XRP, followed by ETH, was the most volatile of the four crypto currencies over the August 7, 2015, to June 29, 2018, sample period. Higher average returns were associated with higher volatility in returns for the individual crypto currencies.
Table 4.4

Summary statistics on daily logarithmic returns: Bitcoin (BTC), Ethereum (ETH), Ripple (XRP), and Litecoin (LTC), August 7, 2015–June 29, 2018

Asset class

Mean

Median

Standard deviation

Skewness

Kurtosis

BTC

0.0029382

0.0029609

0.0408234

−0.207124

7.093563

ETH

0.0047089

0

0.0806132

−1.195264

21.22295

XRP

0.0038189

−0.0017861

0.0942104

1.860641

23.94807

LTC

0.0027994

0

0.0590146

1.775621

17.84802

Table 4.5 ranks crypto currency performance by dividing the mean daily logarithmic return by the standard deviation of logarithmic daily returns. This allows for an examination of the average daily return per unit of risk (volatility). Table 4.5 suggests that based on the ratio of return to risk, BTC outperformed other crypto currencies over the sample period. After BTC, ETH was the highest ranked followed by LTC and XRP.
Table 4.5

Ratio of average daily return to risk based on daily logarithmic returns: Bitcoin (BTC), Ethereum (ETH), Ripple (XRP), and Litecoin (LTC), August 7, 2015–June 29, 2018

Asset class

Mean (1)

Standard deviation (2)

Ratio of return to risk (1)/(2)

Ranking

BTC

0.0029382

0.0408234

0.0720

1

ETH

0.0047089

0.0806132

0.0584

2

XRP

0.0038189

0.0942104

0.0405

4

LTC

0.0027994

0.0590146

0.0474

3

Pairwise correlations between the logarithmic daily returns of the four crypto currencies were examined. Table 4.6 displays Pearson pairwise correlation coefficients between the four series. The daily logarithmic returns of all four crypto currencies are positively related to each other. The daily logarithmic returns of BTC and LTC have the strongest pairwise correlation among the four crypto currency returns. The weakest pairwise correlations are between XRP daily logarithmic returns and the logarithmic returns of the other three crypto currencies.
Table 4.6

Correlations between daily logarithmic returns: Bitcoin (BTC), Ethereum (ETH), Ripple (XRP), and Litecoin (LTC), August 7, 2015–June 29, 2018

 

BTC

ETH

LTC

XRP

BTC

1.0000

   

ETH

0.3483

1.0000

  

LTC

0.5698

0.3177

1.0000

 

XRP

0.1912

0.1322

0.2380

1.0000

Establishment of Exchange-Traded Funds, Options, and Future Contracts on Crypto Currency

Bitcoin and other crypto currencies are still young and, as noted above, characterized by volatility in returns. However, investor interest in crypto currency is causing financial services firms to investigate the establishment of retail exchange-traded funds (ETFs) that contain crypto currency and exchange-traded options and future contracts with crypto currency as the underlying asset. These financial innovations revolving around crypto currencies have come under increased scrutiny of financial regulators, as well as brought new investor capital into crypto currency markets.

On March 3, 2017, the Securities and Exchange Commission (SEC) rejected an application by the Better Alternative Trading System (BATS) to offer the proposed Winklevoss Bitcoin Trust ETF, which would have allowed retail investors to buy Bitcoin in the manner that they purchase common stock (Weiczner 2017). The SEC expressed concerns about the potential for fraud and price manipulation. Despite the SEC’s rejection of the BATS application, the Coinbase Exchange is planning to offer an ETF for retail customers that will be an index fund based on multiple crypto currencies once there is regulatory approval (Weiczner 2018). Bitwise has filed a proposal for an ETF that would track a portfolio of ten crypto currencies (Rooney 2018). Neither the Bitwise nor the Coinbase proposals had been approved by the EC at the time this book was published.

The LedgerX trading and clearinghouse platform received approval from the Commodity Futures Trading Commission (CFTC) to trade and clear swaps and options digital currency. Currently, LedgerX lists options and swaps on Bitcoin.9 As of April 2018, LedgerX planned to expand by trading options and swaps on Ethereum.10 In December 2017, the Cantor Exchange received CFTC approval to offer Bitcoin options contracts.11 As of the time of publication of this volume, the Cantor Exchange had not begun trading of the Bitcoin options.

In December 2017, the Chicago Mercantile Exchange (CME) and the Chicago Board of Exchange (CBOE) received CFTC approval to trade Bitcoin futures contracts.12 Both the CME and the CBOE are in the early stages of offering Bitcoin futures contracts.

Currently, regulated derivative contracts on crypto currency are in their infancy. As they become more established, they provide the promise of providing greater liquidity to trading of crypto currency.

Conclusions and Future Directions in Research

Bitcoin and other crypto currencies have had a short history to date. Although Bitcoin has outperformed conventional financial assets, the high returns have been accompanied by volatility.

As Bitcoin and other crypto currencies mature, along with associated derivative contracts, there is a need for empirical research. Future research needs include:

  • Examination of whether the appearance of derivatives contracts on options are affecting the pricing and efficiency of trading in Bitcoin.

  • The examination of the interrelationship of crypto currency pricing with traditional financial markets.

  • Quantification of the degree to which prices of individual coins are affected by the pricing of other coins.