Cryptocurrency: A New Investment Opportunity?
David LEE Kuo Chuen, Li Guo and Yu Wang
The Journal of Alternative Investments Winter 2018, 20 (3) 16-40; DOI: https://doi.org/10.3905/jai.2018.20.3.016
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Bitcoin was the first cryptocurrency to use blockchain and has been the market leader since the first bitcoin was mined in 2009. After the birth of Bitcoin with the genesis block, more than 1,000 altcoins and crypto-tokens have been created, with at least 919 trading actively on unregulated or registered exchanges. This entire class of cryptocurrencies and tokens has been classified by some tax authorities as having the same status as commodities. If cryptocurrency is viewed in the same class as commodities, how different is it in terms of its risk and return structure? This article sets out to help readers understand cryptocurrencies and to explore their risk and return characteristics using a portfolio of cryptocurrency represented by the Cryptocurrency Index (CRIX). Substantial discussions are centered on Bitcoin and its close variants. Some questions are raised about the potential of cryptocurrencies as an investment class. Results show that the return correlations between cryptocurrencies and traditional assets are low and that adding CRIX returns to a traditional asset portfolio improves risk–return performance. Sentiment analysis also indicates the CRIX has a relatively high Sharpe ratio. Although we should view the results with care, a new form of financing for cryptocurrency and blockchain start-ups is born. The disruption brought about by Bitcoin may be felt beyond payments through what is known as initial crypto-token offerings or initial token sales.
The invention of Bitcoin1 by Satoshi Nakamoto (Nakamoto ) in 2008 spurred the creation of many new cryptocurrencies known as altcoins. These altcoins use similar cryptographhy technology but employ different algorithmic designs. Many of these altcoins were invented for different purposes or to address the pain points of the Bitcoin network, such as the high usage of energy caused by its proof of work (PoW) consensus algorithm or the supply limit of 21 million coins, among others. As the network effect weighs in, the prices of bitcoin and its variants have risen in tandem. These innovations and the perceived investment potential have led to rapid growth in the number of altcoins and the market size of cryptocurrency. According to CoinMarketCap,2 nearly 869 cryptocurrencies are currently trading around the world with a combined market capitalization of US$148.3 billion by circulating supply and US$321.5 billion by total supply as of October 6, 2017. The price of bitcoin surged to US$4,780.15 on September 2, 2017. Many have argued that, despite their payment utility, bitcoin and cryptocurrencies have no intrinsic value and may be the perfect vehicle for forming a bubble.
Even for those who believe that there is intrinsic value to cryptocurrencies, when their prices are rising, there will be doubts about prices running ahead of values. Technologists will argue that their value is higher than Linux and lower than the Internet—yet both are facilitators rather than an asset class. Finance traditionalists will argue that cryptocurrency is just another form of value transfer that raises funds globally using cryptography and creates little value beyond that. For perspective, with US$40 billion and US$100 billion market capitalization for bitcoin and total cryptocurrency, respectively, this investable asset class is minute in size compared to the US$66.8 trillion and US$48.2 trillion for listed equity and gold, respectively.
Cryptocurrency is a subset of the class of digital currency (Lee ), but it has become an important type of digital currency. Unlike other digital currencies that can be centrally issued, circulated within a community or geographical location, or tied to fiat currency or the organizations issuing them, cryptocurrency has very different characteristics. The blockchain technology used by cryptocurrency, such as Bitcoin, is an open distributed ledger that records transactions. This solves the double-spending problem and does not require a trusted third party. Decentralization allows the blockchain technology to have increased capacity, better security, and faster settlement. Some of these features are at the top of the list of shortcomings of traditional financial systems. As a result, blockchains and cryptocurrencies have become two of the most pressing topics in the financial industry. In this article, we focus on the diversification role of cryptocurrencies and explore the possibility that they may generate new investment opportunities based on historical data.
We first evaluate the comovement between traditional asset classes and the cryptocurrency index (CRIX) by studying their correlation coefficients (Chen et al. ). Results suggest a very low correlation between CRIX and traditional assets based on historical data. This observation suggests that cryptocurrency as an asset class is a good diversifier in a traditional portfolio. We then employ a multivariate dynamic conditional correlation (DCC) model to examine dynamic comovements for robustness (Engle ). Consistent with our expectations, cryptocurrencies are considered a potentially better portfolio diversifier under the DCC setting. The largest DCC was between CRIX and gold, with a value of 0.24. Next, we investigate whether the inclusion of cryptocurrencies in a traditional portfolio will lead to additional benefits in terms of risk-adjusted returns. Our empirical results show that CRIX not only expands the efficient frontier of an initial portfolio consisting only of traditional assets, it also provides additional utility to investors, as evidenced by the mean–variance spanning test. However, it seems that cryptocurrencies may not lead to a large improvement in the utility of a mean–variance investor. There are various explanations for this finding. First, the current sample period of CRIX is too short to fully explore the investment opportunity of cryptocurrencies. Second, over the sample period, the cryptocurrency market is too volatile, with a daily maximum drawdown of 22%. Hence, it is important for investors to understand the return–risk structure of cryptocurrencies before making an investment commitment. In this article, we conjecture that the high volatility of cryptocurrency is driven mainly by investor sentiment, not by a change in fundamentals. We do not argue that there are no fundamentals, but rather that there has not been any meaningful interpretation using traditional fundamental analysis. Either the old economy framework is not suitable for a new and complex technology such as cryptocurrency, or immeasurable fundamentals are proxied by sentiments.
We then propose an investor sentiment measure based on the past average returns for the cryptocurrency market. Our measure of investor sentiment reveals a strong return reversal on the next trading day, suggesting rational investors explore the benefit of sentiment-induced mispricing. To further explore the sentiment effect, we use the Fama–MacBeth regression (Fama and MacBeth ) to examine the cross-sectional premium of investor sentiment by using the top 100 cryptocurrencies that are components of CRIX. After controlling trading volume and lagged return, the Fama–MacBeth results suggest that any cryptocurrency with 1% investor sentiment in excess of the average cryptocurrency sentiment tends to have a 0.38% lower future return compared to the entire cryptocurrency portfolio. As a result, we identify potential profits from using daily trading strategies based on investor sentiment. The strategy that buys low-sentiment and sells high-sentiment cryptocurrencies generates an annualized return of 8.54 with a Sharpe ratio of 11.64. We also conduct two analyses to assess the robustness of our findings. Our sentiment strategy survives after assuming reasonable transaction costs from 1 to 10 bps per trade. The result is not sensitive to the selection of formation period of investor sentiment. The average annualized return remains more than 11% with a t-value >15. Overall, our results provide some evidence of cryptocurrencies being a potential candidate as a new investment vehicle.
The rest of the article is organized as follows. We first introduce the background of the cryptocurrency market. The next section presents empirical results on the diversification role of cryptocurrencies, and the following section explains the sentiment impact on the cryptocurrency market with robustness checks. The last section concludes.
From Centralization to Decentralization
The major drawback of the traditional fiat currency payment system is high transaction fees with a long settlement period, which has led people to alternative currencies that allow for shorter peer-to-peer (P2P) processing time without intermediaries, resulting in a thriving market for digital currencies that have lower settlement risk. Prior to the creation of cryptocurrencies, there were many other types of digital currencies. The most common example is a digital currency created by an institution and transacted on a platform. Such currencies can be loyalty points created by companies or digital coins created by Internet-based platforms. The institutions or legal entities control the creation, transaction, bookkeeping, and verification of the digital currencies. In other words, these platform-based digital currencies are centralized. A notable example is the loyalty points of e-commerce companies like Rakuten and iHerb, which function like cash on the platform. Q-coin, introduced by the Chinese social platform Tencent, can be bought using the Renminbi and can be used to buy services at Tencent. World of Warcraft Gold is a game token that can only be earned through completing in-game activities and cannot be bought or exchanged into fiat currencies (Halaburda ).
These centralized digital currencies are transacted within a specific platform and are designed to support the business of the issuing institutions. It is difficult to use them as a substitute for fiat money because these centralized digital currencies are not legal tender. Therefore, decentralized digital currencies seem a potential replacement for fiat money as no central authority is needed to verify the transactions. However, there are still many obstacles to overcome without the use of an intermediary or central authority. One main obstacle is the double-spending problem: It is possible to spend the same digital coin more than once. This problem has remained unsolved for a long time, discouraging the prevalence of decentralized coins. To ensure every transaction is accurately reflected in the account balance for digital currencies to prevent double spending, there is a need for a trusted ledger without a central authority.
The first cryptocurrency, eCash, was a centralized system owned by DigiCash, Inc. and later eCash Technologies. Although it was phased out in the late 1990s, the cryptographic protocols it employed avoided double spending. A blind signature was used to protect the privacy of users and served as a good inspiration for subsequent development. Shortly after the discovery of cryptography protocols, digital gold currency became popular, among which the most used was e-Gold. It was the first successful online micropayment system and led to many innovations, making transactions more accessible and more secure. However, the failure to address compliance issues finally resulted in its liquidation in 2008, despite an annual transaction volume of over US$2 billion (Lam and Lee ).
The global financial crisis in 2008, coupled with a lack of confidence in the financial system, provoked considerable interest in cryptocurrency. A ground-breaking white paper by Satoshi Nakamoto was circulated online in 2008. In the paper, this pseudonymous person, or persons, introduced a digital currency that is now widely known as bitcoin. Bitcoin uses blockchain as the public ledger for all transactions and a scheme called PoW to avoid the need for a trusted authority or central server to timestamp transactions (Nakamoto ). Because blockchain is an open and distributed ledger that records all transactions in a verifiable and permanent way, it solves the double-spending problem.
Bitcoin and “bitcoin”
The cryptocurrency, denoted by bitcoin or BTC, can be accepted as a payment for goods and services or bought either from other people or directly from exchanges/vending machines. These bitcoins can be transacted via software, apps, or various online platforms that provide wallets. Another way to obtain bitcoin is through mining.
The Bitcoin system runs on a P2P network, and transactions happen directly between users with no intermediary. Bitcoin decentralizes the responsibilities of verifying the validity of transactions to the entire network. Transactions are recorded in the public ledger called blockchain and are verified by network nodes, which could be any individual using a computer system with Bitcoin software installed. Once users have made a transfer, the transaction will be broadcast between users and confirmed by the network. Upon verification, it will be recorded in the blockchain, and then the transfer is completed. This record-keeping process is referred to as mining, and people offering the computing power to do so are called miners. Bitcoins are created as an incentive for solving the cryptography puzzle using transaction data; thus, successful miners are rewarded with the newly created bitcoins, on top of transaction fees.
Each transaction contains inputs and outputs. An input has the reference to the output from the previous transaction, and the output of a transaction holds the receiving address and the corresponding amount (Nirupama and Lee ). In general, in a transaction, a certain number of bitcoins is sent from a bitcoin wallet to a specific address, if there is a sufficient bitcoin balance in the wallet from previous transactions. Transactions are not encrypted and can be viewed in the blockchain with corresponding bitcoin addresses, but the identity of the sender or receiver remains anonymous. Typically, bitcoin wallets have a private key or seed that is used to sign transactions. This secured piece of data provides a mathematical proof that the coins in the transaction come from the owner of the wallet. With the private key and the signature, the account can only be accessed by the owner, and transactions cannot be altered by someone else.
Mining is also the process of adding newly verified transaction records to Bitcoin’s public ledger. The records are grouped and stored in blocks. Each block contains a timestamp and a link to a previous block so that the blocks are chained together, thus the name blockchain. The blocks are mined in sequence, and once recorded, the data cannot be altered retroactively. A complete record of transactions can be found on the main chain. Each block on the chain is linked to the previous one and can be traced all the way back to the very first block, which is called the genesis block. However, there are also blocks that are not part of the main chain, called detached or orphaned blocks. They can occur when more than one miner produces blocks at similar times, or they can be caused by attackers’ attempt to reverse transactions. When separate blocks are validated concurrently, the algorithm will help maintain the main chain by selecting the block with the highest value.
There are several systems by which miners can earn rewards through the mining process. Bitcoin uses the Hashcash PoW system and the SHA-256 hashing algorithm. Under the PoW system, rewards are given according to the number of blocks that are mined successfully. Therefore, mining is quite competitive; the miner who first solves a given puzzle or gets the highest value will take all the newly created bitcoins, and the other miners will receive nothing. Rewards thus encourage miners to take an active part in mining data blocks. In addition, mining usually involves a large amount of computation and can be quite energy consuming.
Another commonly seen system is proof-of-stake (PoS). Unlike PoW, no additional work is required under the PoS scheme because investors are rewarded based on the number of coins they hold. For example, a user holding 1% of the currency has a probability of mining 1% of that currency’s PoS blocks (Nirupama and Lee ). In general, this system does not require a large amount of work for the computation. It provides for higher currency security and is usually used in combination with other systems, as in the case of Peercoin, the first cryptocurrency launched using PoS.
Because the supply of bitcoins is limited to 21 million, the bitcoins awarded to a miner for successfully adding a block will be halved every 210,000 blocks (approximately every four years), according to the Bitcoin protocol. When Bitcoin was first run in 2009, the reward amounted to 50 newly created bitcoins per block added to the blockchain, but the reward has been halved twice to 12.5 as of July 9, 2016. The supply of bitcoins on the network is 16.606 million as of October 6, 2017, with a total circulating supply market capitalization of US$ 73.1 billion.3
Features of Bitcoin
Decentralized. Similar to conventional currencies that are traded digitally, bitcoin can also be used to buy things electronically. Unlike any fiat money or platform-based digital currencies, however, bitcoin is decentralized. In other words, there is no single group or institution that controls the Bitcoin network. Its supply is governed by an algorithm, and anyone can have access to it via the Internet.
Flexible. Bitcoin wallets or addresses can be easily set up online without any fees or regulations. Furthermore, transactions are not location specific, so bitcoins can be transferred among different countries seamlessly.
Transparent. Every transaction will be broadcast to the entire network. Mining nodes or miners will validate the transactions, record them in the block they are creating, and broadcast the completed block to other nodes. Records of all transactions are stored in the blockchain, which is open and distributed, so every miner has a copy and can verify them.
Fast. Transactions are broadcast within a few seconds, and it takes about 10 minutes for the transaction to be verified by miners. Thus, one can transfer bitcoins anywhere in the world, and the transactions will usually be completed minutes later.
Low transaction fees. No transaction fee is required to make a transfer historically, but the owner can opt to pay extra to facilitate a faster transaction. Currently, low priority for mining transactions (a function of input age and size) is mostly used as an indicator for spam transactions, and almost all miners expect every transaction to include a fee. Miners historically have been incentivized mainly by newly created coins, but that is changing. As the number of bitcoins in circulation nears its limit, transaction fees will eventually be the incentive for miners to carry out the costly verification process.
Bitcoin is open source and the source code is available on GitHub.4 Therefore, coders around the world have been enlightened by the invention of Bitcoin and have created hundreds of cryptocurrencies, which are referred to as alternative cryptocurrencies, or altcoins. Bitcoin is not perfect. Every new purpose or pain point is an incentive to invent new coins. Coins are invented to address specific issues such as high computation cost of PoW, to increase the number of transactions per second, to increase the block size, to ensure that the ledger is not as transparent, to accommodate more efficient use of smart contracts, and so on. Moreover, to pay for development and launch expenses, developers can raise funds for the project even before the cryptocurrency is launched. In particular, initial coin offerings (ICOs), initial crypto-token offerings, and initial token sales are similar approaches to raising funding to develop new crypto-tokens and cryptocurrencies. ICOs allow people to invest in a project by buying part of its cryptocurrency tokens or prelaunched ERC20-compliant tokens residing on the Ethereum network in advance, typically based on a white paper or other documents on the project for investors to evaluate.
As of October 6, 2017, 869 cryptocurrencies and 269 crypto-tokens were launched and traded,5 with a total market capitalization of over US$148.4 billion. Different from fiat money, cryptocurrencies have a circulating supply, total supply, and maximum supply. Maximum supply refers to the best approximation of the maximum amount of coins that will ever be created in the lifetime of the cryptocurrency, and total supply is the total number of coins existing at the present moment. However, some coins will have been burned, locked, or reserved or cannot be traded on the public market, so the circulating supply is computed by deducting those coins from the total supply. When determining the market capitalization, circulating supply is used because it denotes the amount of coins circulating in the market and accessible to the public.
Based on cryptocurrency market value as of June 27, 2017, Bitcoin dominated the market with more than half of the total market value and the highest price. Ethereum, Ripple, and Litecoin also have large market capitalizations of more than US$1 billion. In addition, the supply of different coins varies substantially due to the unique characteristics of each coin, and some coins are not mined, suggesting a fixed amount of supply. The price of the coins ranges from US$0.002 to well over US$1,000.
In general, some altcoins are very similar to bitcoins, whereas others are created by adopting very different methods or ideas. Market capitalization, different categories of altcoins, and their features are summarized in Appendix A (Ong et al. ).
Appcoins, such as MaidSafeCoin, function like digital shares in a decentralized autonomous organization and are sold in token sales for a portion of future profits. Most altcoins are direct copies of Bitcoin, with some minor changes in parameters such as block-generating time and the maximum limit of coin supply. However, many altcoins have adopted other innovative changes. Among the widely accepted altcoins, Ethereum is the one with the most innovative ideas and widely followed besides Bitcoin. The value token of the Ethereum blockchain is called ether and denoted by XRP. It provides a decentralized Turing-complete virtual machine that features smart contract functionality, as do four other altcoins that have launched based on Ethereum: Ethereum Classic, Golem, Augur, and Gnosis. NEM falls under the third category in Appendix A (i.e., coins coded in a different programing language): It is operated using JAVA programming, as is Nxt. Stellar Lumens and Factom are excluded because they are based on Ripple and Bitcoin protocols, respectively.
To conclude, many cryptocurrencies other than bitcoin are traded actively with a wide assortment of features for investors to invest in.
Cryptocurrencies in the Study
In this study, we choose the top 10 cryptocurrencies based on the frequency with which they are included in the CRIX. Developed by Trimborn and Härdle  as a collaboration of the Ladislaus von Bortkiewicz Chair of Statistics at Humboldt University, Berlin, Germany; the Sim Kee Boon Institute for Financial Economics at Singapore Management University; and CoinGecko, the CRIX is computed in real time and balanced monthly using certain formulas that incorporate inputs such as market value and trading volume of the cryptocurrencies.6 More details on the 10 cryptocurrencies used in this study can be found in Appendix B.
Cryptocurrencies and Alternatives
Alternative investments are widely seen in portfolio management presently and include commodities, real estate, private equity (PE), hedge funds, and others, such as artworks. Typically, alternative investments have a lower historical correlation to conventional asset classes, such as stocks, bonds, and cash equivalents, and thus provide good diversification to the portfolio.
Despite the debate on whether cryptocurrencies can become part of the mainstream financial system, the global daily exchange-traded volume of bitcoin averaged over US$1 billion in 2016, which indicates ample liquidity (Burniske and White ). Moreover, research on bitcoin shows that the price of bitcoin does not fluctuate in the same direction as the stock market, indicated primarily by low return correlations. Although some may argue that the number of bitcoins to be generated is capped at 21 million, potentially limiting future supply, we should keep in mind that there are many promising altcoins in place, and their number is still growing. Thus, cryptocurrencies can be a good alternative investment, especially in terms of bringing diversification to mainstream assets (Trimborn, Li, and Härdle ).
The valuation of cryptocurrencies, however, is very different from that of traditional instruments. Many cryptocurrencies like Bitcoin have a fixed supply, so the valuation of fiat money with an unlimited supply cannot be applied. Furthermore, unlike equities or bonds, digital currencies generate no cash flow, making the discounted cash flow valuation inapplicable. Instead, cryptocurrency tokens are given to investors as proof of future cash flow; payments; possible future exchange; and the right to participate, vote, build blocks, or purchase. On top of the future cryptocurrency benefits, the network effect of cryptocurrency may be a crucial factor in its valuation for the associated technology and perceived value of the cryptocurrency by the public.
Next, we analyze the potential of investing in cryptocurrencies.
DIVERSIFICATION EFFECTS OF CRYPTOCURRENCY
We collect data on the historical price and trading volume of cryptocurrency from CoinGecko and data for other traditional asset classes from Bloomberg. The whole sample period spans from August 11, 2014 to March 27, 2017.
Overall, cryptocurrencies outperform traditional asset class in terms of average daily return, and that of Litecoin is the highest among all (see Appendix C). The annualized return for the CRIX Index is 0.0012 × 252 = 30.24%, which is very high compared to the stock market (0.12%, suggested by Appendix C). Meanwhile, CRIX tends to have a high return volatility compared to the S&P 500, with a daily maximum drawdown of -22.64% and skewness of -1.04. This high volatility with negative skewness suggests high tail risk of the cryptocurrency market. However, a noteworthy fact is that many cryptocurrencies exhibit positive skewness (i.e., the returns increase fast but decrease slowly), indicating a good volatility to generate additional investment opportunities.
In the case of kurtosis, the return distribution of cryptocurrencies greatly deviates from the normal distribution, which makes sense because the market is still developing. As for the one-lag autocorrelation, denoted by Rho, the majority are quite low, suggesting a lack of predictability (Fama ). To some extent, the maximum autocorrelation, 0.1357, basically suggests that current return has around 10% temporary effects on the next period return, and it only has 1% (10%2) left for predicting the next two-period return (see Appendix C). Moreover, there is an upward trend in the price of CRIX.
Almost all correlations in Appendix D are less than 0.1. For example, the correlation between CRIX and the S&P 500 is 0.036. In fact, according to the first row, 7 out of the 11 classes have correlations with the stock market (S&P 500) that are less than 0.05. Even the highest correlation, 0.102, is still very small, and all cryptocurrencies are negatively correlated with some mainstream investment assets. The very low correlations reinforce the assertion that cryptocurrencies may be a promising investment class in terms of hedging the risk of mainstream assets.
The correlation test raises a question about whether the correlation from time to time varies much from the average correlation. To address this question, we adopt the DCC model to further look at the dynamic correlations (see Appendix D). Consistent with our expectation, cryptocurrencies still show good diversification potential over the whole sample period, with a maximum DCC of 0.24 (between CRIX and gold). The persistence of low comovement with mainstream assets further suggests good investment opportunities in cryptocurrency as an alternative asset class.
Next, we examine the performance after adding CRIX to a portfolio that consists of traditional assets, such as S&P 500, PE, real estate investment trusts (REITs), and gold. From the efficient frontier in Exhibit 1, we can see the return and standard deviation of CRIX and six common investments. CRIX has the highest return, and it is the only one that lies on the efficient frontier, while the return of oil is the lowest with a relatively high level of risk.
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Efficient Frontier and Transition Map
According to the transition map of our portfolio performance, S&P 500 and CRIX dominate the portfolio, whereas the other investments only contribute to the portfolio when the portfolio risk is low. Among all seven options, oil seems to have the lowest contribution. Moreover, if a risk-averse investor is willing to tolerate daily volatility above 3%, the transition map suggests investing more than 80% of initial wealth into CRIX.
Exhibit 2 plots the market-efficient frontiers of a mainstream portfolio with and without CRIX. The inclusion of CRIX shifts the efficient frontier upward. This means that, under the same level of risk, a portfolio with CRIX has a higher return than a portfolio consisting of only mainstream assets.