Welcome to the module on using blockchain as an asset. Well, we’ll look at the ins and outs of the cryptocurrency market. My first introduction to the blockchain technology, like many of you stem from my interests getting piqued by the dramatic price movements in the early days of Bitcoin. Despite the technical limitations which prevented it from being a mainstream payment system as intended, we notice it’s potential as a form of digital gold. The market has since then exploded with over 5,000 cryptocurrencies being traded 24/7 on exchanges across the world. Some of them are carbon copies of Bitcoin.
Some of them have additional utilities and functions, yet the interesting question for us to ask is, are they the same from asset pricing perspective? What drives their returns? Do they constitute an asset class that could hold up over time and occupy a nice niche in our investment portfolio? These are some of the questions we’re going to explore in this module. We’ll start at a 30,000 foot view of the cryptocurrency market as a whole, and review some of it’s key features and statistics. Many of these statistics have stayed remarkably constant over time. Then we’ll get into the details of how to actually access the asset, how to invest in cryptocurrencies.
You’ll see that buying and selling cryptocurrencies is a different and more complex process than say, buying and selling stocks and involves a rather unique set of risks. Then we’ll expand the risk concept and discuss some key risk factors that are commonly present in the crypto asset class. We’ll end the module by looking at stable coins which is a new and ongoing development that promises to address a lot of the shortcomings of standard cryptocurrencies. Depending on your background in finance, some of the concepts might seem a bit unfamiliar at first, but don’t worry, we’ll take it slow and include plenty of reference materials and help along the way.
The first thing to note about the market, is to ignore most growth in the size of the market. In early 2016, the total market capitalization is only roughly seven billion dollars. Then in a mere year and half at Bitcoins peak,
the total market cap has expanded to a staggering 830 billion. Things have cooled down dramatically since then, but even close to the end of 2019, the market cap was still above $200 billion. The overall size is still tiny compared to say, the trillions of dollars in the stock or bond markets, but the growth rate and the influx of speculators had been nothing short of spectacular. At the same time however, we should know that the market is incredibly concentrated. In fact, the big three, Bitcoin, Ethereum, and Ripple command over 80 percent of the entire crypto market cap and Bitcoin alone occupies over 50 percent.
This means that, most of the growth in size has been concentrated on the high-profile cryptocurrencies that are well known to the public. Many of the thousands of other cryptos have seen little growth and tended to fade out quickly. Finally, now that we know what blockchain is, we should know that the word cryptocurrency is a bit of misnomer because as we have seen, many of the thousands of other cryptos have seen little growth and tended to fade out quickly.
Finally, now that we know what blockchain is, we should know that the word cryptocurrency is a bit of misnomer because as we have seen, many of these coins and tokens like Ethereum were never intended to be used in place of their currencies anyway. So for the purpose of this course, let’s think of the cryptocurrency as a crypto asset, a publicly traded coin or token that either come with their own blockchain or piggyback as smart contracts on other blockchains, and investable asset that both investors and speculators can easily access. The other defining feature of the crypto market is its volatility. Crypto investing demands are high level of risk tolerance.
The graph on the left shows that, suppose you bought the S&P 500, the US Dollar Index, and the big three crypto; Bitcoin, Ether and XRP. What would the cumulative returns be in percentages toward the end of 2019? The dramatic booms and the equally dramatic crashes are obvious here. 2017 was a great year, 2018 was a terrible year, and 2019 is a relatively good year. Among the big three, Ether is by far the most volatile, and it certainly not for the faint of heart and the risk averse. In fact, the volatility themselves are quite volatile.
If you look at the graph on the right, which shows the time series of daily return volatility, you can spot regular episodes of enormous volatility where in a single day, the return can change 30 percent or more, and relatively quiet episodes with little action. This could be further confirmed by looking at the first four key moments or summary statistics of daily returns. The mean, the standard deviation, the skewness, and the kurtosis. Here again, both the average returns and volatilities of the crypto assets are dozens of times higher the stocks or the dollar. In addition, the third row of the table shows that the crypto returns are incredibly right-skewed.
That is, instead of the regular bell-shaped return distribution, the crypto assets tend to have enormous boom days, which suggests the heavy presence of short-term speculators. The fourth row, kurtosis measures how fat-tailed the return distributions are. Here again, the crypto assets have much higher return kurtosis, which means that, they tend to have a lot of black swan days. The days where you get lucky and have a 60 percent return in a day, happen more often in crypto than in stocks, but so do the bad black swan days when you lose 70 percent in a day.
Now, if you look at this table a bit more, you’ll find that the cryptocurrency returns are quite different than those of stocks and the dollar, but they’re not all that different among themselves. In fact, if you look at the correlation matrix of these five daily return series at the bottom, you’ll see that, within the cryptocurrency group, the correlations are incredibly high up to 40 percent at the daily level. By contrast, the cryptos have very low return correlation with Ether stocks or Fiat currencies with correlations close to zero. This seems to suggest that, the cryptocurrencies could be a distinct asset class on their own.
Within the asset class, the market doesn’t seem to distinguish them as much, but rather view them as similar assets despite the major design differences between the leading cryptocurrencies.