A new study from the universities of Dublin and Chelmsford (UK) examined the return and volatility transmission across three cryptocurrencies,- Bitcoin, Ripple, Litecoin, and gold, bond, equities and the global volatility index (VIX). According to the study from Shaen Corbet, Andrew Meegan, Charles Larkin, Brian Lucey and Larisa Yarovaya this is the first study that addresses the issue of connectedness of these cryptocurrencies with other financial assets using return and volatility spillover analysis.
Researchers say that cryptocurrencies have become an increasingly important topic widely covered by the media, and discussed by government bodies, businesses and academic communities. Besides the numerous policy papers and reports, there were significant attempts by financial scholars to analyse cryptocurrencies as investment assets. Recently, the focus of the research has expanded from the technical aspects and stylised facts of cryptocurrency markets to a variety of issues, such as hedging and safe haven properties of cryptocurrencies, return-volume relationships, speculation and market efficiency. The majority of these papers, however, focused solely on Bitcoin, omitting other cryptocurrencies. Furthermore, there is a lack of research on interconnectedness of the cryptocurrencies with other markets.
The dramatic growth of the virtual currencies challenge politicians and policy makers around the globe. Virtual currencies not only resemble the role of money, but also create an alternative environment for businesses. Cryptocurrency markets have recently experienced increased speculative demand exceeding their role of digital money, placing them into the category of investment assets.
New study, “Exploring the Dynamic Relationships between Cryptocurrencies and Other Financial Assets”, published on November 13, 2017, noted that for the period from October 2016 to October 2017 the market capitalisation of the Bitcoin increased from 10.1 to 79.7 billion, while the price jumped from 616 to 4800 US dollars. The remarkably high growth has been also evident for other cryptocurrencies, like Ripple and Litecoin, during this period. It is not surprising therefore, that investors attracted by the high growth of cryptocurrencies seek to achieve these abnormal returns.
However, due to the limited understanding of the nature of cryptocurrencies as investment assets, desirable returns may be not forthcoming. Investments involve a substantial level of risk due to the high volatility of cryptocurrencies. While investors can choose to invest in various markets it is vital to understand the behaviour of return and volatility of the cryptocurrencies in relation to other important financial assets to explore the benefits of diversification.
Additionally, tremendous growth of the cryptocurrencies is driven by anonymity of the internet, making the prices prone to speculative bubbles. The burst of the bubble may create a significant volatility shock that will spillover to other financial markets. The contagion effect will erase the benefits of portfolio diversification, and may violate the stability of the whole financial system. Therefore, it is crucial to identify the patterns of information transmission across cryptocurrencies markets and other asset classes, noted researchers.
Scientists say that the role of cryptocurrencies as an investment asset is under-researched. There is a lack of financial theories that can fully explain current behaviour of the cryptocurrencies as well as the future of this financial instrument.
The impact of rapid growth of virtual currencies is still unknown and highly uncertain. Therefore, policy makers and regulatory bodies are particularly concerned about the recent tremendous growth of cryptocurrencies. In 2012, the European Central Bank concluded that cryptocurrencies do not jeopardise financial stability, due to their limited connection to the real economy, the low volumes traded and the lack of wide user acceptance.
However, the growth of cryptocurrency markets and their integration to the global economy must be monitored, since cryptocurrencies remain the potential source of financial instability. The risk assessment of the virtual currencies that has been conducted by European Banking Authority indicates the absence of any specific regulatory protections in the EU that would protect users from financial losses in situation of the virtual trading platform or business crashes.
Financial Action Task Force highlights that since the Bitcoin protocol does not require identification and verification of participants, the anonymity of cryptocurrencies increases the risk of money laundering and terrorist financing using this payment instrument.
To be considered as a separate asset class, cryptocurrency markets should demonstrate a high level of integration, to respond to common shocks in a similar manner, and consequently, the return and volatility transmission across these markets should demonstrate similar patterns.
In the first research of its kind, team of scientist hypothesised that cryptocurrency markets, i.e. Bitcoin, Ripple and Litecoin, are strongly interconnected, and demonstrate similar patterns of return and volatility transmission with other assets.
The research concluded that cryptocurrency markets are relatively isolated from market-driven external shocks. Cryptocurrencies can be effective portfolio diversifier, and can offer safe haven properties for investor.
The study also concluded that the major cryptocurrencies – Bitcoin, Ripple and Litecoin are interconnected.
“We found the Bitcoin price can affect the levels of Ripple and Lite. According to the identified dynamics of pairwise spillover, the influential power of Bitcoin is particularly evident for periods of rapid price increases in Bitcoin. Our results revealed the presence of positive contagion effect across cryptocurrency markets. This phenomenon can be explained by the global increase in demand on Bitcoin and other cryptocurrencies. The fact that cryptocurrency markets are decoupled from other popular financial assets, but interconnected with each other, can potentially indicate that the increase in cryptocurrency prices can be mainly due to the high speculative activity on these markets. However, we leave this issue for further research,” the scientists concluded.