Increasingly, institutional investors are entering the crypto space, with managers like Skybridge,6 Blackrock,7 and Tudor8 announcing the addition of crypto to their investment universes or even the launch of crypto-dedicated funds. In this Street View, we will seek to answer this question. We explore how traditional financial risk factor models can potentially explain the risk of the largest crypto asset, Bitcoin.
We then seek to understand the extent to which there are influential, common risk drivers across crypto assets using a statistical technique called Principal Components Analysis. Using Financial Risk Factors to Explain Risk in Crypto Many established risk models, like our own Two Sigma Factor Lens , are constructed to explain the majority of risks and returns in traditional financial portfolios, which often include heavy allocations to well-established asset classes like stocks, bonds, commodities, and fiat currencies, as well as to well-known investment strategies such as trend following in macro asset classes and value investing in stocks.
For a brief overview of some of the ways that investors can transact in crypto and obtain other types of crypto exposures, please see Appendix 1 in the pdf version of this article. The exhibit below shows how the Two Sigma Factor Lens, which does not include a crypto factor, attempts to explain Bitcoin. This is a relatively high amount of residual risk.
There were other statistically insignificant factor exposures that are worth diving into as well, namely positive Commodities, positive Local Inflation, and negative Foreign Currency. Upon further analysis, we found that Bitcoin appeared to be most highly correlated with trend following in equity markets over this period.
Bitcoin exhibited slightly positive correlations with gold and oil over this period, as displayed in Exhibit 5. The lack of a significant relationship to the Foreign Currency factor in the Two Sigma Factor Lens is interesting and perhaps unexpected, given both the factor and Bitcoin in this instance12 are expressed relative to the USD.
To summarize, Bitcoin is not easily explained by the Two Sigma Factor Lens, nor is it substantially correlated to other currencies or any of the major commodities. This leaves us with the following question that we will spend the rest of this Street View analyzing: are there any common risk drivers among cryptocurrencies themselves, or are they each their own beast, carrying a unique, idiosyncratic return even relative to each other?
Correlations Among Crypto Assets To examine common risk drivers across crypto, we first need to establish a universe of crypto assets. We selected the 10 coins,13 including Bitcoin, Ethereum, and Dogecoin, that had the highest day trading volume as of April 19th, according to CoinMarketCap, and that had at least 3 years of price history.
A few interesting observations from the correlations across crypto assets: first, there was not a single negative correlation in the entire matrix. All of the crypto assets exhibited positive correlations. This is particularly interesting because of the different use cases of these two assets.
ETH has that use case as well, but it expands on that by representing a platform on which to build applications using its cryptocurrency, ether. While the correlation has always been in positive territory, the correlation between the two was much lower a few years ago. It substantially picked up around the Q1 crypto crash when both coins suffered their worst quarterly losses up to that point as regulatory scrutiny on crypto was picking up and tech giants, like Facebook and Google, banned cryptocurrency advertising.
The correlation has declined a bit since then, but has been picking up again more recently. In summary, we see fairly high correlations among the ten coins in our universe. Brokers and other financial institutions are working desperately to get approval from the Securities and Exchange Commission for Bitcoin-backed securities —the number held by institutions and large investors will continue to rise as more securities are designed.
Bitcoin volatility is also driven, to an extent, by these investors. It is unclear how Bitcoin whales—investors with BTC holdings in the tens of millions or more—would liquidate their significant positions into fiat currency without affecting Bitcoin's market price. If the whales were to begin selling their Bitcoin holdings suddenly, prices would plummet as other investors panicked as well.
Investors with thousands of Bitcoin may not be able to liquidate their assets fast enough to prevent enormous losses. Emerging technologies like decentralized finance and the metaverse may reveal Bitcoin's market staying power, but it is still speculation whether Bitcoin will have any value or utility in these systems.
Bitcoin volatility is also partly driven by the varying belief in its utility as a store of value and method of value transfer. A store of value is an asset's function that allows it to maintain value in the future with some degree of predictability. Many investors believe that Bitcoin will retain its value and continue growing, using it as a hedge against inflation and an alternative to traditional value stores like gold or other metals.
Bitcoin in the News Because news and media outlets are businesses that need content for their readers and viewers, they often present information and predictions from "experts" that are not always verified by evidence other than opinions. It's not uncommon to hear an opinion from someone heavily invested in Bitcoin stating that the currency will soon be worth hundreds of thousands.
Others hype newly invented cryptocurrencies to try and take away market share from Bitcoin. However, most of this media attention and publicity serves to influence Bitcoin's price to benefit the people who hold large numbers of coins. When media outlets announced Proshare's introduction of its Bitcoin Strategy ETF exchange-traded fund in late October , Bitcoin's price skyrocketed over the next few weeks.
Bitcoin Regulation Rumors about regulations tend to impact Bitcoin's price in the short term, but the significance of the impacts is still being analyzed and debated. Government agency views of cryptocurrency can also affect Bitcoin's price. The IRS also considers Bitcoin a capital asset if it's used as an investment instrument.
Additionally, if you mine a Bitcoin, you are required to report it as income based on the coin's market value on the date you receive it. The tax stance taken by the IRS means taxes must be paid when you use Bitcoin.
As a result, taxes factor into Bitcoin's market price—but it doesn't necessarily contribute to its volatility unless the tax regulations change often and cause investor concerns. China's government and central bank announced in that all cryptocurrency transactions or facilitation were illegal.
Bitcoin mining was cracked down upon following a meeting of the State Council Financial Stability and Development Committee in May, which resulted in a massive shutdown of cryptocurrency mining farms in the country. As such, it is a reasonably stable commodity, as far as price, demand, and supply go. Likewise, fiat currency has been around for some time—while exchange rates between countries fluctuate and are somewhat volatile, their values are to a point predictable based on the issuing country and the economic circumstances it faces.
Bitcoin has only been around for a short time—it is still in the price discovery phase. This means that prices will continue to change as investors, users, and governments work through the initial growing pains and concerns until prices stabilize—if a stable point can be reached. Bitcoin's price fluctuates because it is influenced by supply and demand, investor and user sentiments, government regulations, and media hype.
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Online platforms have generated a large trading activity by speculators seeking to profit from the short-term or long-term holding of digital currencies. Cryptocurrencies are not backed by a central bank, a national or international organization, or assets or other credit, and their value is strictly determined by the value that market participants place on them through their transactions, which means that loss of confidence may bring about a collapse of trading activities and an abrupt drop in value.
Investors must rely upon the strength of their own computer security systems, as well as security systems provided by third parties, to protect purchased cryptocurrencies from theft. Moreover, cryptocurrency is highly reliant upon unregulated companies, including some that may lack appropriate internal controls and may be more susceptible to fraud and theft than regulated financial institutions.
Furthermore, the software needs to be regularly updated and maybe suspect at times. Sourcing the blockchain technology to vendors may result in significant third-party risk exposure. Once the Bitcoins are transferred out of the account and that transaction has been committed to the block chain, those monies are lost forever to the original owner Operational risk With a centralized clearinghouse guaranteeing the validity of a transaction comes the ability to reverse a monetary transaction in a coordinated way; no such ability is possible with a cryptocurrency.
Due to the complexity and decentralized nature of the Bitcoin and the significant number of participants — senders, receivers possibly launderers , processors mining and trading platforms , currency exchanges, a single AML approach does not exist. Market risks The market risks are idiosyncratic as the currency trades only on demand. There is a finite amount of the currency which means that it can suffer from liquidity concerns and limited ownership may make it susceptible to market manipulation.
Furthermore, given its limited acceptance and lack of alternatives, the currency can appear more volatile than other physical currencies, fueled by speculative demand and exacerbated by hoarding. Thus, posing an inherent material risks to the business Many of the individual inherent risks of the currency also manifest and affect the business adding an extra layer of risk. Further risks would include the costs involved in mitigation with respect to regulatory risk compliance Anti-money laundering and privacy laws, would have to be complied with on an individual business level as well as a global level, involving a myriad of balances and checks.
Furthermore, institutions could find themselves taken to task by various jurisdictional law enforcement agencies each with their own agenda, in failing to comply with the many differing local and state laws. The competition risk is great as the businesses will need to accommodate and expand their offering to be all inclusive with regard to payment transmissions, involving a substantial revision to all ready past due systems and infrastructure.
Institutions that support this circumvention either unwittingly or not can find themselves subject to sanctions and or fines. Further business liabilities could also arise from the conversion or de conversion of the currency and the reporting of these instructions. There is no doubt that cryptocurrencies are here to stay as technology advances. If a cryptocurrency miner finds such a block, they earn bitcoins, thus new coins or tokens are generated.
Gold Backed Cryptocurrencies Evolution of Cryptocurrency The history of cryptocurrency has transformed the global monetary landscape. Bitcoin was not introduced as a normal currency by a country. The cryptocurrency was created in late after the global financial crisis and today it allows investors to generate profit. When Satoshi Nakamoto developed the Bitcoin system, he was inspired by companies like DigiCash, which offered an electronic payment system for small payments starting in the early s.
In a whitepaper published in , Satoshi described the open source principle and the logic of a new currency. He presented the case for solving the basic problems associated with traditional currencies. One of these problems is the lack of trust when dealing with unknown third parties. In ordinary monetary systems, people have to trust governments and central banks.
With cryptocurrencies , you do not trust anyone. The basic idea is mistrust, which is overcome by an algorithm and consensus mechanism. After the launch of Bitcoin v0. Many are trying to find the true Satoshi Nakamoto and wondering why the inventor of such an innovation remains anonymous.
The reason may not be modesty, but the knowledge that his invention could change the financial, economic and political power relations of the world. As such, he may be concerned that he would be in danger of being persecuted by governments that could lose their power and control. Evolution of Cryptocurrencies Cryptocurrency Timeline The crypto timeline shows some of the notable events that have defined the phenomenal rise and history of cryptocurrencies.
October Satoshi Nakamoto published a white paper outlining his vision for a cryptocurrency known as Bitcoin. October The first Bitcoin exchange opens a service to buy and sell digital currencies. February Users negotiated the first Bitcoin transactions informally via online forums. Mode of operation The blockchain system is decentralized and thus a pure peer-to-peer p2p network.
Since the network is unstructured, each unit can be removed without affecting other operations.
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