From the emergence of a decade ago, Bitcoin and other digital cryptocurrencies have captured the imagination of technology wizards, Wall Street bankers and investors of all kinds.
Proponents argue that cryptocurrencies, which are decentralized and function outside the control of governments, could one day replace national currencies as the main means of exchange. The skeptics believe that virtual currencies amount to smoke and mirrors and expect their craters to value.
In a new study, the economist of Yale Aleh Tsyvinski and Yukun Liu, a research doctorate. candidate for the Department of Economics, provides the first complete economic analysis of cryptocurrency and the blockchain technology on which it is based.
Tsyvinski, Arthur M. Okun Professor of Economics at Yale, described their work and their findings at YaleNews. A modified transcription follows.
What were you interested in studying cryptocurrency?
There is a lot of mystique surrounding cryptocurrency. It's a new tool, but what exactly is it? Is it an advantage or just a passing fad? There is obviously a wide interest in cryptocurrency because many people are investing in this. Everyone from your local bartender to Goldman Sachs executives talks about it, but most of the cryptocurrency research comes from computer science. However, a global economic analysis is lacking.
We did something very simple. We said: We use text financial tools to help us better understand cryptocurrency. We examined three main cryptocurrencies: Bitcoin, Ripple and Ethereum. We wanted to identify their basic properties. We examined whether they behaved like other asset classes, particularly stocks, traditional currencies and precious metal commodities. We have also assessed their potential to benefit or stop various industries.
What did you learn about the basic properties of cryptocurrency?
We have documented a high yield but with a lot of volatility. Does high return compensate for high volatility? This is called the relationship of Sharpe, which measures the performance of an asset by adjusting to risk. Surprisingly, we have found that the Sharpe ratio of cryptocurrency shows that the return is higher than the risk implied by its volatility. It is higher than the Sharpe ratio for stocks and bonds, but not so drastically. There have been asset classes and trading strategies with Sharpe reports that are the same or similar to cryptocurrencies. So, if you look at the yield compared to the volatility, the cryptocurrency seems more or less normal.
Does cryptocurrency behave like other asset classes?
In my introduction to the macroeconomics course, I teach my students that money has different functions. It can act as a unit of account, which is a function of traditional currency. Money can also be a way to store value, meaning how gold and other precious metals work. Put it in a safe and tomorrow you can use it for something else. Does cryptocurrency serve one of these two functions? Or is it a bet on blockchain technology that dramatically destroys different sectors, namely: does it behave like stocks?
To answer these questions, we examined whether cryptocurrency returns can be explained by the same factors that drive returns of stocks, currencies, or commodities into precious metals. As for stocks, we examined 155 potential risk factors in the financial literature and found that almost none of them represents cryptocurrency returns. They are not like stocks.
We also found no similarity between the behavior of cryptocurrency and five major traditional currencies: the euro, the Australian dollar, the Canadian dollar, Singapore dollar and the British pound. Finally, we have not seen any connection between the behavior of cryptocurrency and gold, silver or platinum. Our findings question the popular narratives according to which cryptocurrencies derive their value from the fact that they serve as units of account, like the usual currencies, or as a store of value, like precious metals.
If cryptocurrency does not behave like these traditional goods, then is it possible to predict its performance?
While we have discovered that cryptocurrency behaves differently than traditional asset classes, we have also found that investors can better understand cryptocurrencies by applying pricing tools that are common to factors specific to them. We demonstrate that some of the factors that people use to predict the performance of traditional asset classes can be used to significantly predict the behavior of cryptocurrency.
The former is called the momentum effect, which in practice means that when a resource increases in value, it will tend to rise even higher. This is a feature of almost all known asset classes and we have found that it has a strong influence on cryptocurrency. To take advantage of the moment effect, we have designed a simple strategy that says an investor should buy Bitcoin if its value increases more than 20% in the previous week. This strategy generates exceptional returns and a very high Sharpe ratio.
The second factor that strongly influences cryptocurrency is the measure of investor attention. We asked the following: If there is an abnormally high number of cryptocurrency mentions we have studied on Google or on Twitter, will their earnings go up? It turns out that they will do it. At the same time, we found that the negative attention of investors, as an increase in the use of the search phrase "Bitcoin hack", would generate negative returns for cryptocurrencies.
There were potential factors that you thought would have predicted cryptocurrency behavior, but is not it?
Yes. The first was the cost of mining, which is the price of cryptocurrency production. We were surprised to see that it does not provide for cryptocurrency returns. The second is the price-dividend ratio, which is one of the most important factors in the valuation of stocks. Is the price of this stock too high compared to the gains or the fundamental? Cryptocurrency obviously does not pay dividends, but you can still study a similar metric. We have found that a proxy for a price / dividend ratio – asking if the price of a cryptocurrency is too high for its fundamental – does not predict cryptocurrency returns.
The same is true of volatility, which is actually quite surprising. It would be thought that the higher the volatility, the greater the yield to compensate for this. This is not the case. Neither high nor low volatility strongly predicts cryptocurrency returns.
What are the odds that Bitcoin or other cryptocurrencies completely collapse in value?
It is reasonable to consider the probability, according to the point of view of the markets, that the value of Bitcoin will fall to zero and become useless. Our calculation is 0.3%. If you are completely risk-neutral, based on the historical performance of the cryptocurrency, you will assign a probability of 0.3% that its value will drop to zero. For comparison, we also calculated the probability of crashes for traditional currencies. Their probability of accident is of varying degrees of smaller magnitude. For example, the Euro is about 0.009%, the Australian dollar is about 0.003% and the Canadian dollar is about 0.005%.
What did you learn about the cryptocurrency potential of changing or stopping industries?  People speculate that cryptocurrency can destroy all types of industries, from music to finance to supply chains. We have taken 354 industries in the United States and 137 industries in China, and we asked the following question: The returns of the shares in those sectors affected by cryptocurrency?
We were trying to assess what the cryptocurrency market thinks. People talk about which industries might be affected, but we were not asking a hypothetical question about what people think will happen. We have tried to understand how the market perceives which industries could be influenced by cryptocurrency.
We have created an index of the potential interruption of cryptocurrency in all major industries. For example, we have found that the health and consumer goods industries have significant and positive exposure to Bitcoin returns, while the finance, retail and wholesale industries have no exposure to Bitcoin. More surprisingly, we have found evidence that the market perceives the Ethereum technology as a potential destroyer in the financial sector. We do not provide explanations, we simply document this behavior, but an explanation could be that Ethereum is essentially based on smart contracts, distinguishing them from Bitcoin, which is intended to function as an alternative payment method.
Based on your analysis, how much Bitcoin should have a typical investor?
Please note that we do not offer investment advice, but it is a very simple question that you could ask about any asset class, and we approach the question at the end of our study. When you invest in your retirement, Vanguard or any platform you use will suggest how to best allocate your portfolio. We did the same for cryptocurrency. If you, as an investor, believe that Bitcoin will work as it has historically done, then you should keep 6% of your Bitcoin wallet. If you think it will do half, you should keep 4%. In all other circumstances, if you think it will be much worse, you should still keep 1%. Of course, we must remember that, as with any other business, past performance is not a guarantee of future returns. Perhaps the cryptocurrency will completely change its behavior, but currently the market does not think it will.