Why are cryptocurrency prices so volatile?
05 September 2019
- Huge volatility in cryptocurrency prices driven by well-informed traders
- Research finds informed traders are timing the market and rest follow
- Opaque cryptocurrency market perfect to exploit information asymmetry
- Study also finds Bitcoin acts like the US dollar in FX markets
New research has found evidence that informed traders and investors’ information asymmetry is driving the huge price swings in cryptocurrencies.
Daniele Bianchi and Alexander Dickerson, a PhD student, used intraday prices and volume data to investigate whether the dominant view that trading activity in cryptocurrency markets predominantly consists of investors speculating on information asymmetries has any foundation.
In the paper Trading Volume in Cryptocurrency Markets, the authors showed - both intraday and on a daily basis - that the interaction between past volume and returns positively and significantly predicts future returns.
This is consistent with existing theoretical models which postulate that informed traders who speculate on their private information are key drivers of the observed price changes.
The research also has practical implications for cryptocurrency trading as a conditional reversal strategy, based on past returns and volume, generated a risk-adjusted annualised return net of transaction costs of 342 per cent and a Sharpe ratio - a measure of the return of an investment compared to its risk - of 2.4, with almost zero correlation with Bitcoin dollar returns.
It outperformed conventional portfolio strategies such as momentum, even when transaction costs were included.
Dr Bianchi said: “The cryptocurrency market is the perfect environment to exploit asymmetric information.
“Its opaque nature and the fragmented system where it mixes web-based brokers and peer-to-peer exchanges with regular major exchanges, which the small exchanges rely on for liquidity, means those who have the information can time the market, make money and drive the prices.
“To test this, we constructed a reversal trading strategy based on volume and past returns and found that it does not correlate with volatility, aggregate market returns, or strategies built on past performances, so it is really volume that has the relevant information.”
What and who is driving cryptocurrency prices?
A slightly similar market structure can be found in Foreign Exchange (FX) markets. However, with previous research showing that the dynamics of cryptocurrency returns and volume is neither bound by economic fundamentals nor correlated with traditional asset classes, FX included, the researchers warn not to expect trading activity in cryptocurrency markets resembling anything like existing asset classes.
The authors tracked 26 cryptocurrencies over 150 exchanges from January 1, 2017, to May 10, 2018, when the cryptocurrency market experienced a huge boom during December 2017 and January 2018, a major collapse from February 2018 to April 2018 and then traded sideways. These major currencies cover more than 90 per cent of the trading volume of coins using Bitcoin as the base currency.
Dr Bianchi believes the research also shows how Bitcoin-centric the cryptocurrency market is, just as the US dollar is in the FX market.
He added: “Unlike more mature, centralised, markets - such as equity - trading in cryptocurrency is inherently generated by an opaque information flow.
“Cryptocurrency markets are made by a highly fragmented, multi-platform structure which is populated by vastly different operators.
“This means the interaction between trading volume and price changes can actually help shed some light on investors’ trading motives, especially as there are no closing times in cryptocurrency markets.”