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Price Shocks of Bitcoin and Correlation to Other Cryptocurrency

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Price Shocks of Bitcoin and Correlation to Other Cryptocurrency Price shocks of Bitcoin and correlation to other cryptocurrency Master Thesis Student name: Marko Jelčić ANR:929706 SNR:2016639 November 2018 Supervisor: dr. Ole Wilms Second reader: dr. Fatemeh Hosseini Tash Abstract The purpose of this study is to examine how the correlation between Bitcoin and other cryptocurrencies changes after Bitcoin price shocks that happened in 2017 and early 2018, when the market experienced a great increase and introduced cryptocurrency to the broader public. Using time series data of returns and using 14-day rolling correlations between Bitcoin and nine other cryptocurrencies, the empirical research will focus on correlation shifts. Quantitative analysis was performed on correlations between cryptocurrencies during the aforementioned period, generalized autoregressive conditional heteroskedasticity analysis was performed as well as a thorough analysis on structural breaks in correlation levels between Bitcoin and other cryptocurrencies. Main hypothesis of the thesis is that correlation levels rise after Bitcoin experiences a price shock. The results indicate that the correlation coefficient shifts after every Bitcoin price shock, but not necessarily in an upwards direction. These results have implications on using Bitcoin and other cryptocurrencies in a portfolio and creating a cryptocurrency portfolio itself, especially concerning diversification possibilities in a portfolio consisting of cryptocurrencies alone. After a structural break happens, the portfolio should be readjusted accordingly, whether it was made of different types of assets or cryptocurrencies alone. Keywords: Bitcoin, cryptocurrency, correlation, diversification, price shocks 1 Contents Abstract ......................................................................................................................................................... 1 1. Introduction ........................................................................................................................................... 3 2. Literature Review .................................................................................................................................. 7 2.1. Bitcoin ............................................................................................................................................. 10 2.2. Currency .......................................................................................................................................... 11 2.3. Legality ........................................................................................................................................... 13 2.4. Transactions .................................................................................................................................... 13 2.5. Dominance ...................................................................................................................................... 14 2.6. Usage as a payment ......................................................................................................................... 14 3. Alternative cryptocurrencies ............................................................................................................... 15 4.1. Ether ............................................................................................................................................ 19 4.2. Litecoin ....................................................................................................................................... 20 4.3. Ripple .......................................................................................................................................... 21 4.4. Dash ............................................................................................................................................ 22 4.5. Monero ........................................................................................................................................ 23 4.6. Stellar .......................................................................................................................................... 24 4.7. NEO ............................................................................................................................................ 25 4.8. NEM ............................................................................................................................................ 26 4.9. Bytecoin ...................................................................................................................................... 27 5. Empirical research .............................................................................................................................. 28 5.1. ARCH and GARCH models ........................................................................................................... 28 5.2. Correlation studies and methodology ............................................................................................. 30 5.3. Structural Break test Methodology ................................................................................................. 33 5.3.1. Bitcoin Price Shocks ................................................................................................................... 35 5.3.2. Break dates for the hypothesis .................................................................................................... 36 5.4. Empirical testing ............................................................................................................................. 37 6. Conclusion .......................................................................................................................................... 44 7. References ........................................................................................................................................... 46 8. Appendix ............................................................................................................................................. 47 2 1. Introduction The aim of this thesis is to provide a background on the cryptocurrency market as a whole and investigate how the correlations between cryptocurrencies act before and after price shocks. Correlation analysis is important because it shows how the currencies act together in such a new and volatile market. This analysis is also important for understanding the volatility of alternative cryptocurrency and how does it tie into Bitcoin, which in a broader scope of things also provides an analysis on a possibility of a cryptocurrency portfolio. Diversification possibilities are weakened if strong correlation between cryptocurrencies persist so this analysis would provide an answer whether extreme cases of Bitcoin price volatility affect them. Cryptocurrencies, or as the European Central Bank (2015) called them, Virtual currency schemes created a whole new payment system by itself, along with many new subjects that create and act in the cryptocurrency market. As in most markets, the inventors are the most important actors, since they develop the technology behind the cryptocurrency. These individuals are usually programmers and computer scientist, as it takes considerable technical prowess to create such powerful systems. Once these units are created, they need to be generated. The volume of these currencies is either predetermined or simply depends on the demand. In centralized cryptocurrency systems, issuers can issue more cryptocurrency, dictate rules of usage and control the supply. In decentralized cryptocurrency systems, miners create new units of currency, by generating new units as a reward for validating a set of transactions and adding them to the payment ledger to avoid double spending, in other words, marking each unit that has been used in a transaction in order to avoid malicious behavior. For a market to work, it needs users, which accumulate and spend their cryptocurrency units on goods and services, or simply accumulate them as a storage of wealth. 3 Number of users who accumulated cryptocurrency, during the mentioned period far surpasses the volume of purchases with vendors that are expected for that volume. According to the Cambridge business school study (2017), number of active cryptocurrency users is between 2.9 million and 5.8 million. On the other hand, number of wallets open in Coinbase1, according to their website is currently over 20 million. This information is highly indicative of the cause of the extreme market growth cryptocurrencies experienced. Most of the people see cryptocurrencies as an investment rather than a payment vehicle. To keep units of cryptocurrency, users have wallets, which are commonly divided into two commonly used categories. Cold wallets, which are usually hardware based and located offline on a physical piece of hardware, usually an USB drive. These types of wallets are deemed safer because of lowered risk of theft. Hot wallets are based online, stored on different types of software, which keeps users’ currency in one place. Exchanges exist in order to provide users with options of trading for their currencies either with a fiat currency, such as US dollars, Euros, Renmimbi or Yen, or with another cryptocurrency. Most popular exchanges include Binance, Bitfinex, Kraken etc. Volume of trading on Binance, which accounts for more than 20% of the exchange market share, can reach over 500 million US dollars a day. A wide range of payment options is usually
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