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Cryptocurrency: a New Investment Opportunity? David Kuo Chuen LEE Singapore University of Social Sciences

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Cryptocurrency: a New Investment Opportunity? David Kuo Chuen LEE Singapore University of Social Sciences Singapore Management University Institutional Knowledge at Singapore Management University Research Collection Lee Kong Chian School Of Lee Kong Chian School of Business Business 3-2018 Cryptocurrency: A new investment opportunity? David Kuo Chuen LEE Singapore University of Social Sciences Li GUO Singapore Management University, [email protected] Yu WANG Singapore University of Social Sciences DOI: https://doi.org/10.3905/jai.2018.20.3.016 Follow this and additional works at: https://ink.library.smu.edu.sg/lkcsb_research Part of the Finance and Financial Management Commons, and the Technology and Innovation Commons Citation LEE, David Kuo Chuen; GUO, Li; and WANG, Yu. Cryptocurrency: A new investment opportunity?. (2018). Journal of Alternative Investments. 20, (3), 16-40. Research Collection Lee Kong Chian School Of Business. Available at: https://ink.library.smu.edu.sg/lkcsb_research/5784 This Journal Article is brought to you for free and open access by the Lee Kong Chian School of Business at Institutional Knowledge at Singapore Management University. It has been accepted for inclusion in Research Collection Lee Kong Chian School Of Business by an authorized administrator of Institutional Knowledge at Singapore Management University. For more information, please email [email protected]. Published in Journal of Alternative Investments, Winter 2018, 20 (3) 16-40. https://doi.org/10.3905/jai.2018.20.3.016 Cryptocurrency: A New Investment Opportunity? DAVID LEE KUO CHUEN, LI GUO, AND YU WANG 1 DAVID LEE KUO he invention of Bitcoin by Satoshi will argue that their value is higher than Linux CHUEN Nakamoto (Nakamoto [2008]) and lower than the Internet—yet both are is a professor at Singapore in 2008 spurred the creation facilitators rather than an asset class. Finance University of Social Sciences in Singapore, of many new cryptocurrencies traditionalists will argue that cryptocurrency Tknown as altcoins. These altcoins use similar is just another form of value transfer that raises and 2015 Fulbright visiting scholar at Stanford cryptographhy technology but employ dif- funds globally using cryptography and creates University in Stanford, ferent algorithmic designs. Many of these little value beyond that. For perspective, with CA. altcoins were invented for different purposes US$40 billion and US$100 billion market [email protected] or to address the pain points of the Bitcoin capitalization for bitcoin and total cryptocur- LI GUO network, such as the high usage of energy rency, respectively, this investable asset class is is a PhD candidate in the caused by its proof of work (PoW) consensus minute in size compared to the US$66.8 tril- Lee Kong Chian School algorithm or the supply limit of 21 million lion and US$48.2 trillion for listed equity and of Business at Singapore coins, among others. As the network effect gold, respectively. Management University weighs in, the prices of bitcoin and its vari- Cryptocurrency is a subset of the class in Singapore. [email protected] ants have risen in tandem. These innovations of digital currency (Lee [2015]), but it has and the perceived investment potential have become an important type of digital cur- YU WANG led to rapid growth in the number of alt- rency. Unlike other digital currencies that is a research fellow at the coins and the market size of cryptocurrency. can be centrally issued, circulated within a Singapore University According to CoinMarketCap,2 nearly 869 community or geographical location, or tied of Social Science in cryptocurrencies are currently trading around to fiat currency or the organizations issuing Singapore. [email protected] the world with a combined market capital- them, cryptocurrency has very different ization of US$148.3 billion by circulating characteristics. The blockchain technology supply and US$321.5 billion by total supply used by cryptocurrency, such as Bitcoin, is as of October 6, 2017. The price of bitcoin an open distributed ledger that records trans- surged to US$4,780.15 on September 2, 2017. actions. This solves the double-spending Many have argued that, despite their payment problem and does not require a trusted third utility, bitcoin and cryptocurrencies have no party. Decentralization allows the block- intrinsic value and may be the perfect vehicle chain technology to have increased capacity, for forming a bubble. better security, and faster settlement. Some Even for those who believe that there is of these features are at the top of the list of intrinsic value to cryptocurrencies, when their shortcomings of traditional financial systems. prices are rising, there will be doubts about As a result, blockchains and cryptocurrencies prices running ahead of values. Technologists have become two of the most pressing topics 16 CRYPTOCURRENCY: A NEW INVESTMENT OPPORTUniTY? WINTER 2018 in the financial industry. In this article, we focus on sentiment-induced mispricing. To further explore the the diversification role of cryptocurrencies and explore sentiment effect, we use the Fama–MacBeth regression the possibility that they may generate new investment (Fama and MacBeth [1973]) to examine the cross- opportunities based on historical data. sectional premium of investor sentiment by using the We first evaluate the comovement between tra- top 100 cryptocurrencies that are components of CRIX. ditional asset classes and the cryptocurrency index After controlling trading volume and lagged return, the (CRIX) by studying their correlation coefficients (Chen Fama–MacBeth results suggest that any cryptocurrency et al. [2016]). Results suggest a very low correlation with 1% investor sentiment in excess of the average between CRIX and traditional assets based on historical cryptocurrency sentiment tends to have a 0.38% lower data. This observation suggests that cryptocurrency as an future return compared to the entire cryptocurrency asset class is a good diversifier in a traditional portfolio. portfolio. As a result, we identify potential profits from We then employ a multivariate dynamic conditional using daily trading strategies based on investor senti- correlation (DCC) model to examine dynamic comove- ment. The strategy that buys low-sentiment and sells ments for robustness (Engle [2002]). Consistent with our high-sentiment cryptocurrencies generates an annual- expectations, cryptocurrencies are considered a poten- ized return of 8.54 with a Sharpe ratio of 11.64. We also tially better portfolio diversifier under the DCC setting. conduct two analyses to assess the robustness of our find- The largest DCC was between CRIX and gold, with a ings. Our sentiment strategy survives after assuming rea- value of 0.24. Next, we investigate whether the inclusion sonable transaction costs from 1 to 10 bps per trade. The of cryptocurrencies in a traditional portfolio will lead to result is not sensitive to the selection of formation period additional benefits in terms of risk-adjusted returns. Our of investor sentiment. The average annualized return empirical results show that CRIX not only expands the remains more than 11% with a t-value >15. Overall, efficient frontier of an initial portfolio consisting only our results provide some evidence of cryptocurrencies of traditional assets, it also provides additional utility to being a potential candidate as a new investment vehicle. investors, as evidenced by the mean–variance spanning The rest of the article is organized as follows. We first test. However, it seems that cryptocurrencies may not introduce the background of the cryptocurrency market. lead to a large improvement in the utility of a mean– The next section presents empirical results on the diver- variance investor. There are various explanations for this sification role of cryptocurrencies, and the following sec- finding. First, the current sample period of CRIX is tion explains the sentiment impact on the cryptocurrency too short to fully explore the investment opportunity market with robustness checks. The last section concludes. of cryptocurrencies. Second, over the sample period, the cryptocurrency market is too volatile, with a daily CRYPTOCURRENCY maximum drawdown of 22%. Hence, it is important for investors to understand the return–risk structure of From Centralization to Decentralization cryptocurrencies before making an investment com- mitment. In this article, we conjecture that the high The major drawback of the traditional fiat cur- volatility of cryptocurrency is driven mainly by investor rency payment system is high transaction fees with a sentiment, not by a change in fundamentals. We do not long settlement period, which has led people to alterna- argue that there are no fundamentals, but rather that tive currencies that allow for shorter peer-to-peer (P2P) there has not been any meaningful interpretation using processing time without intermediaries, resulting in a traditional fundamental analysis. Either the old economy thriving market for digital currencies that have lower framework is not suitable for a new and complex tech- settlement risk. Prior to the creation of cryptocurrencies, nology such as cryptocurrency, or immeasurable fun- there were many other types of digital currencies. The damentals are proxied by sentiments. most common example is a digital currency created by We then propose an investor sentiment measure an institution and transacted on a platform. Such curren- based on the past average returns for the cryptocur- cies can be loyalty points created by companies or digital rency market. Our measure
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