Cryptocurrency and Efficient Market Hypothesis. Drunken Risibility.

According to the traditional definition, a currency has three main properties: (i) it serves as a medium of exchange, (ii) it is used as a unit of account and (iii) it allows to store value. Along economic history, monies were related to political power. In the beginning, coins were minted in precious metals. Therefore, the value of a coin was intrinsically determined by the value of the metal itself. Later, money was printed in paper bank notes, but its value was linked somewhat to a quantity in gold, guarded in the vault of a central bank. Nation states have been using their political power to regulate the use of currencies and impose one currency (usually the one issued by the same nation state) as legal tender for obligations within their territory. In the twentieth century, a major change took place: abandoning gold standard. The detachment of the currencies (specially the US dollar) from the gold standard meant a recognition that the value of a currency (specially in a world of fractional banking) was not related to its content or representation in gold, but to a broader concept as the confidence in the economy in which such currency is based. In this moment, the value of a currency reflects the best judgment about the monetary policy and the “health” of its economy.

In recent years, a new type of currency, a synthetic one, emerged. We name this new type as “synthetic” because it is not the decision of a nation state, nor represents any underlying asset or tangible wealth source. It appears as a new tradable asset resulting from a private agreement and facilitated by the anonymity of internet. Among this synthetic currencies, Bitcoin (BTC) emerges as the most important one, with a market capitalization of a few hundred million short of $80 billions.

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Bitcoin Price Chart from Bitstamp

There are other cryptocurrencies, based on blockchain technology, such as Litecoin (LTC), Ethereum (ETH), Ripple (XRP). The website https://coinmarketcap.com/currencies/ counts up to 641 of such monies. However, as we can observe in the figure below, Bitcoin represents 89% of the capitalization of the market of all cryptocurrencies.

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Cryptocurrencies. Share of market capitalization of each currency.

One open question today is if Bitcoin is in fact a, or may be considered as a, currency. Until now, we cannot observe that Bitcoin fulfills the main properties of a standard currency. It is barely (though increasingly so!) accepted as a medium of exchange (e.g. to buy some products online), it is not used as unit of account (there are no financial statements valued in Bitcoins), and we can hardly believe that, given the great swings in price, anyone can consider Bitcoin as a suitable option to store value. Given these characteristics, Bitcoin could fit as an ideal asset for speculative purposes. There is no underlying asset to relate its value to and there is an open platform to operate round the clock.

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Bitcoin returns, sampled every 5 hours.

Speculation has a long history and it seems inherent to capitalism. One common feature of speculative assets in history has been the difficulty in valuation. Tulipmania, the South Sea bubble, and more others, reflect on one side human greedy behavior, and on the other side, the difficulty to set an objective value to an asset. All speculative behaviors were reflected in a super-exponential growth of the time series.

Cryptocurrencies can be seen as the libertarian response to central bank failure to manage financial crises, as the one occurred in 2008. Also cryptocurrencies can bypass national restrictions to international transfers, probably at a cheaper cost. Bitcoin was created by a person or group of persons under the pseudonym Satoshi Nakamoto. The discussion of Bitcoin has several perspectives. The computer science perspective deals with the strengths and weaknesses of blockchain technology. In fact, according to R. Ali et. al., the introduction of a “distributed ledger” is the key innovation. Traditional means of payments (e.g. a credit card), rely on a central clearing house that validate operations, acting as “middleman” between buyer and seller. On contrary, the payment validation system of Bitcoin is decentralized. There is a growing army of miners, who put their computer power at disposal of the network, validating transactions by gathering together blocks, adding them to the ledger and forming a ’block chain’. This work is remunerated by giving the miners Bitcoins, what makes (until now) the validating costs cheaper than in a centralized system. The validation is made by solving some kind of algorithm. With the time solving the algorithm becomes harder, since the whole ledger must be validated. Consequently it takes more time to solve it. Contrary to traditional currencies, the total number of Bitcoins to be issued is beforehand fixed: 21 million. In fact, the issuance rate of Bitcoins is expected to diminish over time. According to Laursen and Kyed, validating the public ledger was initially rewarded with 50 Bitcoins, but the protocol foresaw halving this quantity every four years. At the current pace, the maximum number of Bitcoins will be reached in 2140. Taking into account the decentralized character, Bitcoin transactions seem secure. All transactions are recorded in several computer servers around the world. In order to commit fraud, a person should change and validate (simultaneously) several ledgers, which is almost impossible. Additional, ledgers are public, with encrypted identities of parties, making transactions “pseudonymous, not anonymous”. The legal perspective of Bitcoin is fuzzy. Bitcoin is not issued, nor endorsed by a nation state. It is not an illegal substance. As such, its transaction is not regulated.

In particular, given the nonexistence of saving accounts in Bitcoin, and consequently the absense of a Bitcoin interest rate, precludes the idea of studying the price behavior in relation with cash flows generated by Bitcoins. As a consequence, the underlying dynamics of the price signal, finds the Efficient Market Hypothesis as a theoretical framework. The Efficient Market Hypothesis (EMH) is the cornerstone of financial economics. One of the seminal works on the stochastic dynamics of speculative prices is due to L Bachelier, who in his doctoral thesis developed the first mathematical model concerning the behavior of stock prices. The systematic study of informational efficiency begun in the 1960s, when financial economics was born as a new area within economics. The classical definition due to Eugene Fama (Foundations of Finance_ Portfolio Decisions and Securities Prices 1976-06) says that a market is informationally efficient if it “fully reflects all available information”. Therefore, the key element in assessing efficiency is to determine the appropriate set of information that impels prices. Following Efficient Capital Markets, informational efficiency can be divided into three categories: (i) weak efficiency, if prices reflect the information contained in the past series of prices, (ii) semi-strong efficiency, if prices reflect all public information and (iii) strong efficiency, if prices reflect all public and private information. As a corollary of the EMH, one cannot accept the presence of long memory in financial time series, since its existence would allow a riskless profitable trading strategy. If markets are informationally efficient, arbitrage prevent the possibility of such strategies. If we consider the financial market as a dynamical structure, short term memory can exist (to some extent) without contradicting the EMH. In fact, the presence of some mispriced assets is the necessary stimulus for individuals to trade and reach an (almost) arbitrage free situation. However, the presence of long range memory is at odds with the EMH, because it would allow stable trading rules to beat the market.

The presence of long range dependence in financial time series generates a vivid debate. Whereas the presence of short term memory can stimulate investors to exploit small extra returns, making them disappear, long range correlations poses a challenge to the established financial model. As recognized by Ciaian et. al., Bitcoin price is not driven by macro-financial indicators. Consequently a detailed analysis of the underlying dynamics (Hurst exponent) becomes important to understand its emerging behavior. There are several methods (both parametric and non parametric) to calculate the Hurst exponent, which become a mandatory framework to tackle BTC trading.

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2 thoughts on “Cryptocurrency and Efficient Market Hypothesis. Drunken Risibility.

  1. Interesting. But doesn’t a person have to initiate a quantity of bitcoin from their regulated national currency? Doesn’t that play into all the bitcoin hoopla? Because eventually one would pull their ‘real money’ out of bitcoin. And then we would have a basis for what is happening there. No?

  2. When bitcoin becomes widely accepted, it will be backed by the value of the goods and services sold by people who accept bitcoin in exchange. In effect, it would have crowd sourced backing. When governments no longer asserted they would exchange paper money for gold as the basis for backing, their currency became fiat currency–its value assigned by fiat or legally binding national asserting–for whatever that is worth. No concrete backing. Currently bitcoin’s value seems much to variable for any prudent merchant or provider of services to price their wares at a fixed level with bitcoin. Selling anything at a price expressed in bitcoin is a crap shoot. The other mechanism, which works less effectively is market supply and demand. That could conceivably be manipulated to stabilize price by controlling the supply of bitcoin in circulation. This could be done by revising how miners are rewarded. Currently the bitcoin reward is a fixed amount denominated in bitcoin and the duration over which transactions are collected to form a blockchain is also fixed. It might be possible to modify the mining reward so that the number of bitcoin in active circulation is adjusted. As the price rises, increase the supply at a faster rate. As the price declines, reduce the rate at which the supply is growing. This of course, is only limited control since reducing the miners reward beyond zero is not possible. Adding transaction fees may not be enough and high fee levels may reduce bitcoin’s usefulness. It is conceivable that bitcoin futures or call options might form the basis for a suitable reward, keeping new coins out of active circulation until a point in future time. There are the large collections of bitcoins extant that were given out or earned by mining in the currency’s earliest days. Note that is is to the interest of those who hold these collections that the price not begin falling. They have a self interest in maintaining some level of price even if it is no longer rising. Like the de Beers and other diamond interests; like OPEC for Oil, they have a collective interest in insuring the price remains stable. Their tacit agreement to keep their selling in check might result in a win-win situation for all concerned.

    Yes, Bitcoin (BTC) is a fiat currency. But there’s an interesting aspect of BTC that makes it different from what we normally think of when we hear this term. First, here’s a definition of the term: “Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of.” Although Bitcoin is not governed by national government or law in the traditional sense (like the US dollar in the United States), the technical properties of BTC – like the supply – is governed by the network of Bitcoin-operators (miners) who agree to use the same algorithm. For example, if a sufficient majority of the operators agree to change the supply of BTC from 21 million to 21 trillion, then it will happen. Legal jurisdiction is another matter. Few national jurisdictions legally recognize BTC as a form of legal tender. That said, if two counterparties share a legal agreement that treats BTC as legal tender for transactions between those counterparties, then BTC as tender should be able to stand up in court.

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