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Crypto Currency Economics Study – Survey Paper [2nd Full DRAFT]

Editor’s note: the thesis is co-written by Charlie (kai) Tsai (蔡凯龙 in Chinese) when he’s studying for a PhD in finance at Cornell University. Charlie (kai) Tsai was a former chief strategy officer(CSO) at crypto exchange Huobi, and used to serve as vice president in strategy and technology department of Deutsche Bank(US), manager of risk control in MXEnergy and assistant professor in the department of finance at Business School of University of Houston.

Crypto Currency Economics Study – Survey Paper [2nd  Full DRAFT]

June 17th, 2019

Students: Cai and Yang; Mentors: Prof. Hong and Prof. Turvey


This article is aiming for a broad, comprehensive and detailed survey based upon literature review for investigating the current state of study on cryptocurrencies. We comprehend the background, emergence and development of crypt currencies and evaluate the concerns that are addressed by scholars and the public in objective logic, particularly explain the phenomenon in context of finance and economics. The sections include: (1) Introduction; (2) Crypto Exchanges; (3) Pricing and Bubble; (4) Categorization; (5) Market Efficiency; (6) Risk, Volatility and Hedging; (7) Regulations; (8) Future Developments; (9) Conclusion.


Abstract: 1

  1. Introduction: 3
  2. Exchange 18
  3. Pricing, Bubble and Sentiment 28
  4. Categorization and Classification: 38
  5. Market Efficiency and Liquidity 54
  6. Volatility, Risk and Hedging 59
  7. Regulation and financial Rules 67
  8. Future developments 77
  9. Conclusion: 79

Citations 80

 1. Introduction:

  • 1.1 Background of FinTech, Blockchain and Cryptocurrency
    • 1.1.1  Financial Technology (FinTech)

“Financial Technology”, looking at this terminology literally, it originates to mid-19th and early 20th centuries, when the early financial industry began to use the transatlantic cable (1866) for the first time, and using the Fedwire (1918) to transfer fund. After the World War II, the first electronic checker (1960) and the first ATM (1967) were considered as huge technological revolutions for the financial industry, providing faster and more efficient access to withdraw and deposit checks and cashes. In 1980, the rise of telephone banking allowed banking business to break through the geospatial limitations for the first time. In 1990, online banking started emerging, allowing more financial service operations can be conducted on the internet. The history of the financial industry development is closely tied to its utilizations of technologies.

However, the true meaning of “Financial Technology” that is analogous to recent FinTech discussions was actually the development after the 2008 financial turmoil. Looking at the two parts of this term “Financial Technology”: (1) The technology sector has had extensive advancement especially during 1999-2008 after recovering from the bubble burst, especially in the areas of the social network represented by Facebook, the smartphone represented by iPhone, and the cloud computing represented by Amazon cloud have matured. (2) Tough due to the impact of financial crisis in 2008, the financial industry urgently needed to adjust its strategy to reduce costs and improve efficiency when there is lack of profit sources. At that critical time, many large financial institutions began to explore the ways to innovatively apply new technologies in financial sector for improvement. It is under such special historical conditions that FinTech has become a fast-emerging development area, especially in digital and mobile banking, attracting extraordinary attention in the global financial industry.

Advancement usually comes from imagination, collaboration and application, the recent advancement of financial profession rides on the horsepower of Financial Technology, or FinTech, which is an interdisciplinary collaboration between finance and technology. FinTech is about using technology to design and deliver financial services and products. The emergence of FinTech has inspired chains of technology inventions in the financial sector and people’s daily life, to make the financial service and product delivery process cheaper, faster, better and overall more efficient. Specifically, FinTech increases competition, lowers customer costs, and provides services to underserved population of traditional banking by creating a new product and market infrastructure (Mastermind 2016). Recent and future developments of FinTech are in the areas of: new information platforms and the growing importance of digital distribution, digital marketplaces and improved product interconnectivity, shifting payment behavior and fragmented customer portfolios, distributed ledger technologies like blockchain, the surge of machine learning and artificial intelligence (McWaters 2016). One particular area worth noting and expanding further is the blockchain technology.

  • 1.1.2 Blockchain


Figure 1. (Temporary graph: coin applications in different industry. We are currently asking the authors to obtain original data/graph. **We will reorganize good formatted graphs after first round of review, also for the rest of the tables/graphs we have.)

Blockchain is a decentralized and distributed digital consensus ledger that record permanent data in blocks, which are chained by cryptographic hash function. The blockchain was first described as a way to timestamp digital document in 1991 by Sturat Haber and W. Scott Stornetta (1991), then improved in 1992 by Bayer, Haber and Stornetta (1992). Blockchain was used by Satoshi Nakamoto (2008) as the public transaction ledger for the first successful cryptocurrency Bitcoin in 2008.  As Bitcoin became popular, Blockchain’s value is gradually recognized. Blockchain’s main characteristics, including trustless, openness, reliability, anonymity and collective maintain mechanism, have attracted a lot of researchers and entrepreneurs to analyze and apply. By its openness, it develops to 3 types of blockchains: Public Chain, where anyone can equally access to the chain, Private Chain, where the chain is not open to public and Alliance Chain, where only admitted members can access. Many blockchain applications and products have been built. Among them, Cryptocurrency is by far the largest and most important application of blockchain. There are 2112 type of cryptocurrencies actively trading around the world as of March 19th, 2019 (CoinMarketCap), and continue to develop and grow.  Since blockchain is called “Trust Machine” (2015), it has implication far beyond cryptocurrencies.  Besides cryptocurrencies, Blockchain’s utilization has expanded to banking, trade finance, healthcare, poverty reduction, food origin, and many other fields.

  • 1.1.3.Overview of Bitcoin and Cryptocurrencies

Even though developments of these many applications of FinTech especially Blockchain are quite intriguing, our study focuses on cryptocurrencies and their role in economics and finance. Bitcoin, as the leading crypto currencies, with a 53% market share of the total cryptocurrency market as of Mid-March of 2019 (Coin Dance), has attracted abnormal amount of attention in public especially since 2017-2018, other cryptocurrencies will also be briefly discussed in a later paragraph.


Figure 2. CryptoCurrency Market Cap Shares in 2019.

Bitcoin along with other cryptocurrencies have been establishing their standing in the market more and more firmly, with global market cap of $793 billion US dollars at October 2018 but already dropped to $139 billion in March 2019 as shown in below. Such fast development and huge movement entice the media speculations on making their way to trillion-dollar market. The reason for its attractiveness is not only about fast growth; but also the innovative design, exceptional volatility, emotional hype, useful application and more. Here below introduces Bitcoin and its characteristics, as well as other cryptocurrencies in general.


Figure 3. CryptoCurrency Market Cap Historical


  • 1.2.Bitcoin and CryptoCurrency
    • 1.2.1.Background and Emergence

For many years, computer experts have been trying to create a crypto currency that can be used dependably without the need of management of government or central bank; because of the excitement from discovery, and also some people’s distrust of the fiat money system, for example, printing money when needed, as well as concern on efficiency and accuracy of electronic payments mostly done by financial institutions. In 2008, in time with the financial crisis, the peak of people’s disbelief of the centralized currency system and the disappointment of financial institutions, a pseudonymous brain trust called Satoshi Nakamoto published a white paper that explains their solution to the currency problem, with Bitcoin. Nakamoto wrote “Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes…. What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.

For whatever reason Nakamoto found the current system of monetary transfer via financial institutions or PayPal insufficient in that they could not ensure that payment between parties was not reversible. Part of this appears to be motivated by the global standard of ‘Know Your Customer” or KYC which entrusts to intermediaries (e.g. banks) the global obligation to ensure that the banks are not being used for purposes of money laundering, terrorism, or other illegal activities. Under KYC a bank can refuse to complete a transaction if it believes that the transaction involves illegal activity and in some cases are obligated to notify law enforcement. These arguments are purely libertarian with little economic value beyond the opportunity costs of having to provide more details about self or organization under KYC or having monies intercepted and confiscated under various legal statutes related to money laundering, drug trafficking and terrorism etc.

Perhaps the most celebrated case justifying Nakamoto’s cryptocurrency was PayPal’s refusal to process donation to Julian Assange’s whistleblowing organization Wikileaks because of what PayPal believed to be participating in illegal activities.  Ironically, Assange was a member of a group in the 1990s called the cypherpunks – a group that distained most government regulations and discussed via a mailing list the ability to achieve privacy and libertarian ideals by using cryptography.  In 1998, another member of the cypherpunks, Wei Dai, proposed b-money, a digital, distributed, anonymous currency that would allow “untraceable pseudonymous entities to cooperate with each other more efficiently, by providing them with a medium of exchange….”. Thus, what Nakamoto was talking about was not ‘currency’ in the normal use of the term, but a means to evolve a platform for irreversible transactions. Nakamoto figured out how to implement the currency using encryption and blockchain and released software to make it work.

  • 1.2.2.Bitcoin Market Mechanism

The electronic coin is a chain of digital signatures. According to Wikipedia, a digital signature is a mathematical scheme for demonstrating the authenticity of digital messages or documents. A valid digital signature gives a recipient reason to believe that the message was created by a known sender (authentication), that the sender cannot deny having sent the message (non-repudiation), and that the message was not altered in transit (integrity). One of the bigger problems faced was the double-spending issue in which the recipient of a bitcoin has to be guaranteed that the coin was not simultaneously sent to another recipient at the same time. This is the equivalent to writing two checks each for $100 with only $100 available in an account. The first check cashed is covered, while the second is rejected. To solve this problem was development of a timestamp which keeps track of each coin at each instant in time. The encryption includes the current timestamp and all previous time stamps linked in what is referred to as a blockchain. The longer that a coin has been represented in a blockchain the more difficult it would be to double-count, sabotage or steal the coin because in order to alter its history, including ownership, the attacker would have to recreate a block and all blocks that follow it, requiring immense computing power to overtake the natural block construction.

The network requires a particular algorithm to work. Nakamoto’s algorithm is:

  • New transactions are broadcast to all nodes.
  • Each node collects new transactions into a block.
  • Each node works on finding a difficult proof-of-work for its block.
  • When a node finds a proof-of-work (i.e. digital validation), it broadcasts the block to all nodes.
  • Nodes accept the block only if all transactions in it are valid and not already spent.
  • Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash (digital signature) of the accepted block as the previous hash.

This is already too technical, but the important point is that bitcoin, once created, enter a labyrinth of linked computers and networks which allow for anonymous and irreversible transactions on a peer to peer basis, outside of the functional economy. The only records of an individual would be either an initial money transfer to cryptocurrency exchange to purchase bitcoin (or any other coin) or a cash out transaction to convert cryptocurrency into fiat currency. Beyond that the coin enters the owner’s ‘wallet’ as cryptocurrency, where the owner’s identity is also encrypted so that transactions themselves are public, but the owners are anonymous. With further development and concerns, now only the trading in the private wallet setting is not identified, and trading on some crypto exchanges would have to register with real identity under the pressure from the regulation. Thus, the only way that authorities can affect the use of cryptocurrency for legitimate purposes would be through a regulated market.

Basically, Nakamoto proposed a system that seemed to secure financial transactions without the authority of a central bank or process of large financial institutions. The system distributed the task of verifying transactions across a whole network of computers, and the way to discover, confirm and store transaction in a block is conducted by crypto mining, this idea can be referred to the core of aforementioned technology, Blockchain.

Summarize to be more briefly: Bitcoin is a digital, decentralized, partially anonymous currency, not backed by any government or other legal entity, and not redeemable for gold or other commodity. It relies on peer-to-peer networking and cryptography to maintain its integrity. Fundamentally, bitcoin is a secure system for storing and exchanging money anonymously on the internet. It works like untraceable money, a safety-deposit box without a bank, or a tradable financial asset like a stock or bond. But each of these above metaphors has limitations, as bitcoin has incredible price volatility, which complicates transactions and undermines the safety-deposit-box approach; and, unlike the stock, bond or commodity futures, where valuations are based at least theoretically on expectations of future company value, redeemable value, or consumption value, there is no “fundamental” basis of speculative value for bitcoin. Many academic research, professional studies and media discussions try to compare Bitcoin with stock, gold and currency but couldn’t really find a finite definition for it yet; we will cover the categorization of Bitcoin in later section more in depth.

  • 1.2.3.Supply of Bitcoin


Figure 4. Bitcoin Supply Released and Projected

The accumulation of bitcoins is another important issue. The system managers, whoever they are, made a determination that coins will be issued according to a specific schedule so that by 2040 there are no more than 21 million coins available. Currently there are (March 19th, 2019) 17,599,000 coins in circulation.  Once the 21 million mark is hit the supply will be perfectly inelastic at a fixed point so that any increase in demand via a demand shift will clear the market at a higher price and any decrease in demand will clear the market at lower price. Compare this to open market operations of a central bank which can increase and decrease money supply as needed in order to maintain exchange. That is an increase in the demand for money, signaled by an increase in interest rates for example, can be offset by an increase in supply. Credit facilities will become more inelastic as market risks increase dampening the demand for credit and money, with elasticity returning as risk diminishes. The central bank will moderate inflation and economic growth through these credit markets by reducing supply at the federal reserve discount window, reducing or increasing the money supply, or through moral suasion and other methods to get money into circulation or out of circulation. Cryptocurrencies have no such moderating impact. When bitcoin hits 21 million coins the supply of bitcoin will neither increase nor decrease.

The method by which cryptocurrency enters the market is through a network of miners. These miners are not bankers but computer programmers who will set up networks to evolve the blockchain. Bitcoin enters the market according to a scheduled geometric decay so that the amount of coin entering the market in one year will be less than the previous, and more than the next, almost on a double-declining balance (reduced by half in each year). Technically the 21 million will never be reached but will be close enough by 2040 to satisfy fulfilment. Once issued they cannot be recalled, and nothing as of yet can affect the rate at which they are released. Nonetheless, if the cumulative demand for bitcoin increases at a rate greater than its declining entry into the cybermarket the price will naturally increase at an increasing rate providing the first ingredient for a bubble. But this is a structural characteristic, not an emotional one. Emotion simply accelerates the process.

This has given rise to a flurry of new currencies that compete with bitcoin, so in effect the supply of cryptocurrency will actually be increasing. Bitcoin, ripple, dodgecoin, ethereum, litecoin and hundreds more have been issued. So, while the overall supply of a particular coin such as bitcoin may be limited, the total supply and market capitalization of cryptocurrency will forever be increasing, but never decreasing.

  • 1.2.4.Cryptocurrency at a glance

Cryptocurrencies are an area of heightened technological, pecuniary, and investment interest. A cryptocurrency can be thought of as a digital asset that is constructed to function as a medium of exchange, premised on the technology of cryptography, to secure the transactional flow, as well as to control the creation of additional units of the currency. There is a plethora of cryptocurrencies worldwide, including Bitcoin, Ethereum, XRP, EOS, Stellar, Litecoin, Tether, Cardano and 2000 others. The innovativeness, mystery, volatility, and popularity of cryptocurrencies motivated many researchers, including us to study it further, especially the economics of it.

  • 1.3. Cryptocurrency industry development

Before 2010, the use of cryptocurrency was only among geeks. At the early time geeks who were running mining codes with a normal personal computer could mine a lot of cryptocurrencies. Geeks use these cryptocurrencies as a kind of reward points from mining and give others for free. On May 22nd, 2010, the first historical record of transaction between cryptocurrency and real economy finally took place. Laszlo Hanyecz, a Florida engineer, used 10,000 bitcoins to buy two pizzas from Papa John’s. Since then, May 22nd is considered as “bitcoin pizza day” among the crypto community. Although Bitcoin worthen almost nothing during that time when transaction was made, the importance was Bitcoin’s milestone in achieving conduct physical transaction for the first time in history, which showcased the world that Bitcoin does have medium of exchange function in the real world.

As more and more people become aware and accept Bitcoin, its medium of exchange function was beginning to be recognized. Hackers and criminals are undoubtedly the most sensitive group of people, who perceive the transnationality and anonymity of cryptocurrency. These people began to use Bitcoin as a payment tool on the dark web. The most famous dark web was launched in February 2011: Silkroad, an online black market and the first modern darknet market, best known as a platform for selling illegal drugs. FBI investigated, shutdown and charged Silkroad and its related activities. However, despite this reinforcement, various dark webs still exist, and the cryptocurrency represented by Bitcoin is still the main payment method on the dark web. In addition to the dark web, the mainstream society has gradually begun to accept cryptocurrency. In 2016, Japan recognized Bitcoin as a legal payment method and became the most supportive country for cryptocurrency in the world. In the United States, there are many large multinational companies such as Microsoft, Overstock, CheapAir and Gyft among many other firms also started accepting bitcoin payments. The increase in users, coupled with the influx of speculators and investors, has pushed up the price of Bitcoin: In Feb. 2011, it broke through 1 US dollar. In 2013, it broke through 100 US dollars and 1000 US dollars. By 2017, it reached an all-time high of 19,343 US dollars. Then in 2018, bitcoin prices fell in a cliff-like manner, falling to $3,860 by the end of 2018, causing speculators to suffer heavy losses, which resulted many participants returned to rationality.


Figure 5. BitCoin Daily Price History in USD 2011-2019 (in Level) Bloomberg Data Source


Figure 6. BitCoin Daily Price History in USD 2011-2019 (in Natural Log % Change) Bloomberg Data Source

The number of people participating in cryptocurrency has decreased, but the institutional participation has increased. For example, in early 2019, Facebook wanted to issue cryptocurrency; Singapore National Investment Corporation started to participate in Coinbase, or ICE, NYSE’s parent company established BAKKT exchange. These traditional financial and Internet companies will firmly advance the cryptocurrency market at this current low point of crypto market. As institutions with big brand and good reputation entering the crypto market, it is hopeful and exciting for its future development. In the below charts we will find the interests on Bitcoin among different industry sectors and across various age groups, based on google search and their related analytics. We can see the financial and software sector, and younger age groups are definitely dominating.


Figure 7. Bitcoin Community Interests by Sectors (Coin Dance Web)


Figure 8. Bitcoin Interest by Age (Coin Dance Web)

The stars/protagonists in the cryptocurrency world are constantly changing. Bitcoin is a star in the early days; though Ethereum that has smart contracts nature is faster, more functional, thus it became the protagonist of the market in 2017. With the help of Ethereum, ICO has become a fast-track for new crypto currency’s issuance and financing. ICO is essentially unregulated securities that are issued under the token or coin. So many ICOs have been blown out in 2017-2018, replacing the traditional VC fund raising. However, because ICO is unregulated, it may contain a lot of frauds. Regulators in most countries have taken actions, requiring ICO to be included in the existing securities system, especially the U.S. Securities and Exchange Commission, which requires the issuance of Tokens to be issued in an alternative trading system, and is called STO. The ICO boom gradually receded in 2018. Ethereum also lost its aura as the ICO’s mania faded away fade.

Another group of cryptocurrency protagonist stepped onto the stage: Stable Coins. Before Stable Coin, there were two biggest problems with cryptocurrency trading. The first was its excessive volatility, which made the merchants bear excessive risk when liquidating. At the same time, cryptocurrencies have not yet reached the standards of the financial system because of KYC and AML. Many financial institutions refuse to do business related to cryptocurrency, so cryptocurrency is difficult to convert freely with legal tender. Facing these problems, Stable Coins naturally became the best solution. It is stable in value, usually 1:1 anchored to Fiat Currency. At the same time, Stable Coins’ clearing does not need to go through financial institutions, so there is no need to use external financial institutions to execute the internal circulation of cryptocurrency. Therefore, in 2018, Stable Coins became the most active and most popular cryptocurrency in the market, and its market share continued to rise.

Cryptocurrency is undoubtedly innovative, dynamical and fast changing, which presents many new challenges for regulators. Regulators in each country have gone through two phases: first, learning cryptocurrency, mainly to identify the nature of cryptocurrency and discuss whether to regulate the trading, circulation, distribution and sales of cryptocurrencies. Currently the world’s major cryptocurrency countries such as the United States, Japan, South Korea, Hong Kong, Singapore, etc., have completed the first phase. At present, these countries have entered the stage of implementing the supervision rules, mainly through the issuance of licenses and regulatory sandboxes, a mechanism for developing regulation in an experimental environment.

2. Exchange

  • 2.1.The current state of cryptocurrency exchanges

No matter how we define cryptocurrency as currency, asset, commodity or anything else, its price can only be realized at the marketplace of buy and sell, or cryptocurrency exchanges.  Like its counterparts, cryptocurrency exchanges play an essential role in facilitating trading, improving pricing discovery and provide liquidity.  Unlike traditional financial markets, cryptocurrency exchanges are boardless, open 24/7, and have low barriers to entry. However, because of the uniqueness of trading subject, cryptocurrency exchanges demonstrate many distinguished, fascinating and sometimes self-conflicting properties: centralized, unregulated, and nontransparent.

Exchanges were one of the first services to emerge in the cryptocurrency industry. After 2017-2018 exploding growth, there are about 244 cryptocurrency exchanges, trading 2112 coins with 139 Billion USD market as of March 20, 2019. (CoinMarketCap 2019)


Figure 9: Top 10 Cryptocurrency Exchanges (CoinMarketCap 2019)


Figure 10. Bitcoin Holding Volume by Currency
(USDT is a special cryptocurrency called stablecoin, whose is 1:1 pegged to USD)

  • 2.2.The development of crypto exchanges

From 2010-2016, cryptocurrency exchanges first evolve as the gateway between highly-regulated finance world and the wild cyber finance space. Most users buy first cryptocurrency via exchanges using fiat currency.  Then the user can use the cryptocurrency to purchase goods and services or fund a company (usually a blockchain project), or simply hold it for speculation.  When the user decides to exit, he usually sells at exchange to get fiat currency back.  Exchanges here work as an entrance and exit point, the interface of unregulated cryptocurrency world to real finance world.  Due to its ease of use, anonymous and decentralization, Cryptocurrency is notorious for it being used for cybercrime, money laundry and other illicit activities. The exchange has become a tool/place to breed crime, so the regulator is highly vigilant against the exchanges. Only a few countries have officially issued cryptocurrency licenses (e.g. Japan and South Korea, Thailand), most of them are still studying how to supervise, and a few countries even prohibit the whole exchanges business. (e.g. China). The regulator imposes tough AML and KYC rules on banks and payment companies who provides financial services to the exchanges, which leads to a fact that only a few financial institutions (normal small regional banks) are willing to take the risk to provide service for cryptocurrency exchange.

Since 2017, as Bitcoin prices began to skyrocket, a large number of coins are emerging as the result of booming ICO (Initial Coin Offering) activities, ways to raise capital usually via popular cryptocurrency through issuing then trading new coins in exchanges. Different from the previous format of interchanging between Fiat currency and digital coins, the new emerging period are primarily interchange from coin to coin. The coin to coin trading volume increase substantially to 66% of total trading volume in 2018 (Diar 2018).  The coin to coin trades between current cryptocurrency holders and does not involve fiat currency, therefore it is free of regulation. Binance, Huobi, Okex and Bifinex grow to be the top global top exchanges by volume and only provide coin to coin trading, partially because they try to avoid high complaint cost associated with fiat trading.

A notable feature of the cryptocurrency exchanges is unregulated and lack of transparency. There is no universally unified regulatory policy, most countries are still observing, exploring and analyzing. Most of them are waiting for the US regulatory to take place so they can follow the action. According to the four major characteristics of the cryptocurrencies, current US regulation discoveries are mainly categorized into four parts: 1) currency under FinCEN, consider cryptocurrency as a currency, exchange is the administrator of the currency transaction, so it needs to apply for Money Service Business under FinCEN’s regulations, specifically, a money transmitter.   2) Property under IRS, IRS considers cryptocurrency as a property under tax code so any gains from transaction need to pay property tax.  Therefore, the exchange is required to provide to IRS the taxpayers’ transaction information. On 29/11/2017 Coinbase was ordered by court to report 14,355 users to the IRS.  3) Commodity under CFTC, Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities, therefore, any derivatives trading platform fall under CFTC jurisdiction. CFTC already approve CMT and COBE to list bitcoin futures. 4) Security under SEC, Virtual coins or tokens may be securities and subject to the federal securities laws. In 2018, the US Securities and Exchange Commission maintained that “if a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration”.

  • 2.3.Regulation on crypto exchanges

Exchanges are also very contradictory about regulations in their thinking. On the one hand, exchanges want to be regulated as a compliant exchange, so they can connect to finance world using financial services such as banking, payment, and hope can innovate more cryptocurrency products and services to gratify more people. On the other hand, most of the current exchanges are operated and managed by non-financial professional teams, and thus their practices maybe irregular and unprofessional, might include false reporting of exaggerated transaction data on purpose, market manipulation, front run trading, etc. that violate with existing financial regulatory rules. Therefore, if an exchange becomes compliant and regulated, it will lose a large number of existing sources of income. In reality, we saw an interesting phenomenon: some exchanges turned to purely unregulated currency transactions, particularly coin to coin interchange.

In fact, the main income sources of major top-ranking exchanges are from unregulated currency transactions. Some exchanges registered themselves in a country or location without or relatively easy on regulatory supervision. For example, the top three exchanges are compelled to relocate out of China including: Binance exchange first moved to Japan, then Hong Kong, and finally registered in Malta; the registration of Huobi moved from China to Singapore; and OKEX was forced to move to Hong Kong from China. These exchanges conduct this type of movement in order to circumvent regulation and possible prosecution. Some exchanges adhering to compliance and legal operations, are very limited in the types of transactions offered, and at the same time undertake huge compliance tasks. For instance, the famous American Fiat exchange, Coinbase, is registered in California, and obtained trading licenses for many states in the United States are regulated by the corresponding states, and its transaction volume is only ranked about 20 in the world. The only types of transactions Coinbase offered are between 5 cryptocurrencies and the US dollar in 2018, which is in obvious disadvantage when comparing to many other exchanges who provide 300 types of trading pairs. Apparently exchanges alike Coinbase are in advantage as aligning with compliance, because investors and institutions are more assured. There are also some exchanges, for example, Localbitcoin, that only operate OTC business, transferring the tasks of compliance, such as Know Your Customer (KYC) and Anti Money Laundering (AML) to traders and users.

The unregulated business part of exchanges has low barriers of entry: a website and an order book matching system can let an exchange run its basic functions. Therefore, there are 220 reported exchanges running globally according to Coinmarketcap. But the cryptocurrency exchange is a type of business that “the winner takes all”. Although there are so many exchanges, there are only a few dozens of them can stand out of the crowd and have real large trading volume, because it is quite challenging to run a successful exchange. Among 220 exchanges, top 10% of exchanges own 45% of total daily volume worldwide. The volume of these transactions, especially of reported from those small exchanges, is unreliable, ie, exchanges using wash trade method boost up the trading volume. There was a report on web source calculating 2/3 of the trading volume shown on Coinmarketcap are exaggerated (Exchange Rankings 2018). The report also indicates that most of the fictitious trades are fabricated by exchanges that are out of top 20th range. If this is true, in fact, then the proportion of the top 10% exchanges trading volume can reach 75% of the world’s total. The monopoly power is quite noticeable in this crowded play.

  • 2.4.Safety of crypto exchanges

Safety is the first challenge. Cryptocurrency is a string of 0,1 digits, most people place these numbers in the exchange’s wallet, and a small part is transferred to their private digital wallet. So, the exchange’s wallet is a fortune treasury house, unsurprisingly becomes a hacker’s natural target. The high return to risk ratio of stealing the exchange’s cryptocurrency is too tempting: as cryptocurrency is high in value, semi-anonymous, difficult to track, irreversible in transactions, and lack of legal protection. Nowadays the way hackers stealing the exchange’s cryptocurrency has developed from lone ranger to grouped organized crime. Hackers’ stealing events have become normalized attack attempts rather than sporadic events. There has been a total of 30 public hacking events towards exchange in history. The most famous of which was hacking to Mt.Gox, the world’s largest exchange at that time. In February of 2014, Mt.Gox was invaded and lost $357 million equivalent cryptocurrency, resulting in Mt.Gox collapse and bankrupt soon after. This is still not yet the highest loss. In January of 2018, the Coincheck exchange was hacked and lost $496 million equivalent cryptocurrency. Coincidentally, both exchanges are based in Japan. But in fact, the number of hacking events to exchanges are more than what publicly is reported, as exchanges try all means to not disclose this type of negative information that will potentially hurt their reputation. Safety is so important that any taint can cause user concern and affect the business. This is the drawback of exchanges being unregulated. Users and the public can only know what the exchange wants to let everyone know, the imperfect information is quite a concern to many degrees.

In order not to lose assets due to hacking intrusion, large exchanges spend huge amounts of money each year competing against hackers in security. But there is a relatively simple way to prevent intrusion, called Cold wallet. Cold wallet is a type of wallet that stores cryptocurrency physically and completely isolated from the network, compared to hot wallet which is connected to network. Cold wallet method ensures that hackers cannot invade through the network. The drawback is the efficiency deterioration. When the exchange deposits or withdraws cryptocurrency to or from cold wallet, it requires significant more time than to or from hot wallet. This is a Balance need to be delicately kept between safety and efficiency. Most exchanges have about 60-90% cryptocurrencies stored in cold wallets, and the rest are placed on hot wallets to meet daily transaction requirement. Of course, the proportion has been constantly changing according to the operational requirement. Even if the cold wallet is completely disconnected from the network, it is not completely foolproof. In the end of 2017, the CEO of a UK-registered exchange was kidnapped in Ukraine and released after paying one-million-dollar equivalent of bitcoin. (Williams-Grut 2017). Cryptocurrency has been used by criminals for money laundering and other criminal tools, and even people engaged in cryptocurrency has become a target of kidnapping. Engaging in this profession has become high-risk. This partly explains that, except volume and price these types of trading information, the exchange rarely reveals too much information about the organization’s management address and team members. There are a large number of exchanges, even top-ranking exchanges, where users are unable to know their real office location and management team. This peculiar phenomenon can only be seen in the cryptocurrency world.

Like any other exchanges, liquidity and product diversity are two other success factors. At present, the cryptocurrency market is smaller than the traditional financial market, with a relatively smaller market capitalization and less participants. Therefore, transaction liquidity is another key to attract users. The biggest problem facing new or small exchanges is the lack of liquidity, the inability for users to trade in time without high cost. The products diversity of an exchange is for enabling users to trade the desired coin on an exchange with convenience. Therefore, in addition to provide several popular ones like BTC, ETH, Litecoin, etc., the exchange also needs to constantly add new currencies with good potential onto the market.

  • 2.5.The comparison with traditional financial exchanges

The larger and more experienced exchanges, with their accumulated brand benefits, clearly have advantages over small exchanges in safety, liquidity and product diversity, and are more likely to attract new users and expand businesses, which in turn allows the big exchanges to enhance their leading position. The income sources of the big exchanges include 0.1% on average transaction fee and coin listing fees, and investment income. The Coin listing fee is the fee required to be listed on the exchange for a new cryptocurrency to ICO. Big exchanges have the advantage of all traffic portals, so the new cryptocurrency will strive their ways to list on well-known exchanges, therefore the listing fee has also risen with the competition. The individual coin listing fee for being added to the well-known exchanges once exceeded $1 million during the ICO zest mania. The investment income of exchanges is the return profits from their investment in the business: investment in the upstream of the cryptocurrency industry, such as mining industry; or downstream like cryptocurrency applications. The high transaction volume along with its transaction fee, the lucrative listing fees and the booming return from the investment made an exchange very profitable business. Taking the number one exchange Binance as an example, Binance was founded with less than 200 employees in July 2017. Though in the second quarter of its establishment, which is October to December of 2017, the profit was as high as 200 million US dollars. In comparison, in the first quarter of 2018, Deutsche Bank, Germany’s biggest bank and one of Europe’s leading financial institutions, recorded a profit of $146 million (Young 2018).

The exchange who is established first, which expands freely in the unregulated digital world. The exchange not only provides the exchange’s business, but also deals with trading rules and rating services. Also providing digital wallet deposits, cryptocurrency investments, cryptocurrency investment banks and securities firms, and a series of financial derivative services, becoming the financial hub of the digital world, has become a giant and established its own set of ecosystems, becoming the top of the food chain in the cryptocurrency field, the most influential players in this industry.

Ironically, as a decentralized cryptocurrency that provides trading exchanges, it is highly concentrated and dominating. The drawback in the exchange has absolute dominance in terms of the project side and the investor. without supervision, it easily produces monopoly and unfair market operations. At the same time, centralized exchanges have the potential risk that could be hacked. In view of this, many entrepreneurs and technicians have been trying to provide decentralized exchange (such as Paradex, which was aquired by coinbase May 2018). However, under the current state of the art, decentralized exchanges are not very successful, they are executing transactions. And the speed of liquidation, as well as liquidity and products, are far from meeting the needs of trading customers, and it takes a long time to develop.

Centralized transactions have such high returns, and their special status. Many traditional exchanges are also eager to enter the cryptocurrency exchange industry. Of course, to enter this industry, compliance and regulation are the biggest hurdles for traditional institutions. In 2017, one of the most eye-catching events in the cryptocurrency space is that the US CFTC’s approval about introduction of bitcoin futures transactions by CME and COBE. This is a huge recognition of Bitcoin, simultaneously provides a very powerful investment instrument for traditional institutional client investment management of bitcoin investments. NASDQ is also preparing to launch bitcoin derivatives trading at the end of 2018.

  • 2.6.Economic research on crypto exchanges

Because of the core position of the exchange in the field of cryptocurrency, the exchange has become an important research object in the study of cryptocurrency, unfortunately, the current academic research on the exchange is very limited, mainly limited to legal compliance, security technology, operational and organizational structure. These are obviously interesting topics of the exchange, but we are interested in economic and financial aspects, there are few academic studies in this area. The only valuable information is about Morton (2015) research price discovery on bitcoin exchange and Provide a way to study how exchange impact price and the price discovery during a shock.

The future economic research on exchanges might cover the following areas:

1. Cross Exchange price arbitrage: In theory, the exchange is globally borderless, it can instantly trade anywhere by using network. Therefore, the same currency on each exchange should be equivalent based on theory. However, in reality, the same currency has a small price difference between each exchange, which creates a new profitable business, and some professional traders specifically earn cross-platform spreads. It is worth to research the development of these differentials and the impact on pricing.

2.The cryptocurrency Derivative exchange’s impact on the industry. CME and COBE’s bitcoin futures have a significant impact on the industry. But this is just the start. Many traditional exchanges, such as NASDAQ. And cryptocurrency exchanges, such as OKEX, HUOBI, BIXMEX, they are all starting launch derivatives trading. NYSE Parent ICE to Launch Bitcoin Swaps, if these derivatives exchange will be the same as other assets’ derivatives trades, which can help price discovery, reduce price volatility, provide good hedging, or increase speculation into the market?

3.Exchange’s StableCoin: StableCoin is a type of cryptocurrency that is anchored to fiat currency to fix the price via either fiat or cryptocurrency or bond collaboration. Stablecoin acts like USD in crypto world, become the fundamental currency and connection between real and crypto world. Stablecoin is of great demand due to the fact that cryptocurrencies are all very volatile and connection to fiat currency faces tremendous compliance hurdle. Bitfinex’s USDT (or Tether), which has issued more than $2.7 bn and claimto peg USDT 1:1 to USD by read USD in bank accounts, although unverified, is by far the most popular stablecoin, actively trading in almost all exchanges. Couple stablecoins are on the pipeline.  One of them is USDC, peg 1:1 to USD as well and issued by Circle, who investor includes Goldman Sachs, Baidu and China International Capital Corporation and bitman, the largest bitcoin hardware mining producer.  The other is TUSD, pegging 1:1 to USD as well and issued by TrustToken, whose investor includes 10 famous VC including Andreessen Horowitz.  The completion between stablecoins is getting fierce.  What makes any stablecoin successful?  How stablecoins can impact the industry and the monetary policy?

3. Pricing, Bubble and Sentiment

  • 3.1.Overall Introduction and Illustration of Pricing

The rise of Bitcoin and derivative coins and tokens as part of a Fiat-free globalist electronic currency has many economists scratching their heads. For what appears to be the first time in history individuals and institutions are actively trading an ‘asset’ that has seemingly no discernable fundamental value. The many platforms to trade and exchange have led to a carnivalistic, wild-west, a euphoric orgy of speculative delight, which  a group of researchers consider like the gold rushes of the 19th century, or tulip bulbs in the 17th century, or emu in the 20th century, a big bird that was advertised has premium meat. Business news is evenly split between the bears who believe that bitcoin and cryptocurrency will nigh collapse the economy, while the bulls, locking horns in collective solidarity, spin the orgy into stardust. The useless part comes with the misunderstanding that cryptocurrency has properties identical to any other financial asset.

Cryptocurrency is an asset in its own classes. Currencies are invented by individuals, computers and CPU, but it is the Irreversibility of supply that distinguishes bitcoin from all others. Commodities respond in elasticity to supply and demand, conventional currencies can expand or contract as needed to support government policy objectives, stocks can be issued or repurchased as the situation warrants. But there is no mechanism to reduce the supply of cryptocurrencies as economic conditions might warrant. On top of this, commodities, stocks, and conventional currency are ground to some tangible fundamental value whereas it is not clear at all what the fundamental basis of cryptocurrency is since for the vast majority of purchases beyond the deep web can be purchased in cash, credit card, debit card, PayPal, or mobile transfers. Without any fundamental grounding in the real economy, cryptocurrency price fluctuations are ubiquitously determined by human emotion, with a design that exacerbates volatility and guarantees a structural bubble with any increase in demand. With the underlying releasing structure of Bitcoin, it has designed be having a total 21 million available to be mined at a decreasing rate until all the coins are mined. In fact, as will be illustrated here the only circumstance in which the price of Bitcoin or other cryptocurrencies can sustain a stable price is if the rate at which demand increases, actually decreases with increased scarcity – an economic outcome that defies direct observation and any axiom of economics known to man.

  • 3.2.Pricing, Sentiment Analysis & Bubble

Pricing comes as a natural question when something is categorized in finance domain, no exception to bitcoin and actually very much so. Especially seeing the enormous price movements, the argument of questioning Bitcoin a bubble has been raised and discussed. A unique phenomenon is that the more far-sighted authoritative people in the financial world, the less optimistic they are about bitcoin. They think bitcoin is just speculative bubble or a fraud, economists are especially in this category.

Many famous economists including several Nobel Prize laureates have expressed their opinions in public: Dr. Robert Shiller was calling Bitcoin a bubble, on a CNBC interview in April 2018 he said: “To me, it’s interesting as another example of faddish human behavior. It’s glamorous. It reminds me of the Tulip mania in Holland in the 1640s”. Another Nobel Prize-winning economist Joseph Stiglitz says bitcoin serves no useful function – other than circumventing legality, who has called on bitcoin to be outlawed (Business insider 2018). Shiller and Stiglitz are not alone, another Nobel Economics Prize winner Paul Krugman said “[bitcoin] looks like a pure bubble” (paulkrugman twitter 2018).

Industry and Politics Leaders are more diverse in thinking about bitcoin. Particularly, we see business leaders in technology industry is more welcoming bitcoin. Co-founder of Microsoft, Bill Gates said “[Bitcoin] is a technological tour de force.” Executive Chairman of Google Eric Schmidt discussed “[Bitcoin] is a remarkable cryptographic achievement. It is not a speculative investment even though it is being used as such by other people.” Founder of the software and anti-virus company McAfee Associates John McAfee even made price prediction saying, “In the long-term Bitcoin moves above $500,000 within three years”.

However, on the opposite, most Finance industry leaders do not like bitcoin. JPMorgan Chase’s CEO Jamie Dimon’s commented on Bitcoin in 2017 saying “It’s a fraud” and “worse than tulip bulbs.” Though later in February Berkshire Hathaway’s CEO Warren Buffett told CNBC the cryptocurrency will “come to a bad ending.” Former partner of George Soros of Quantum Fund legendary Investor Jim Rogers, “It looks and smells like all the bubbles I have seen throughout history.” CEO of Goldman Sachs, Lloyd Blankfein held neutral attitude in October 2017, posted on his twitter: “Still thinking about #Bitcoin. No conclusion – not endorsing/rejecting.” Yet, among the major financial business leaders, there’s still someone in favor about Bitcoin: CEO of Morgan Stanley, James Gorman said “[Bitcoin is] certainly something more than just a fad.”

Political Leaders do not agree on how to think and treat bitcoin. On Feb 27, 2014, the U.S. Federal Reserve Chairwoman Janet Yellen at the time said, “The Federal Reserve simply does not have authority to supervise or regulate bitcoin in any way”. On June 29, 2015, the Managing Director for Monetary Authority of Singapore, Ravi Menon said “[Bitcoin is] Potentially transformative”. Ben Bernanke, former chairman of US Federal Reserve mentioned on Nov. 19, 2015 saying, “Bitcoin has serious problems”. Haruhiko Kuroda, governor for the Bank of Japan commented on Aug. 23, 2016 saying “[Bitcoin] may have the potential of significantly changing the structure of financial services”. International Monetary Fund’s Managing director, Christine Lagarde said on Sept. 28, 2017, “I think it may not be wise to dismiss virtual currencies.”

There has also been an increasing number of studies in the academic world about the pricing of cryptocurrencies and the existence of bubbles. The debate of whether there exists a bubble is rather mild as people do commonly see it, and the extent of the bubble and the intrinsic value of Bitcoin was more controversial. Some researchers have tried to analyze the price of bitcoin from the traditional supply and demand relationship, some study from the perspective of production cost, and others use the sentimental analysis in behavioral finance to study the price of bitcoin.

  • 3.2.1.Pricing

The earliest study from the supply and demand relationship approach of bitcoin prices is Buchholz et al. (2012), who find that Bitcoin price movements to a large extend, can be explained by interactions between its supply and demand. However, from the perspective of supply demand, the supply of bitcoin is fixed: not only the total number is fixed, but it will all be release by 2040, and the frequency of releasing is also preset. Since there is no dynamic adjustment of supply, the change in demand is directly reflected in the price change. This is also the unique supply demand relationship of Bitcoin, which causes the high volatility of its price.

Bitcoin demand is mainly in sources of exchanging and speculation. Koutmos (2018) focus on the transaction demand for bitcoin by utilizing bivariate vector autoregression (VAR) models to show the strong linkages between Bitcoin returns and transaction activity. He believes bitcoin price is not determined by the economic fundamental but the transaction activities, which can be proxy by the number of bitcoins transaction and unique addresses.  He considers bitcoin’s economic value comes from being as a medium of exchange, which having the network effect, i.e, the more bitcoin being used, the more valuable it becomes. The paper also shows returns quantitatively explain more of the variation in transaction activity than vice versa.

Ciaian et al(2016) integrated previous methods of studying the formation of bitcoin prices, using 2009-2015’s bitcoin daily time-serial data to assess the three determinants of bitcoin price formation:  1) supply and demand; 2) attractiveness or speculation; 3) global macroeconomics and financial development.  The results show supply and demand play an important role while hypothesis that speculative behavior impact short and long run price cannot be rejected.  The macro factor impact on bitcoin price is not supported in the test.

Kristoufek (2015) utilize continuous wavelet analysis, specifically wavelet coherence, to identify the possible sources of bitcoin price movement ranging from fundamental economic sources to speculative and technical sources.  The paper conclude that the Bitcoin price behaves according to the quantity theory of money in the long run, but it is prone to bubbles and busts in the short run. However, the transaction aspect of the Bitcoin value seems to be losing its weight in time.

Different from other people’s research in the direction of supply and demand, Hayes (2016) suggests that Bitcoin does indeed have a quantifiable intrinsic value and formalizes a pricing model based on its marginal cost of production mainly considering mining supply and market demand. This article uses the marginal cost of production model to propose the value of Bitcoin and back-test the historical data (Hayes 2018). The model shows that the market price of Bitcoin tends to fluctuate around the model price, and with the model price explaining the market price in a statistically significant manner, challenging recent allegations that Bitcoins are essentially worthless. Even with markets pricing Bitcoin in the thousands of dollars each, the valuation model seems robust. The data show that a price bubble that began in the Fall of 2017 resolved itself in early 2018, converging with the marginal cost model.

The research done by Wheatley et al (2018) on predictability of bitcoin uses generalized metcalfe’s law and the Log-periodic Power law Singularity (LPPLS) model to analyze the bubbles, crashes and pricing of bitcoin. This study says that LPPLS model provides an ex-ante warning of market instabilities, quantifying a high crash hazard and probabilistic bracket of the crash time consistent with the actual corrections; although, as always, the precise time and trigger (which straw breaks the camel’s back) being exogenous and unpredictable.

  • 3.2.2.Sentiment analysis

There are still many people who think that bitcoin is more of a hype, an irrational speculative behavior, so it forms a huge bubble, and it can last for a long time. Therefore, many researchers have studied from the direction of behavioral finance, using sentiment analysis largely.

Kristoufek (2013) might be the first researcher to study the relationship between bitcoin price and public mood. In the article, Kristoufek believe the bitcoin market consist practically only of speculative trader with no fundamentalists as there is no fundamental value to the bitcoin.  Using google and Wikipedia search as the proxy of public sentiment, the paper finds positive correlation between these measures and the price of Bitcoins.   Georgoula et al (2015) take a step further by using time-series and sentiment analysis to detect the determinants of bitcoin price.   Instead of using google search and Wikipedia, Georgoula use twitter and Wikipedia as the proxy, through machine learning algorism, to show that public mood does have positive short-term impact on bitcoin price. One interesting finding is that the hash rate (measuring the mining difficulty) have the positive impact on price as well.

Using the same Google trend search queries as proxy for bitcoin attention, Dastgir et al(2018)  employ the  Copula-based Granger Causality in Distribution (CGCD) test to examine the causal relationship between Bitcoin attention and Bitcoin returns for the period from January 1, 2013, to December 31.  The article observes that there exists a bi-directional causal relationship with the exception of the central distributions from 40% to 80%. That is to say, bi-directional causal relationship only exists in extreme performance, either poor or superior.

Karalevicius et al (2017) extend the sentiment analysis by using natural language processing techniques, following by lexicon-based dictionaries (a generic and finance-specific psychosocial dictionaries) to measure the influence of Bitcoin news media on investor sentiment in an attempt to better understand and predict the Bitcoin price. The main findings of this study are that with the expert media, one can predict semi short-term Bitcoin price movements, the market initially overreacts resulting in multiple corrections.

  • 3.2.3Bubble

Since the hype of the bitcoin market, the public and academia have questioned its real value, and some have argued there exists bubble in the crypto market. Some academic research has been emerged to examine the market performance to support their argument of claiming the bubble. Though these studies were approached from different angles to test the claim of bubble, the conclusions were not solidly drawn. Some studies applying well-established methodologies on testing bubble directly. Some studies took the route of analyzing the fundamental value of it, where a portion of those argued little fundamental value was found so the bubble will burst, and price will collapse, others were saying that the values are yet to be determined but won’t entirely collapse.

One of the very early and highly referred academic study on bitcoin bubble conducted by Cheung et al(2015), uses a well-established methodology Phillips-Shi–Yu (2013) with Mt. Gox bitcoin prices to identify and evaluate bubbles. The study found that during the period 2010-2014, there were a number of short-lived bubbles; and most importantly three huge bubbles in the latter part of the period 2011-2013 lasting from 66 days to 106 days, with the last and biggest one being the one being the demise of the Mt Gox exchange. This study naturally enlightens us to wonder what is accumulating the bubble and what is causing the bubble to burst and if there’s structural breaks among the performance.

Thiesa and Molnár (2018) applied Bayesian change point analysis on investigate average return and volatility of the Bitcoin price. The study found structural breaks in average returns and volatility of Bitcoin are very frequent. Based on the structural breaks the study partitions the time series into segments where they find that by merging segments with similar properties into regimes we identify several regimes with positive average returns and one regime with negative average returns. Across regimes, higher volatility is associated with higher average returns, with exception of the most volatile regime, which is the only regime with negative average returns. The time variant pattern of the time series can stimulate further and deeper econometrical examinations.

Besides looking at the time series directly with bubble and structural breaks testing models, understanding the fundamental values of bitcoin has been a desire among the discussion as it is major indicators in evaluating the true value that will almost always hold, to distinguish from the bubble value that may disappear sometime.

Along with structural break, long memory is a close tied topic that can help understand the predictability and bubble of markets. Mensi et al (2018) conducted study on Bitcoin and Ethereum prices to identify the impacts of structural breaks on dual long memory, using four different generalized autoregressive conditional heteroskedasticity models (GARCH, FIGARCH, FIAPARCH, and HYGARCH). They found the persistence level of both returns and volatility decreases after accounting for long memory. In addition, FIGARCH model with structural breaks variables provides a comparatively superior forecasting accuracy performance. These findings help to understand the market behavior that investors may see the opportunity of predictability and long memory in hope of high return. It’s also intuitive that market is in fear of risk and self-correct some time or influenced by some casual events, the structural breaks can imply the bubble that are more related to the non-fundamental part of the price.

There were two main remarkable gain periods for cryptocurrencies especially Bitcoin, in 2013 and 2017 recently. The 2017 one is in much higher magnitude. During 2013 there were already some scholars claiming the bubble of bitcoin, if that was a solid claim, then this much higher growth in 2017 is definitely more of a bubble. Looking back, MacDonell’s (2014) paper commented on the 2013 market gain. The study first uses autoregressive moving average (ARMA) functions to explain trading values and found Bitcoin values react to the CBOE Volatility Index, suggesting that a primary force at the time driving Bitcoin values is speculation by investors looking outside traditional markets rather than any fundamental value. The paper also applies log-periodic power law (LPPL) models in an attempt to predict crashes and see it accurately predict ex-ante the crash that occurred in December 2013. Thus, this study claims LPPL model is a potentially valuable tool for understanding bubble behavior in cryptocurrencies. This inspires our interest in looking further into this model while testing with the newest data.

Fry and Cheah (2016) have been following the cryptocurrencies studies quite intensively and published a series of articles on the topic, here another one talking about the negative bubbles and shocks in cryptocurrency markets. This article says econophysics plays a crucial role in global cryptocurrency, also show the evidence of speculative bubbles in Bitcoin and Ripple as well as the spillover effect among the two markets. This study also shows that negative events’ impacts are in mix where sometime do not only result in negative shock. The event impact is very interesting to study as people may be very interested in predicting a certain event’s effect. In another article, Cheah and Fry (2015) show that Bitcoin price appear to contain substantial speculative component and exhibits speculative bubbles. They use empirical evidence to prove that the fundamental value of Bitcoin is Zero. However, Corbet et al. (2017) claims Bitcoin price would be in bubble phase if it exceeds $1000.

From this above discussion, it’s observable that bubble is in the sense of the face value which exceeds its actual fundamental value. In other words, in order to detect and evaluate bubble we need to understand two pieces of the superficial value of the cryptocurrencies: fundamental value and bubble value, which is the part of the price not supported by fundamental use. However, it might be more feasible to identify fundamental of commodities based on the use, or securities based on companies’ products and services, though it’s much harder to identify the fundamental value of cryptocurrencies, as it’s very controversial topic on seeing intrinsic value of itself versus the technology behind it. Bubbles formed in financial markets could come from irrational investors, claimed by one of the very first academic study on bubble written by John Maynard Keynes (1936). However, study of Brunnermeier & Abreu (2003) argued that bubbles can persist because rational investors rather ride bubbles instead of going short. A bit on the side that as Richard Thaler states that humans are predictably irrational, if we would relate bubble to irrational behavior, the question is even harder to answer. Sentiment trading on cryptocurrencies discussed previously try to address some behavioral thinking that assist our understanding of bubble formation.

There  referring to well-established models of testing bubbles that have been empirically tested in other markets such as real estate and general financial markets. An article done by Weites et al (2010) on comprehensively discussing econometric bubble detection models contains useful insights that we can refer and implement into the evaluation of cryptocurrencies. This article assesses the advantages and shortcomings of existing bubble tests, including Variance Bounds, West’s (1987), Diba & Grossman’s (1988a), Froot & Obstfeld’s (1991), Wu’s (1997), Van Norden’s (1996) and Hall & Solas’ (1993), Phillips, Wu & Yu´s (2007). Weites et al claims that these eight most famous bubble tests all have at least some type of shortcomings. In a more general summary, they conclude these models do not efficiently distinguish between a change in fundamentals and the existence of a bubble, the tests’ results are too sensitive to assumptions imposed by researchers, and do not reveal useful information about the structure of the bubble element. The authors proposed and empirically tested three sets new bubble testing models including Dividends’ Growth Expectation Test, Price/Earnings-ratio Tests and Option Based Tests that have rather indicative detection power though still do not sufficiently help prove the quantitative existence of bubbles.

There’s also extensive discussion about quantitative and qualitative approach of testing bubbles. White (1990, p. 67) expresses certain skeptic about the suitability of quantitative methods when testing for bubbles. In particular, he states that econometric approaches cannot distinguish between an increase of fundamentals and a bubble. And we find the similar pattern in the articles of current literature that tested bubble in cryptocurrencies market, where people find easier to identify if there appears bubble, though much more challenging and ambiguous of defining what certain portion as bubble of its market value or trace the change of fundamental value versus bubble value among time.

4. Categorization and Classification:

Before we get too far on analyzing the properties and characteristics of Bitcoin and related cryptocurrencies, we try to think and explore: should we categorize them as currency, commodity, security or something new and different? This has been an ongoing discussion remained open among academics, businesses and government. This chapter is just about addressing that, we uncover the qualifications and remaining questions of which might be considered in each of these possible categories and conclude with defining it in more of a synthetic setting due to its innovativeness and uniqueness.

  • 4.1.Currency: Medium of Exchange
    • 4.1.1The characteristics and property of currency

Understanding general features of a currency may help we think through whether or not we categorize Bitcoin as a currency with logical comparisons. Currency is a medium of exchange, its existence is solely to avoid the imperfections, asymmetries, inconvenience, and transactions costs associated with barter. Currency is issued by fiat by a governing authority that has the right and obligation to ensure that the currency holds value. This used to be on the basis of gold or silver so that one note of currency could be legally exchanged for a unit of gold or silver or some other commodity that held economic value. The underlying commodity would hold a store of value and would rise and fall in tandem with the demand-to-supply of goods and services. The privateers of old would raid other galleons in the hopes of recovering gold or silver which could then be used to back bond issues, or put more currency into circulation. This worked well so long as the supply of commodities did not bind the amount of currency that could be in circulation, and so most major currencies decided to remove themselves from a gold standard to what essentially became a tax standard; that is the value of the currency would hold its value in trade so long as it was backed by the issuing government. The reasoning behind a national standard currency was that currency issued by individual banks simply did not work. These banks would hold gold or silver in their vaults and issue currency which could, in theory at least, be redeemed for the amount of gold values in the currency. The problem was that the paper currency or coins issued by one bank might not be exchangeable with notes at another bank. A trader in one town would have to exchange paper for gold, carry that gold to another town with a different bank, exchange that gold for local bank notes and then buy the goods in local currency. This was not very practicable.

  • 4.1.2.China’s Example of currency development and possible issues

Take China for example, in China currency through 1949 were not a new problem. About 620 AD in the Tang Dynasty there was the first attempt to standardize coinage by creating a coin with inscribed by Chinese characters with the meaning ‘Kai-yuan’. This set a standard for coinage, but ever since the days of the Mongols, 960-1125, AD paper currency came into vogue. By the turn of the 20th century the currency situation was chaotic. S.R. Wagel, writing in 1889 stated “The subject of Chinese currency demands not a brief paragraph but a comprehensive essay, or rather a volume. These chaotic eccentricities would drive any occidental nation to madness in a single generation or more probably such gigantic evils would speedily work their own cure. In speaking of the disregard for accuracy…100 cash are not 100 and 1000 cash are not 1000 but some other and totally uncertain number, to be ascertained only by experience”.

It is bad enough that a coin count in one region may be totally different in other, but also complicating matters is that coins are minted in terms of copper, silver and gold. Farmers are paid in copper but their purchasing power depends on the exchange with silver, which in turn has a value determined by its exchange with gold. Banks issuing notes might link the notes to silver or gold, so the exchange of copper – the unit of currency most often used for paying wages – could easily change one to the other depending on the spot exchange of copper to silver or copper to gold. So long as copper, gold, and silver were highly correlated the exchange value would be stable. But as the correlations weakened the exchanges became more volatile. A wholesaler purchasing in silver would increase or decrease the copper price to the laborer or farmer depending on the copper to silver price ratio. Even if demand and supply remained reasonably constant retail prices could swing wildly depending on the copper to silver price ratio, and the silver to gold price ratio.

Another example was with the tael, which is a unit of measurement (not a currency although at times currency might be described in tael units) based on a weight of silver of a given fineness representing the standard for all banking and commercial operations. But even the tael might differ by region. In 1923, for example, 1000 Shanghai tael was equivalent to 964.5 Wuhu taels, 965 Suzhou taels, 990 Hankou taels, 960 Nanging taels and so on.

So it is true that in the evolution of transactions there have been multiple iterations in the determination of mediums of exchange and the establishment of currency backed by a governing authority and accepted by people as a convenience in trade. To the developers of bitcoin, a move to a global cryptocurrency is seen simply as part of this evolution.

  • 4.1.3.Cryptocurrency may be appropriate as categorizing to a currency

Based on the discussion above about the main features and historical development example of currency, we may think conceptually there is comparability between Bitcoin and currency. Here below we discuss more in detail how cryptocurrency may be appropriate being considered as currency and also what are some possible questions may raise to conflict the categorization. According to Kaplanov (2012), a currency can be used as a means of trade, a vehicle to store value, or a unit of account in order to compare the value of different goods or services. These three main aspects are also in some degree a summary of above discussion in the historical development and examples. Unit of account is important in defining a currency, though it is already a consensus among industry participants that use bitcoin as a measure of unit of count is not quite feasible because of the high volatility and speculation participation. Rather, stable coins such as USDT (Tether), TUSD, and USDC are established just for this reason, where they are more stable in values that support the view of unit of account, which has been a rising area of advancement in the profession. The unit of account part is for valuing goods and services, record debts, and make calculations, which Bitcoin doesn’t serve as good use, stable coins now emerged solves the problem. Here we mainly focus on these two aspects: means of trade and storage of value.

Talking about the means of trade aspect, we can refer to one popular question asked regarding categorizing Bitcoin to currency is: can it be used to buy and sell, exchange goods and services in its values or accepted in the shops we observe. There are hundreds of businesses that accept Bitcoin, Ethereum, ESO, Litecoin, Dogecoins and other Altcoins including some major firms like, Expedia, eGifter, Microsoft, CheapAir and many others. However, we do observe limitations even within this group of businesses who accept Bitcoin. For instance, in case of Microsoft has many fine prints including restrictions like: you can use your Bitcoin deposit funds in to Microsoft account to purchase games, movies, and apps in the Windows and Xbox stores, though you cannot use these funds to purchase items in the Microsoft online store; deposited Bitcoin in account can’t be refunded; you can’t use deposited Bitcoin to buy gift cards; and other limitations.

In the aspect of storage of value, the theoretical models in explaining the current versus future value are mostly centered around Hull–White model on future interest rates. We don’t go in detail with this model and the importance of this model in identifying the storage of value, though we highlight the importance revealed by the literature in regarding interest as important approach for valuing underlying properties of currency. However, Bitcoin is not in line with the feature of interest rate in contrast to traditional currencies, where central banks provide interest rates and interest rate term structures, derived from bonds with different maturities. Thus the evaluation of the future value and its storage potential is left determined by other methods.

  • 4.1.4.Cryptocurrency may be questioned as categorizing to a currency

One might compare each new coin issue as a sort of fiefdom where the issuers have complete control over the emergent supply and the security of its own currency. But the comparison ends there. The currency in a real fiefdom will adapt and adjust and increase and decrease depending on the domestic production and consumption of tangible goods and services and trade with other fiefdoms. Within each fiefdom the currency responds to GDP and changes in GDP which will generally be optimized according to comparative advantage. But the comparative advantage with bitcoin appears to be no more than the ability to transact faster, form more blockchains – in other words CPU. What the coins actually do that fiat currency cannot is nothing but buying things a bit quicker and with anonymity. Hardly an advantage when most things that can be purchased can be done on line instantaneously with a credit card. The cypherpunks objected to financial charges associated with transactions, but the reality is that cryptocurrency is not transactions free. The exchanges, like any other financial institutions, charge transactions fees. And in the same way that investment bankers negotiate a fee for moving USA government bonds or corporate bonds, the miners that distribute bitcoin are paid in bitcoin. As bitcoin and other cryptocurrencies increased in value then so too did the monetary rewards for pushing more blockchains and assigning greater CPU to the crypto market. As the pace at which a particular coin decreased as in the bitcoin model, then the amount of bitcoin issued would be twice that of the previous year in order to accumulate the same reward. There was every incentive to reproduce the technology and create new coins that would be issued at higher volume and push these into the market.

If the comparative advantage of different cryptocurrencies is solely in security and CPU what about the coin itself. As mentioned, a credit card can be used to purchase virtually anything needed for consumption or travel. Debit cards can access cash almost anywhere and instantaneously. Fees are charged for without the fees there will be no incentive for traditional financial networks to invest in technology and human capital and resources to deploy the convenience. The early adopters were privacy and cryptography enthusiasts, government mistrusting individuals, criminals and speculators. Online merchants included web hosts, online casinos, illicit drug market places, auction sites, technology consulting firms, adult media and sex toy merchants – places and things for which anonymity was valued. Beyond this, the vast majority of consumers have no concerns about the revelation of name, address, and credit card information on modern ecommerce platforms. Using bitcoin to donate to a tax-exempt charity hardly requires anonymity when a tax-receipt is desired, and a credit card or even text message will do.

Even the idea of a borderless currency was flawed. For sure there might be a particular market place, fully closed to the outside world for which bitcoin can be used in exclusive form. But at some point, the coin must be converted to currency, whether that be USD or RMB or Euros. At some point, most likely the start of a value chain where producers might be more atomistic (say farmers or miners) the initial input will be purchased in dollars. Then this has to be converted into some measure or bitcoin. Once a bushel of corn worth $7 is said to be worth X bitcoin then immediately there is an exchange value of $/bitcoin. Suppose a bushel of corn was said to equal .0517 bitcoin then the ratio would be 7/.0517=135.5 $/BTC and that could then stand for all goods, so that a gram of marijuana selling for $10/gram on the street could be sold on the web (e.g Silk Road)  for .073 bitcoin (10$/135.5 $/BTC=10/135.5BTC=.074BTC), or a television worth $1,000 would sell for 7.38 bitcoin. If the crypto market were to operate alongside the regular market the law of one price must hold. So if a television can be acquired in trade for 142.86 bushels of corn, the television in the crypto market must also be exchangeable for the bitcoin equivalent of 142.86 bushels of corn. Of course, it is a bit extreme to link bitcoin to the price of corn, but to the same effect the $ value of bitcoin could be attached to a basket of durable and nondurable goods in the same way a CPI index is tied to a basket of goods. But the basic idea must hold that a 1:1 equivalence on price changes must exist in the real market and the crypto market in order for the two to exist side by side as the cypherpunks imagined.

But that is not what happened. The prices of corn and bitcoin as represented above are as they were in April 2013 when bitcoin first came on line. The current price (1/8/2018) for bitcoin is $16,200. The price for corn is about $3.15/bu. The price for a TV is around $600. So, a bitcoin in April 2013 which could have purchased 19.34 bushels of corn and 13.5% of a high def TV, can today purchase 5,143 bushels of corn or 27 high def televisions, or 221 kg of marijuana. No matter what the ideals of cryptocurrency the purchasing power is always going to be anchored to prices in the real economy and anything different defies not only economic logic but defies the laws of economics, a particularly harsh indictment for a group that rested its laurels on the Austrian model according to liberalism and laissez-faire-economics that economic performance is optimized when there is limited government interference.

  • 4.2.Commodity Gold

The sense that it’s plausible to consider Bitcoin or other cryptocurrencies as commodity, is originating from the concept that the coins are mined from the crypto codes as the process of competing to build the blocks, just like mining gold. Even the profession call programmers who calculate these codes as miners, the financial technology and crypto industry consensually admit mining as a vocation. It’s not surprising how easily find a video that explains cryptocurrency would include cartoon of people mining out the coins from the mountain. This whole concept and environment created the mindset of virtual commodity or sometimes called virtual gold. But whether it should be considered as commodity, is yet determined. Here we discuss some studies done in the literature comparing the characteristics between bitcoin and gold, to reveal some reasons cryptocurrencies may or may not be considered as commodity.

As it may sound abnormal to compare virtual coin with physical commodity that we can see and use, it’s not easy to conclude whether Bitcoin has too much of different market performance compare to gold. According to Dyhrberg (2016), which analyzes the relationship between Bitcoin, gold and the US dollar, the study implies that Bitcoin can be classified as something in between gold and the US dollar. Though a replication and extension study done by Baur et al (2018) which has applied similar methods with more timely data, which states Bitcoin displays distinctively different return, volatility and correlation characteristics compared to other assets including gold and the US dollar. The above two studies that were conducted just 2 years apart using same methods have concluded very different results, can somewhat imply the ambiguousness of Bitcoin’s categorization as gold. Further, another study conducted by Klein et al (2018) further enhanced the position of not too reasonable of categorizing Bitcoin as gold or other commodities.

We can see the three studies above mentioned all comparing cryptocurrencies with commodity, especially gold in terms of their financial performance, as they both appear in the financial market that makes more comparable. It’s probably not hard to make sense of not comparing a crypto coin with a piece of bread, a bushel of corn or a truck of apple, as the former is virtual and the latter is physical. As fundamentally it’s impossible to use cryptocurrencies for direct consumption, unlike even gold is highly financialized we can still see gold to be used for watch, computer chips or any other things provide functions during our daily life. Even though CME Group Inc. (Chicago Mercantile Exchange) & CBOE (Chicago Board of Trade, who stop listing new bitcoin contracts on March 2019 because of low trading volume) are  known to be specialized in commodities trading and have launched Bitcoin futures in December 2017, it is still index based which is still highly financialized product. In spite of the approach to compare Cryptocurrencies with commodities ignoring the physical use aspect, it’s still problematic even if just looking at the financial aspect of commodity.

Dyhrberg (2016) used GARCH and exponential GARCH considering Bitcoin price, currency exchange ratio, gold future and cash prices, and interest rates for analyzing the mean and the also the variance, trying to explain the statistical relationship among time series of cryptocurrencies, gold and dollar. Baur et al’s study (2018) followed the similar approach taking into account the two new years of data that captures the excessive growth in Bitcoin price especially in 2017 and find the extremeness of Bitcoin is far different from gold. Klein et al study (2018) also took the approach of comparing volatility, correlation, portfolio performance and stable hedging capabilities between Bitcoin and gold and find Bitcoin is much more volatile than gold that can hardly draw conclusion to categorize Bitcoin as commodities. Intuitively makes sense, as before 2017 bitcoin is rather stable and statistically comparable with other traded assets, commodities or securities, though with the emotional hype and the high attention peaked since 2017, Bitcoin will not look like anything but itself or other cryptocurrencies.

In this sense we would suggest to re-think the approach of simply comparing the market performance to categorize Bitcoin to commodity. Counterfactually, all financial products are under rather similar macroeconomic environment who would be influenced relatively in parallel trends, it’s probably fair easy to see Dow Jones index is highly correlated (1971-2017 is positive 0.71) to gold but we surely cannot say Dow Jones is commodity. There is much more work needed to be done in order to conclude categorizing crypto currencies to commodities, even in just the financial sense. This would be the same theme among this chapter and the whole article that we aim to comprehensively understand the state of cryptocurrencies and better interpret them with observing them from many angles objectively.

  • 4.3.Investment (Speculative) Asset and Security

In just less than a decade, Bitcoin’s price has hy-rocketed from a penny to $19,535.7 and back to around $4000 nowadays (as of 3/19/2019), its return on investment has dumbfounded many people. 2017, is the golden year of Bitcoin, its price clambered from $1000 at the year beginning, to all time high of $16,000 around the year end. Its annual return on investment in 2017 broke the ceiling of sky and reaches 1500%. The excessive media exposure and propaganda about bitcoin holders become rich, has significantly highlighted the lucrativeness of bitcoin thus attracted many more speculators to enter, although some of them lost big in the following downfall. Making money is the sole reason of many people to buy bitcoins or other currencies. The high volatility of Bitcoin is known as well, it’s not rare to see a double-digit percent price change within a day. Bitcoin price has fallen around 73% from the beginning of 2018 to now. Such high volatility also becomes one of the characteristics that speculators in favor. Many exchanges have introduced Bitcoin futures and other derivatives, hence, taking short positions of derivatives can also be a pathway to become wealthy.

How should we categorize if Bitcoin is an investment or speculative asset? Such topic has aroused many scholars’ interest. Baur et al. (2018) & Burniske (2017) respectively conduced a correlation study about returns on bitcoin and returns on other types of assets including currencies, equity, bond, precious metals and energy products, with result showing they have consistently low correlations between group. In consequence, Bitcoin is actually an appealing investment product to diversify possible financial risks no matter in normal market or market turmoil.


Figure. From ARK Investment Management LLC & Coinbase.

All transaction records are public because Bitcoin itself is a public ledger. From Baur et al. (2018) ’s further study about Bitcoin’s transaction record, reported the results that “about a third of Bitcoins are held by investors, particularly users that only receive Bitcoin and never send to others. A minority of users, both in number and Bitcoin balances, appear to use Bitcoin as a medium of exchange”. Thus, Bitcoin is thought to be closer to investment (speculative) asset. Nothing is perfect, Baur et al. (2018) is lacking sufficient and convincing explanation for the standard of distinction when categorizes user type. In addition, the data they used of 2010-2013 are outdated especially in the high paced crypto world. Therefore, its conclusions are inevitably not strongly convincing.

Coinbase is the largest cryptocurrency exchange in the United States, also the world’s largest trading platform between dollar and crypto currency. Chris (2017) studied Coinbase’s user types in 2012-2016 and found that more than half of the users are investment users who buy and hold bitcoins for more than a year, whereas the rest of the users trade more frequently who are considered as transactional medium. However, the definition of transactional medium in the article might be too arbitrary. Think if trading is high-frequency and short-term speculations, then position holdings may not be long. Though in the definition of Chris (2017), high-frequency and short-term speculators are treated as transactional medium, which bias the estimation of user type in this group.


Figure. From ARK Investment Management LLC & Coinbase.

Florian (2014) analyzes the relationship among bitcoin exchange volume, bitcoin network volume and new bitcoin users, concludes that newly uninformed Bitcoin users treat it as asset rather than currency. The justification is that the new users will open accounts in the exchanges and use fiat currency to buy bitcoin, which can add Bitcoin exchange volume. If users are investors or speculators, they will trade within the exchanges, such transactions won’t increase Bitcoin network volume. If users’ primary purpose is to exchange crypto currency with real world products and services: they will take out the cryptocurrency from the exchange, digital wallet or flash drive depends on where they saved their crypto coins, then buy consumer goods and services, which can increase the Bitcoin network volume. If users’ goal is to invest in crypto coins wishing to see growth, i.e. buy at low and sell at high from time to time either long or short term. Then these trades can be considered as within the circle of the crypto exchange that don’t increase the Bitcoin network volume but do increase the Bitcoin trading volume, thus through this type of use we consider coins as assets. This study’s logic and algorithms are more persuasive than previous academic studies. It’s possible that asset’s property is stronger than currency. That explains what we see from International Monetary Fund’s 2018 second quarter Global Financial Stability Report, calling cryptocurrency as “Crypto asset”.

Many academic scholars think Bitcoin is investment asset, or speculative asset, then another question comes with that is: whether Bitcoin, other Altcoins and cryptocurrencies should be considered as securities or not. Keep in mind that securities is a special type of asset. This question is very crucial for the industry as the regulators need to know if it’s appropriate to use securities laws and regulations to regulate cryptocurrencies. In the consequence, exchanges and cryptocurrency companies wants to know if they should comply with securities laws. If that’s the case, the exchanges and cryptocurrency releasers will be significantly forced to alter their current business model, as they are operating at the model of not being regulated by any type of national securities law. Such issue has been an extraordinarily controversial topic that is still up in the air soaring. Recently, especially in 2018, the attitude of SEC in the U.S. become more and more lucid. On February 6th of 2018, the Chair of SEC Jay Clayton said, “I believe every ICO I’ve seen is a security,” SEC is trying to incorporate cryptocurrencies into current regulations for securities. While during the two hearings of the U.S. Congress on cryptocurrencies in 2018 (one on February 6th and other on July 18th), even though they don’t declare clear attitude, it was rather obviously indicated that the congress wanted SEC to be the main regulating force of cryptocurrencies. Which indirectly showed the congress agrees SEC to regulate cryptocurrencies as securities.

Whether or not the cryptocurrency is securities? The most definitive answer can be derived from words of William Hinman, who is the director for division of the Corporation Finance in the SEC, he said in a meeting on June 14th, 2018: “In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise.” SEC considers the digital asset is securities, regardless if it is called ICO or token or any other names. SEC is mainly evaluating digital asset based on how it actually works but not what it appears. However, William also said: “Where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it is created “, then the digital asset can be ruled out as securities, for example Bitcoin.

In the United States, the securities law is used to determine if something should be treated as securities, where the judges usually refer to the “Howey Test” rule when they decide (SEC v. W.J Howey Co., 328 U.S. 293 (1946).). Howey Test is mainly to see if there is investment of money in a common enterprise with an expectation of profit derived from the effort of others.  According to this standard, most of the ICOs should be regarded as securities, except Bitcoin and Ether. The Howey Test is focusing on how the coin are sold and whether the purchaser expects to profit from the operation of a company enterprise to determine whether the ICO is securities or not. For example, Bitcoin has been identified as a commodity by CFTC, and the SEC believes that they are not securities because Bitcoin satisfies the fact that no centralized company operates the asset, and the owner of bitcoin cannot benefit from the rise of bitcoin value coming from any organization’s performance. However, if Bitcoin is packaged as an ETF then the Bitcoin ETF belongs to the securities because the way it is organized and sold to public. Whether the Bitcoin EFT can be approved by SEC has a significant impact as much as CFTC’s approval on Bitcoin futures on cryptocurrency industry, because it signifies that the mainstream investors are comfortable to invest on cryptocurrency as an alternative investment product. Unfortunately, SEC has rejected multiple bitcoin ETF applications for several times in 2 years.

Of course, whether a cryptocurrency is securities is not immutable. Ethereum was the first introduced to the public, in such a way that it was considered as securities by the SEC, but with the expansion of Ethereum’s use and the decentralized operation, recently on March 12th, 2019, the SEC chairman Jay Clayton confirmed that Ethereum is not securities.

  • 4.4.Synthetical New Asset Class: combination of Equity, Gold, Currency and Fine Art


We try to address the question about classification of cryptocurrency, though have not yet near to define a specific class. Further, we brainstorm it might not be actually in any of the major classes. In 1997, Robert J Proposed the concept of Super Class, which is based on the characteristics of traditional asset. This classification is divided into: Capital Assets (Equities, Bond, and real estate), Consumable/ Transformable Assets (Commodities and some precious metals), and Store of Value Assets (some other precious metals, currency and fine art). According to the way of super class defining these sub-categories, cryptocurrency has these three properties at the same time. Categorizing cryptocurrency into any existing specific type may not be completely and comprehensively represent the properties of it. Thus, perhaps altering conventional idea to not be so strict to any particular one. But define cryptocurrency as similar to many types, though not exactly fit in any specific type. The reason is that the classification of traditional finance can’t satisfy appearance of the new phenomenon when enter into the digital world, this may be a revolution. The things that people were not able to imagine before, now become more and more virtualized and getting online. From that, there’s a need to create new cryptocurrency, digital asset, digital gold and digital collectibles. We can treat cryptocurrency as a synthetic asset class in the digital world. Summarize as refer to what Selgin said in the past, the cryptocurrency is “Synthetic Commodity money”. (Selgin, G., 2015. Synthetic commodity money. J. Finan. Stabil. 17, 92–99.)

The classification of cryptocurrency is uncertain, though it can be verified using a simple method: looking at the properties of its users and the purpose. Given the decentralized property and anonymity of bitcoin, plus the opaqueness of current exchange data, it is challenging to confirm specific user’s attributes and their holding purposes. However, we can still see the change of Bitcoin’s identity from the history of its development.

From Bitcoin’s birth in 2009 to its first transaction in real world on May 22nd, 2010 (Bought on 22nd May 2010 by Laszlo Hanyecz, the programmer paid a fellow Bitcoin Talk forum user 10,000 BTC for two Papa John’s pizzas (Caffyn 2015). Before that, Bitcoin is just circulating in a very small network. Miners were the major users of Bitcoin at the time, they hold bitcoins as a byproduct of their personal hobbies, and they treat Bitcoin more like a toy. After 2010, Bitcoin starts trading in the real world, with the occurrence of transactions and the advent of exchanges, Bitcoin price rose gradually. It climbed to $10 in year 2011, Bitcoin attracts some of the geeks who follow digital money with interest in the early days (programmers who pay close attention to crypto currency). They own bitcoins for the sake of collection interest, and no one could have forecasted the development of Bitcoin market to today. Also, during this time, Bitcoin attracts the attention of many criminals who find that Bitcoin can be the best payment tool for money laundering, illegal trading and tax evasion. The user of the famous Silk Road website is a typical representative. In the view of these criminals, Bitcoin is the universal currency in the illegal world. It spent 2 years for Bitcoin’s price to increase from $10 to $100 in early 2013, and another 4 years from $100 to $1000 in early 2017. Such a huge price fluctuation, which attracts many adventurous speculators. They regard Bitcoin as a fast-growing speculative product. From at the beginning of 2017, investors stats to recognize the investment of Bitcoin and participate in this investment. During year 2017, Bitcoin appears a dazzling wave of movement. Media starts to report Bitcoin massively, which lets investors starts caring about this virtual investment product in the first time. During that time, many users went to the exchange to open a new account and buy bitcoins so that they have chance to earn profit with future appreciation of crypto currency. Institutional clients also followed this trend. Of course, another purpose of institutional customers to buy bitcoins is to use Bitcoin as a means of investment payment so that they can invest in blockchain projects. The cryptocurrency is required for invest in Blockchain projects. At this situation, Bitcoin undertakes measure of value and payment’s function.

In present, the share of different type of users, the main functions of crypto currencies, the main effects on their prices, are discussed in detail at earlier section of Pricing and Bubble.  In conclusion, the classification and attribution of crypto currency has always been controversial and has been dynamically changing. We should keep an open, unconventional and thoughtful attitude towards the current and future state of this rising star in the galaxy.

5. Market Efficiency and Liquidity

The world of crypto currency has shined the way through its development and has hit its 10-year milestone from Bitcoin’s appearance till today, it has formed a very unique and charm crypto currency trading market. In views of the traditional financial world with long history, 10 year is only a fleeting pulse. Crypto currency is still in its baby stage, so it’s plausible of not having sufficient and persuasive evidence obeying theory of economics or finance. Naturally, researchers began to test crypto currency market performance with the traditional financial theory, using well verified methods that were utilized by the market for decades. The most famous one for testing market efficiency is the effective market theory (EMH), it is the cornerstone of modern finance. The efficient market hypothesis (efficient markets HYPOTHESIS, EMH) was proposed and deepened by Eugene Fama (Eugene Fama) in 1970, Fama won the Nobel Prize in economics primarily because of EMH.

EMH claims that investors who involved in the market should be sufficiently rational. In addition, these rational investors should be able to react on available market information timely and properly. The theory should hold in a market with concrete law system, high transparency and sufficient competition. All valuable information has been reflected in the stock price movement timely, completely and accurately, which includes the current and future value of the enterprise, investors are unlikely to get excess profits above the market average by analyzing past prices unless there is market manipulation. EMH is one of the most representative theories explaining current financial academic studies on the logic of financial asset pricing and stock market fluctuation.

There are three forms of the effective capital market hypothesizes:

  1. Weak – Form Market Efficiency

The hypothesis says that in the case of weak – form market efficiency, market price has fully reflected all historical stock information, which includes stock’s transaction price, volume, short positions, financing values, and etc.

The first inference: if the weak form market efficiency hypothesis is valid, technical analysis method for stock prices will lose its meaning, though the fundamental analysis may still provide value for investors to obtain excessive profits.

  1. Semi-Strong-Form Market Efficiency

The hypothesis claims that market prices sufficiently reflect all publicly available information about the company’s operating potentials. This information contains transaction price, volume, profit information, profit forecast value, company management status and other publicly disclosed financial information. If investors have quick access to this information, then share prices should respond quickly.

The second inference: if the semi-strong effective hypothesis is valid, the use of fundamental analysis in the market will lose its power, insider information might still provide access to gain excessive profits.

  1. Strong – Form Market Efficiency

The strong efficient market hypothesis thinks prices fully reflect all information about company’s operation, which includes information that has been made public or private.

The third inference: In a strong and effective market, there is no way to help investors get excess profits, even if the fund and those people with insider information.

The most common Weak-Form Market Efficiency has already been thoroughly tested and discussed in all large categories of financial assets, then the academic community began to use Weak Form ME to check whether the digital money market is an effective market.

Andrew (2016) used several types of econometric methods to conclude that the Bitcoin market significantly inefficient through Bitcoin return data of 2013-2016’s. However, Andrew discovered if samples are divided into different time periods, the Bitcoin market becomes more and more efficient, especially in the later stage of data sample. Thus, Andrew concluded Bitcoin is in the process of gradually moving towards to an efficient market.


Base on Andrew’s research, Wang Chun Wei (2018) made some improvements:

(1) The scope of the data period was extended to the latest year – 2017, which is the most exciting year of bitcoin so far, as Bitcoin price skyrocketed during 2017. (2) The objects of the study expanded from bitcoin only to more than 400 altcoins. (3) It studied the relationship between liquidity and market efficiency. Andrew’s prediction on bitcoin market becoming more efficient can be supported by Wei’s research using more timely data. Wei’s research shows that most altcoins have inefficient markets. Mainstream coins with high liquidity and relatively low volatility have a market of high efficiency. Wei explained that the main reason is that arbitrage trading advances price discovery and eventually improve market efficiency. Aviral (2017) proved market is efficient at most of time by using a more advanced model and Monte Carlo plus Rolling windows method, which also shows that bitcoin market is efficient in most of the time.

Aurelio F. Bariviera (2017) applied sliding windows method to study Market efficiency dynamically. He believes this method can be more effectively reflect Bitcoin market efficiency as time proceeds and market develops. Additionally, Aurelio researched long term memory of Bitcoin’s daily volume and return by using sliding windows method. He found daily volume presents a strong trending effect on daily return. (i.e. which is not a random walk and show some consistent pattern)

There are also some antagonistic views, as Nadarajah, S., Chu, J. (2017) researched two certain markets: USD BTC and CNY BTC during the period 2010 – 2017, he found most of markets were inefficient. Nadarajah further mentioned the market is especially inefficient during the time of price bubbles rise and fall, market effectiveness is found mainly in stable price interval.

Eng-Tuck Cheah (2017) studied adaptive capability of Bitcoin markets following changes in the regulations and/or arrival of a stochastic market shock. Bitcoin markets are found not completely ‘memory-less’, rather are autoregressive in nature. The implication is that a shock in this market can leave a long – lasting impact on equilibrium prices given its long memory property. He found there is a correlation between Bitcoin markets across countries because of its market inefficiency and long memory. That is, the impact of regulation in a specific country will be transmitted to other countries worldwide through the global link of the market, and these impacts have memory. This helps traders evaluate how to conduct cross-border arbitrage trading. Eng-Tuck used econometrics method to show that bitcoin has system memory, thus conclude bitcoin market is from moderate to high inefficient.

Khamis (2018) examined the long-memory feature and time-varying efficiency of the Bitcoin market in comparison to the stock, gold, and currency markets. He used market deficiency measure (MDM) (Wang et al., 2009), found Bitcoin is the most inefficient market, but whereas stocks are relatively efficient. He suspected the reason for the inefficiency is the absence of regulation in the Bitcoin market. The long-memory evidence suggests that investors could profit from the historical return series to forecast the future prices and therefore beat the market with historical information.


The practical significance of these studies is that: if economists’ predictions are right, which the bitcoin market is becoming more and more efficient, then we need to find the answer if we should beat the market or buy index directly. Recently, many exchanges have started to launch index products, but the market seems not in favor of these index products. Do we still need to make money through arbitrage across various exchanges? At the beginning of second half of 2018, there was less and less profit in arbitrage due to more traders (including the hedge fund, which come from traditional financial institutions) entered into the market and made the market more liquid and efficient, thus less opportunities for arbitrage.

Topics that are worth to study in the future:

  1. Testing EMH with new data, especially the dramatic drop of crypto currency since the beginning of 2018 and the bear trend followed. Crypto currency volatilities have sharp decelerations and thus show more towards weak form market efficiency; even further, reflect the Semi-strong form of the EMH. And we can study the reasons behind these shifts that are meaningful to understand.
  2. In the future, is it possible for crypto currencies market to continue improving on EMH, and what is its intrinsic logic that is behind the scenes?
  3. The impact of policy introduction and implementation on EMH.
  4. The EMH differences among numerous countries and exchanges, and more specifically its relationship with liquidity.

6. Volatility, Risk and Hedging

  • 6.1.High Volatilityand Risk

“After Lehman Brothers toppled in September 2008, it took 24 days for US stocks to slide more than 20 per cent into official bear market territory. Bitcoin, the new age cryptocurrency that has been breaking bull market records, did the same on Wednesday in just under six hours”

Financial Times—30 November 2017—Bitcoin swings from bull to bear and back in one day

There’s more than enough media coverage and academic attention mentioning high volatility or riskiness of Bitcoin along with other cryptocurrencies comparing to traditional asset classes. We can obviously see from the historical price charts (figure 5 in section 1.3) the huge swings they have. Also looking at the table 1 of listing basic volatilities calculation of the top cryptocurrencies comparing to what are for other financial products. Several strands of literature are existing: (1) comparing returns, volatility and speculative properties of Bitcoin with other assets like gold, dollar or securities, to categorize bitcoin and to highlight the role of it; (2) the methods to investigate bitcoin volatility; (3) time varying volatility of Bitcoin, long versus short term observations from different frequency; (4) the comparison of volatilities among cryptocurrencies comparing with Bitcoin; and (5) long memory and persistent volatility applying the knowledge of random walk and fractional Brownian motion.

Coin Name Bitcoin Ethereum XRP Bitcoin Cash EOS Stellar Litecoin Tether Cardano Monero IOTA
Volatility 0.6998 1.2633 1.2487 1.4976 1.6674 1.3080 1.0740 0.3857 1.6823 1.2062 1.4968

Table 1. Volatilities of Top 10 Cryptocurrencies

Recent discussions have been claiming that Bitcoin is more commonly used as an asset rather than a currency (Baek and Elbeck, 2015; Dyhrberg, 2015a; Glaser et al., 2014). Grinberg (2011) questions the classification of Bitcoin among stocks, investment contracts, commodity and currency, thus has imposed the question of its legalization path as well as the market volatility associated with it. Cheah and Fry (2015) states Bitcoin market is highly speculative and volatile, which is subject to speculative bubbles with fundamental value hardly definable or near zero. Though on the opposite view, Blau (2017) states that high volatility of Bitcoin is not related to speculative trading when looking at the first large price wave in 2013, given the following supporting arguments: (1) the speculative trading volume was not high during the high volatility periods; (2) speculative trading is not positively related to Bitcoin volatility but rather exists negative relation; (3) using generalized method of moments (GMM) with controls for Newey and West (1987) standard errors to conduct univariate tests and multivariate tests shows same finding; and (4) using probit regressions to capture extreme change days of Bitcoin value appears to be negatively related to the level of speculative trading.

Dyhrberg (2015a) recommends that bitcoin has a place in the financial markets and in portfolio management, in turn Katsiampa (2017) suggests examining its volatility is crucial given the emerging market capitalization and its enhancing role in the financial market. Digging into deeper, we might question what the most appropriate method is to study volatilities of Bitcoin or other cryptocurrencies. Dyhrberg (2016) analyzes volatility of Bitcoin using GARCH as seeing the following characteristics: it may have a positive time trend and shows non-stationarity, referring to statement of Enders (2010) on Bitcoin saying that the most noticeable stylized fact is volatility variability, contains periods of very high volatility and also relative tranquility, also confirmed by Engle’s Lagrange multiplier test that showed strong ARCH effect in the first differenced logged bitcoin price residuals. Further, the research done by Katsiampa (2017) extends to estimate the volatility of Bitcoin using various GARCH models to compare and see which one of these GARCH has the best goodness-of-fit to Bitcoin price data; and concluded with evidence that AR-CGARCH is the best one, that suggests it’s crucial to consider both short-run and a long-run component of conditional variance. On the other side, Klein et al. (2018) finds asymmetric response to market shocks appears in Bitcoin returns, and states FIAPARCH to be the best fitting model for Bitcoin conditional volatility measuring.

From another angle, looking among over 2000 cryptocurrencies, the volatility differs as well. It’s beneficial to learn their risk properties for investment and risk management. Gkillas and Katsiampa (2018) uses a timely dataset of 5 major cryptocurrencies Bitcoin, Ethereum, Ripple, Bitcoin Cash and Litecoin. And they employed extreme value theory to investigate the tail behavior of the returns of these cryptocurrencies. This article concluded that Bitcoin Cash is the riskiest cryptocurrency, whereas Bitcoin and Litecoin are the least risky cryptocurrencies.

  • 6.2.Risk Management and Hedging

We see risk management and hedging of Bitcoin in two categories, here first we call it internal and external hedging. Internal as to using Bitcoin futures to hedge for Bitcoin, or any other crypto currencies, which is requiring particular underlying relationship and efficiency to call it a hedge. On the other category, we use Bitcoin to manage risk of other asset classes, which requires less of specific relationship, but more comprehensive in market dynamics in general. There are more literatures in the second category, as there’s relative smaller portion of people involved in futures market.

  • 6.2.1Internal: Hedging Effectiveness of CME Futures on Bitcoin

This part looks at whether or not the futures contract launched by CME in December 2017 will actually be useful for hedging cryptocurrency other than Bitcoin or say cross hedging. To test this, we use a simple model which under the assumption of normal distribution of changes in prices provides the minimum variance hedge ratio. This hedge ratio gives the percentage of asset holdings to be hedged using Bitcoin. Without providing proof the hedge ratio, h, is obtained from a simple regression of the log of cryptocurrency against the log of bitcoin;

In a regression of this type h is the slope coefficient which captures the covariance between the dependent and independent variables,


In theory this is called the minimum variance hedge ratio because no other percentage of hedge can reduce risk further than what can result from this hedge. Using this approach, the hedge ratios are for Ripple h= 0.612, Ethereum h= 0.483, and Dodge h=0.861. What these numbers mean is that if you owned Ripple (you are long) you would take a short position in the Bitcoin futures market to cover 61.2% of the value of your Ripple holding. Likewise, for Ethereum and Dodge the hedge ratios are h=0.483 and 0.861 respectively. In other words, you might be able to use Bitcoin futures to place a reasonable hedge on Dodge coin, but the hedge is less effective for Ripple, and quite ineffective for Ethereum. For example, with Dodge coin, only 13.9% of holdings are exposed to risk, whereas 51.7% of Ethereum is exposed to risk.

What is interesting about these numbers is that in principle all cryptocurrencies should be highly correlated since they are designed by the same mechanism. The hedged part can be referred to as systematic risk, things that are common to Bitcoin and its competitors. But this is also saying that the residual amount, 13.9% or 51.7% is part of the risk that is uncorrelated with Bitcoin. This means that significant portions of crypto coins are uncorrelated with each other when in theory they should be highly correlated with each other. We can only conclude that the new Bitcoin futures markets will be good for hedging Bitcoin price risk, but will not be effective for many other forms of cryptocurrency.

However, from an industry point of view, this type of correlation and hedging ratio among crypto currencies will likely to fall. The core reason being that when Bitcoin was first emerged, it has the dominant market share and the first round of alternative cryptocurrencies follow the similar type of design which is called Proof-of-Work, this group of coins can be considered as the first generation. While later on the Ethereum and its alternatives’ mechanism is based on smart contracting, which can be considered as the second generation. More recently, the development of EOS is relying on the Proof-of-Stake, that can be considered as the third-generation group of coins. Where these three types of cryptocurrencies based on somewhat different underlying technology and market structure, thus the correlation and hedging ratio could go even lower than current observations.

  • 6.2.2External: Risk Management and Hedging Capability of Crypto Currencies on Financial Products and Portfolio Management

Using crypto currencies to leverage the risks in general financial investment and portfolio management has been among the discussions. Baur et al. (2018) find return properties of Bitcoin are nothing similar to traditional asset classes including securities,, currencies and others. The correlation between Bitcoin and the other assets are relatively low. Therefore, Bitcoin offers great benefits of being a risk diversifier both in normal and turmoil times. This article finds that about a third of Bitcoins are held by investors shows, users that only receive Bitcoin and never send to others, which indicates that bitcoin is considered more as of investment. Thus, for Bitcoin, medium of exchange function is still relatively small compare to investment purposes. Then also mentioned once it’s become more accepted and used it may raise risk or threat to financial or monetary stability. Nonetheless, from current observations of its property especially only seeing low correlation with other assets, we may indicate it has some potential being a risk diversifier, though we may need to keep skeptical and evaluate the properties more comprehensively.

Another two papers analyzing Bitcoin’s hedging capability towards other assets that follow the same illustration of risk management: Baur and Lucey (2010)’s definition of hedge, diversifier and safe haven. A hedge is uncorrelated or negatively correlated relationship of the applied and underlined asset, where diversifier is positively (but not perfectly) correlated, and safe haven is uncorrelated or negatively correlated during market stress or turmoil. This hedging definition is popularly referred as almost the standard, that the following two papers build analysis upon along with other hedging analysis in different fields.

Bouri et. al. (2017) uses a dynamic conditional correlation (DCC) model to examine Bitcoin across major world stock indices, bonds, oil, gold, the general commodity index and the US dollar index to see if it acts as a hedge, diversifier or safe haven. The paper indicates that Bitcoin is a poor hedge and is appropriate for acting as a diversifier only. On the other end, Bitcoin can only act as a strong safe haven against Asian stocks’ weekly extreme down movements. This study also shows that Bitcoin hedging and safe haven properties is varying across time horizon, that we can see this time variance in later discussion among all these studies’ conclusion from time to time, or authors to authors.

This other paper, using similar approach and methodology, with testing not the major financial assets, but the major currencies. Urquhart et. al. (2018) investigates whether Bitcoin can act as a hedge or safe-haven against major currencies at the hourly frequency level, capturing intraday large volatility that Bitcoin experiences. This paper uses an asymmetric dynamic conditional correlation (ADCC) model to analyze and finds Bitcoin can be an intraday hedge for currencies: CHF, EUR and GBP, and diversifier for AUD, CAD and JPY; as well as using the non-temporal Hansen (2000) test finds that Bitcoin can be a safe haven during extreme market turmoil for CAD, CHF and GBP. With the two studies above, we can see Bitcoin is harder to act as a hedge than diversifier or safe haven, the same time we can summarize that Bitcoin’s hedging capability is better captured in higher frequency setting.

More specifically investigating Bitcoin’s hedging capability, to compare it with gold, Klein et al. (2018) claims that bitcoin is significantly different from gold. Where gold has always been playing the role of flight-to-quality in financial distresses, but bitcoin behaves exactly opposite as it moves together with downward markets. A bit more specifics about methods and models, the article investigates the volatility behavior of cryptocurrencies in comparison to stock indices and commodities, explores the hedge and safe haven capabilities of cryptocurrencies in comparison to Gold by means of a dynamic correlation analysis, and apply a portfolio analysis which emphasizes the behavior of Gold and Bitcoin in times of distress. They apply a BEKK-GARCH model to estimate time-varying conditional correlations for Bitcoin and Gold. This paper concludes that volatility dynamics share some aspects with Gold and Silver, however, from a portfolio perspective, Bitcoin does not serve as a safe-haven which is a prominent feature of Gold. This article conducted Portfolio-based test of hedging property for various asset combinations among Bitcoin, S&P 500, gold, MSCI World and have found that gold tends to have the dominantly largest weight in the portfolio with almost 90% as the top and average around 36.98%, versus Bitcoin carries only around 3-4% in determining Minimum Variance Composition. Here below chart from figure 7 of Klein et al. (2018) illustrating the discrepancy of Gold and Bitcoin weights in contributing risk management of portfolio. Thus, it interprets Bitcoin hedging capability is far from what gold has.


However, an earlier study by Dyhrberg (2016) has concluded a different view while comparing hedging capabilities of bitcoin and gold by implementing asymmetric GARCH method. The article claims that bitcoin can hedge against stocks in the Financial Times Stock Exchange Index. The study also shows that hedging abilities of bitcoin are also seen to against American Dollar in the short-term. With the multi-dimensional hedging abilities seen of bitcoin that are similar to gold, the authors suggest bitcoin can be added to the toolkits of managing market risk, just like gold and other risk diversifier. We can see this article is a couple years older than what discussed above, thus we may question if the discrepancy among various studies due to time invariance of bitcoin market property itself. Interestingly, other studies of Dyhrberg (2015a) claims that Bitcoin’s hedging capability is somewhere between gold and the US dollar, though later  Dyhrberg (2015b) argues that Bitcoin can act as a hedge against UK equities and the US dollar. This observation of varying properties among scholars or even studies of the same scholar among different times, is common among other property discussions for bitcoin and cryptocurrencies, as Bitcoin market dynamics has changed many times along its development, some studies also studied the structural breaks of the market. With Thiesa (2018) being one example, using Bayesian change point (BCP) analysis to analyze average return and volatility of the Bitcoin price, then found structural breaks in average returns and volatility of Bitcoin are very frequent.

The literature holds different views on how good of a hedge Bitcoin can be for various asset classes, with the references we’ve got we can imply that it doesn’t generally serve as a hedge for many classes, though it provides intraday hedge for certain currencies at different level of efficiencies and market conditions. The studies tend to compare Bitcoin with Gold, as it has always been showing solid risk management capability to other asset classes. Articles that we reviewed all tend to conclude that Bitcoin has some similarities with gold but can hardly reach the level of risk management capability that gold has.

7. Regulation and financial Rules

There are prompting regulators paying more attention to crypto currency industry due to: the rapid rise of crypto currencies market cap, the increasing involvements of retail investors and institutional investors, as well as the huge price volatility. This industry is still quite young, which only has 10 years of history, and it is really the latest 3 years that has brought attention to regulatory. Because of the young age and controversial classification of crypto currency, regulators are still trying to understand it, thus the regulation of crypto currency is still in its infancy. The regulation status in every country is different due to various environment, plus the dynamic of each country’s market is also fast changing which makes regulation even more dynamic and diverse.

Most of the academic discussion about digital monetary regulation focuses on the legal category, concentrating on the legal definition of crypto currency, such as whether crypto currency is legal, the nature of ICO, how to prevent money laundering, how to coordinate global norms, etc. The economic community has relatively fewer discussions about its regulation. Given that the current biggest determinant of the crypto currency industry is regulation, we make a systematic overview of regulation in the final part of this survey paper.

Regulation by Country

The definition of crypto currencies and regulation are different across countries around the world. Of the 251 countries in the world, 111 countries are unrestricted according to web sources (Coin Dance). Based on the volume and influence of crypto currency, we here mainly looking at the major players: The United States, China, Japan, South Korea, the United Kingdom, Russia, and Singapore.


The United States

The regulation of crypto currency in the United States has become the vane of global regulation and has a very important exemplary role. As early as 2012, the U.S. Congress held a hearing on Bitcoin. In 2015, New York State took the lead in passing the world’s first licensed crypto currency license Bitlicense. In 2017, CFTC approved CBOE and CME to launch Bitcoin futures contract. By 2018, US regulatory action has become more frequent, but attitudes toward cryptocurrencies have changed: from the initial debate on whether crypto currency is a benefit or harm, to the identification of crypto currency innovation and the need to regulate properly. Because there is no uniform regulation on the attributes of cryptocurrencies, and the United States implements federal and state supervision in different levels, the US regulatory policy on crypto currency is relatively complicated.

Specifically, there’s a Federal Reserve in the federal level, while the Fed’s attitude is not to directly regulate the crypto currency. Just like in December 2017, acting Fed Chair Yellen said: “The Fed doesn’t really play any regulatory role with respect to Bitcoin, other than assuring that banking organizations that we do supervise are attentive, that they are appropriately managing any interactions they have with participants in that market, and appropriately monitoring anti-money laundering, bank secrecy act responsibilities that they have.”

Based on Tax considerations, IRS (Internal Revenue Service) believes bitcoin and other encrypted crypto currencies are property rather than currency, thus in accordance with the Capital appreciation tax law supervision, corresponding provisions were launched. Individuals and institutions are required to declare each year on the basis of capital appreciation or loss. The biggest impact thus far is in November 29, 2017, a federal judge in San Francisco ruled that Coinbase (The largest crypto currency exchange in the United States) must supply the IRS with identifying information on users who had more than $20,000 in annual transactions on its platform between 2013 and 2015. At the time, IRS calculated that amounts of taxpayers, and found that they did not honestly declare the profit of the crypto currency. Therefore, Coinbase was asked for providing transaction information to IRS. Coinbase refused on the grounds of customer privacy, and hence, the IRS sued Coinbase. After this incident, many customers (could not be quantitatively estimated) moved their digital assets to overseas exchanges to avoid U.S. taxes.

The U.S. Securities and Exchange Commission (SEC) has a very clear view for crypto currency: cryptocurrency produced by ICO is security, therefore the listing process needs to be regulated in accordance with security law. However, Bitcoin is not generated by ICO, thus Bitcoins does not belong to security, which is not under SEC regulation. But the ETF of crypto currency, which is part of the SEC’s regulatory scope. At present, the SEC requires any ICO to register, taking the security Token offering (STO) process and following the existing security regulation. As of October 2018, The SEC has approved 39 STO projects (Huobi 2019) STO Trading is designed to the existing alternative trading System (ATS), which is under the supervision of the SEC. In the second half of 2017 and 2018, the SEC cooperated with other law enforcement authorities, conducted intensive activities to combat the illegal listing of ICO, that have effectively curbed the momentum of illegal ICOs in the United States.  As for ETF of crypto currency, the SEC has turned down its applications for various times, believing that ETFs are currently unable to protect investors, mainly because of crypto currency’s opaque information, market price manipulation, also due to ETFs are difficult to price, its volatility is too large, liquidity is not enough, and custody is not ready yet, etc.

The CFTC identifies Bitcoin belongs to commodity, and declared that its regulatory targets included fraud, manipulation and other acts involving Bitcoin in intercontinental trade, as well as commodity futures trading directly linked to Bitcoin.  As a result, CBOE (who stop listing new bitcoin contracts on March 2019 because of low trading volume) and CME were approved to launch Bitcoin Futures, and the CFTC recently stepped up its enforcement about fraud and market manipulation in bitcoin futures.


Figure: Trading Volume Comparisons of Bitcoin Futures on CBOE and CME. (Diar 2019)

FinCen, an agency under the Treasury, they believe the crypto currency is rather closer to currency. FinCen’s regulation approach of crypto currency is mainly focused on preventing the use of cryptocurrency crime and money laundering. In the United States, all agencies involved in crypto currency require registration as Money Service Business (MSB) on FinCen, also need to internally set up appropriate compliance departments to prevent money laundering and criminal actions in crypto currency.

Different states of U.S. define and regulate crypto currencies in a variety of methods, besides New York State requires a tangible license called biticense ,most states do not have specific regulatory measures, but rather use cryptocurrency as a payment tool that is subsumed under the money transittment category, which need to obtain appropriate currency transfer license MTL (Money transmitting License). After multiple rounds of hearings, the U.S. congress tends to let the SEC and the CFTC jointly regulate crypto currencies at the federal level.


China’s regulation of crypto currency is dominated by the central bank “People’s Bank of China”. In 2013, the People’s Bank of China issued a notice on the prevention of bitcoin risk, positioning Bitcoin as a specific virtual commodity, there is a great risk involved.   In September 2017, People’s Bank of China issued a ban to forbid the public trading of crypto currencies and also prohibit ICO. In 2018, Beijing’s regulatory department forbid release of STO. Although China is a big trading country for crypto currency, the Government takes a restrictive approach to crypto currency, that has led many institutions moved their headquarters away from China to countries and regions that are friendlier to crypto currencies, such as Singapore and Hong Kong.

China Hong Kong

Prior to November 2018, Hong Kong imposed differential supervision on crypto currencies. If crypto currencies belonged to securities, it was under the control of the Securities and Futures Commission (SFC). By November 2018, Hong Kong promulgated new regulatory framework for management companies, fund distributors and trading platform operators of Digital asset portfolios (simply called “New Rules”), which confirmed the SFC’s position on the overall regulation of digital assets, also introduced a licensing system. In certain circumstances, implementing sand-box regulation with specific corresponding practices.


In Singapore, crypto currency is regulated by Singapore Monetary Authority (MAS), in November 2017, MAS released “A Guide to Digital Token offerings”, which was regarded as a clarifying document for MAS’s regulation of digital asset financing, later a new version of the Guide was released in November 2018. Singapore’s regulations are categorical for crypto currencies: one type is divided into Capital Market Product, which belongs to the securities, following the supervision of Securities and Futures Act. The other is Utility Token, which is relatively flexible. But no matter what category it is in, they need to follow general regulations, such as AML and KYC etc. At the same time, Singapore has allowed crypto currencies to enter SandBox (A regulatory testing mechanic )  to conduct supervision experiment. In a broad view, Singapore’s regulation is relatively open and friendly.


Japan was the first country in the world to provide legal protection for digital assets. In May 25, 2016, Japan’s Cabinet signed amendment: Fund Settlement Act, and incorporated digital money into the legal regulation system, also recognized crypto currency Bitcoin as a legitimate means of payment. The act was taken effect on April 1, 2017, which has very critical meaning in the development for regulation of digital assets in the world. Japan’s Financial Services Agency (FSA) is responsible for the regulation of its crypto currency, crypto currency exchanges need to apply for a license to operate.  At the same time, they established research associations and industry Self-Discipline Associates to promote the development of the crypto currency industry. In February 2018, Japan’s National Tax Agency identified digital assets as personal income, incorporating digital assets into the tax category.


The UK government has been so hesitant on regulating crypto currencies. Its central bank issued a statement in 2018 that hoped to elevate crypto currency exchanges to have the same regulatory standards as the stock exchanges, and said it would step up efforts to crack down illegal financial activities in crypto currencies and impose stricter regulations on crypto currency exchanges. At the same time FCA (Financial conduct Authority) approved 11 blockchains and cryptocurrency companies into Regulatory Sandbox.

With the view of major countries regulatory standing on crypto currencies, we can generally summarize a few primary challenges for the current global regulation of crypto currency:

  1. Prevent Cryptocurrencies from Becoming Criminal Tools

How to prevent the money function of crypto currency from becoming a criminal tool for money laundering has always been the challenge; because the anonymity of crypto currency, the irreversibility of transactions, and the difficulty of chasing internationally are very suitable as a tool for criminals. This has been criticized by the public and is the focus of the regulatory body. Current supervision mainly adopts direct and indirect methods. The first straightforward way is to require all companies that are involved in crypto currency to register and have a compliance team to do AML and KYC, this method was taken in place by the US FinCen agency and has gradually become a model for other countries. The other is to strictly controls AML and KYC for financial institutions such as a bank that touches cryptocurrency. Because crypto currency ultimately needs to be in contact with financial institutions, mutual exchange of legal and crypto currencies is realized to achieve entry and exit of crypto currency. Because of this, traditional financial institutions, especially banks, are particularly cautious and careful about transactions with crypto currencies. Many banks don’t want to be the subject of supervision, so this has caused a major problem facing the current digital monetary institutions: finding financial institutions who are willing to cooperate on regular operations.

There are some discussions in the academic community about crimes generated by crypto currency (especially bitcoin), cybersecurity issues, and tax evasion etc. Jafari et al. (2018) suggested that when formulating laws, comprehensive consideration should be given to the problem, to take full advantage of its technology and eliminates the disadvantages to the greatest extent possible. Kaponda (2018) suggested that relevant legislation, regulatory agencies, and law enforcement agencies take protective measures to increase supervision and strengthen risk education for citizens.

Foley et al. (2018) used Network Cluster Analysis (SLM) and Detection Control Estimation (DCE) to analyze bitcoin transaction user data for 2009-2017 and found that there are currently about 25% of Bitcoin users and 44% of Bitcoin transaction volume is involved in illegal activities; 20% of bitcoin transaction value and 51% of bitcoin holding size is related to illegal activities (see Table 2). In terms of time series, the proportion of transactions using Bitcoin for illegal activities has decreased, but the absolute number continues to rise.


Table 2: Estimated size and activities of legal and illegal user groups

  1. How to Regulate Securities Natured Cryptocurrencies

In terms of securities attributes for Crypto currencies, how to standardize its distribution and transaction custody in order to ensure the rights and interests of investors. At present, all countries have standardized securities laws, Therefore, it is the consensus of all countries to incorporate crypto currency and ICO into the existing securities law regulation. However, there is a difficulty, crypto currency is not the same as ordinary securities. As its distribution, hosting, trading and liquidation are not available to use existing systems. So, it requires constant exploration and experimentation by national regulations. Because of the volatility of crypto currencies, opaque information, lack of liquidity, and the ease of being regulated, the crypto currency market is highly vulnerable to manipulation. Gandal and others (2017) are one of the few articles to study price manipulation in bitcoin transactions. The author cleverly took advantage of the bitcoin exchange Mt. Gox leaks from February 2013 to November up to 18 million user transaction data, then identified and analyzed suspicious trading behavior on the Exchange. Gandal’s discovery is due to Mt.Gox’s data breach. Other exchanges where data are not publicly available and are not regulated, there’s a huge incentive to manipulate the market, which is one of the reasons why the SEC has repeatedly vetoed bitcoin ETFs. In the face of these problems, regulation needs to find appropriate solutions and coping strategies in order to protect the rights and interests of investors.

  1. Global collaboration to prevent regulatory arbitrage

Crypto currency is inherently globalized and was born that way, as transactions and transfers are borderless. There is a general phenomenon of regulatory arbitrage due to the varying attitudes of countries towards crypto currencies and the varying degrees of rigor of regulation: Crypto currency practitioners register a company or head office in a country where regulation is looser, and they provide services to countries with more stringent regulations through the Internet. Typically, for example, with the U.S. regulation hits ICO and taxes, and China banned crypto currency trading and ICO, many companies have moved to Singapore and Hong Kong away from the U.S. and China, but major customers still come from the United States and China. Regulators in various countries are also aware that regulation of crypto currency requires global collaboration. Hence, the question about regulatory collaboration was mentioned during G20 conference. However, regulation is still in the early groping stage for many countries of their own currently, global regulatory collaboration is only possible when countries are relatively mature about understanding cryptocurrencies.

  1. Whether to launch a sovereign crypto currency, how to launch

Since crypto currency has not always been considered as a currency, an important reason being no national endorsement was granted, and another being it cannot be a stable measure of value. Central banks in many countries are beginning to study carefully about crypto currency. They hope to learn from the properties of cryptocurrency and underlying technologies. And issuing their own national crypto currency that are in their hand, something like Central Bank Crypto currency (CBDC). Central banks who have such intents are Bank of Canada, the People’s Bank of China, the Monetary Authority of Singapore, and the Swedish Riksbank. We look forward to seeing the mainstream countries break the current regulation deadlock, to launch influential and accepted CBDC in the future.

8. Future developments

  • 8.1. The crypto currency market returns from fanaticism to rationality

From the significant market price growth, large trading volume, extensive news reports, active fundraising for new projects, newly added Bitcoin account addresses and other observations, we can certainly infer the market fanaticism from 2017 to 2018. Then from 2018 to 2019 we saw speculative enthusiasm of crypto currency has been greatly reduced, and most participants return to rationality who are no longer hoping to get rich overnight. Now investors pay more attention to the practicality and innovation of projects, and more investing into medium to long-term programs. Many cryptocurrency companies will be eliminated in the near future, even the powerful companies will also suffer from the market, as facing the challenges in funds, talents and policies that are caused by the downturn.

  • 8.2. Regulation will be taken place in many countries.

The regulatory arms of many countries began to be implemented, and the regulatory competition between countries led to a change in market distribution. The common regulatory mode is licensing plus sandbox supervision. The regulatory frameworks of various countries have been issued and they have begun to move from the discussing stage to constructing and implementing stage. Crypto currency community will also gradually establish some influential organizations.

  • 8.3. Stable Coin will play more important role

Stable coins will play a more important role, with gradually encroaching the market share of Bitcoin. Because of the emergence of stable coin, the already declining market share of Bitcoin has been decreasing even faster. Due to the huge volatility and regulation tightening of crypto currencies, institutions and individual investors found harder to use crypto currencies for investment and payment. With the advent of Stable Coin, the market share of bitcoin has gone down. In addition, as stable coin become more compliant with regulations, this bitcoin market share decreasing trend will become more and more significant.

  • 8.4. Asset back Token

Token issued in 2017 -2018 were mainly based on crypto currency. With the fall of crypto currency, investors began to distrust tokens that are not endorsed by assets. Therefore, asset backed tokens start to attract people’s attention. In addition, the U.S. SEC supports Security Token Offering (STO). Market participants believe that more and more Tokens will be issued in this asset backed form in the future, then register as STOs through the SEC will, and enter into the financial market under regulation supervision of SEC.

  • 8.5. Traditional financial institutions and Internet companies steadily enter the crypto currency market

Facebook recently talked about going to issue a crypto currency; Singapore National Investment Corporation invested in Coinbase becoming shareholder; China’s huge internet companies: Baidu, Tencent, and Alibaba have also occasionally been mentioned by medias with involvement in crypto currency. ICE, NYSE’s parent company established BAKKT exchange. These traditional financial and Internet companies will firmly advance the cryptocurrency market at this current low point of crypto market. As institutions with big brand and good reputation entering the crypto market, it is hopeful and exciting for its future development.

9. Conclusion:

The fast-emerging pace of crypto currency is seen among the participants or interested public. Several sectors of the private sector, government, and academia all sparked enormous but cautious interests. This study tries to keep a focus on discussing academic studies about cryptocurrencies, the same time integrated real-world analysis and discussions from the industry and the government, to provide both rigorous and practical ground knowledge for future studies. This survey paper relied on abundant but yet far from explored studies, and covered wide range of topics in crypto exchanges, pricing, bubble, sentiment, categorization, market efficiency, volatility, risk management and hedging, regulations, and future development. Arguments about cryptocurrencies may go two opposite sides, though we try to balance the existing attitudes and provide scenes on rather true state of the world in an objective standing.

There is a saying in cryptocurrency industry that “one day in cryptocurrency industry is as long as one year in life”. This exaggeratively points out a fact that cryptocurrency is fast evolving, dynamic industry, which is exactly the point fascinates most academic researchers. From a short period of time as long as ten years, the industry has grown into a young ecosystem, with 140-Billion-dollar market cap involving thousands of participants and millions of users. Pioneers in this industry have tirelessly innovate new and controversial ways to disrupt the current financial system, which forces regulators and academic researchers to keep up the fast pace.  The survey paper is by far the most comprehensive snapshot of cryptocurrency industry from economic point of view, which can be a guide book for anyone who would like to quickly keep abreast of this controversial field.


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