THE NATURE OF THE BEAST (Part 2 of 3)
The Risk Protocol (TRP) is a pioneering DeFi primitive that tokenizes risk. Using a novel “splitting” mechanism, we create SMART tokens that are designed to harness crypto volatility. The following is an excerpt from a research study that we had published in 2023 titled “The Nature of the Beast”. The full report can be found here: https://www.riskprotocol.io/insights
The Curious Case of LEO: In looking at correlations among the top 50 cryptocurrencies, LEO (Unus Sed Leo) stands out as a confoundingly unique case. The average correlation among all the 50 currencies is 0.524 while Bitcoin and Ethereum have the highest correlation at 0.872. LEO has the lowest correlation with other cryptocurrencies across our universe. The average correlation between LEO and the 49 other cryptocurrencies is only 0.013, the maximum correlation is 0.03 and the minimum correlation is -0.014. So LEO is basically not correlated to any of the other cryptocurrencies in our universe. LEO, by way of quick background, is a utility token of centralized exchange Bitfinex and was issued through an IEO in 2019. Bitfinex is owned by iFinex, which is also the parent company of Tether. There have been reports in the past around inappropriate transfers between affiliated companies Bitfinex and Tether to cover losses at Bitfinex. Tether of course has been the subject of consistent speculation regarding the adequacy and liquidity of its stablecoin reserves. Is it mere coincidence that LEO has the unique trading pattern it does? This issue bears further examination given the controversial past of both Bitfinex and Tether.
Volatility is Predictable: Our analysis reveals that while cryptocurrency returns themselves are not predictable using their own past, their magnitude, hence their volatility, is strongly predictable. Overall, the study shows that cryptocurrency volatility is similar to volatility patterns exhibited by other financial asset returns. However, they behave more like equities than currencies. The volatility has a long memory structure as shown by Ding, Granger and Engle in their 1993 paper for S&P 500 returns.
Returns have Leptokurtic Distribution: Unsurprisingly, cryptocurrency returns have a non-normal distribution and are fat-tailed with greater likelihood of extreme events occurring. As with most other financial asset returns, they exhibit the so-called leptokurtic property with fat tails. Out of the 50 cryptocurrencies analyzed, 40% have a negative skewness number. The standard deviations over the sample period are also very different for different cryptocurrencies. LEO has the lowest annualized standard deviation at 76% while MANA (Decentraland) has the highest at 338%. As a reference point, the annualized standard deviation over the past two decades is 20% for the S&P 500 and 25% for Nasdaq.
Magnified Gain/Loss Asymmetry: Cryptocurrencies exhibit gain/loss asymmetry, which refers to the observation that it usually takes less time for a financial instrument to drop a certain amount than it takes to move up by the same amount. This attribute of crypto is similar to broader equity markets and in contrast to FX exchange rates which exhibit greater symmetry in up/down moves.
Increasingly Correlated with Broader Equity Markets: In comparing returns against other asset classes, it is observed that prior to 2019, there was no significant correlation between BTC returns and broader stock market returns. However, for the past three years from 2020 to 2022, the return correlation has become very significantly positive, especially between BTC and Nasdaq.
Evidence of Negative Correlation to USD: While there is little correlation between BTC and the Dollar Index for daily frequencies, the correlation gradually becomes significantly negative as one goes from daily to monthly data, and from monthly to annual. The annual return correlation between BTC and the Dollar Index reached a very significant -0.75 level. This lends credence to the popular narrative that over a longer horizon, if the US dollar weakens, one would expect BTC returns to be stronger with negative correlation to the dollar.
One-way Volatility Spillover: Finally, we found significant volatility spillover from the broader US stock market to crypto, especially in recent years. This is more pronounced for some of the more mature cryptocurrencies. Our hypothesis is that the spillover currently is unidirectional i.e. while volatility in traditional financial markets has an impact on crypto markets, volatility in crypto is self-contained and does not flow into traditional finance (“TradFi”). However, we could not statistically establish that there was no spillover from crypto to broader markets.
To be continued…
