Cryptocurrency liquidity during extreme price movements: is there a problem with virtual money?

Abstract

The enormous rise of the cryptocurrencies over the last few years has created one of the largest unregulated markets in the world. In this study, we obtain millisecond data for the five major cryptocurrencies—bitcoin, ethereum, ripple, litecoin and dash—and two cryptocurrency indices—Crypto Index (CRIX) and CCI30 Crypto Currencies Index—to investigate the relationship between cryptocurrency liquidity, herding behaviour and profitability during periods of extreme price movements (EPMs). We demonstrate that cryptocurrency traders (CTs) facilitate EPMs and demand liquidity even during the utmost EPMs. We observe the presence of herding behaviour during up markets across the entire dataset. Our robustness checks indicate that herding behaviour follows a dynamic pattern that varies over time with decreasing magnitude. We also provide novel evidence of CTs’ profitability after transaction costs, and demonstrate their strong profitability-generating record in the future.

Keywords:

• Cryptocurrency markets
• Market efficiency
• Herding behaviour
• Market regulation

JEL Classification:

• G14
• G15
• G17
• G18

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

† For instance, the sum of all bitcoin balances is set to 21 million bitcoins (Velde 2013).

‡ This decentralisation is achieved by using the blockchain—a comprehensive ledger that enables the recording of transactions and keeps track of individual accounts.

§ Cryptocurrency transactions are validated by competing market participants from different markets known as miners, who solve highly sophisticated cryptologic algorithms. The winner in this validation process receives a fraction of the validated cryptocurrency in return.

¶ Corbet et al. (2018) investigate the existence of bubbles in Bitcoin and Ethereum and conclude that there are periods of clear bubble behaviour, while Cheah and Fry (2015) observe that Bitcoin exhibits speculative bubbles and the fundamental price of Bitcoin is zero.

∥ In the last two years, cryptocurrency liquidity dramatically increased because most cryptocurrencies are gaining fast acceptance as a form of payment, mainly in online shops. This acceptance increased by nearly 800% in September, 2017, compared to the beginning of 2015. Now, more than 370,000 merchants in 182 different countries around the world accept cryptocurrencies, including some of the big US corporations (such as Microsoft, Apple, Amazon, IBM PayPal and Home Depot).

† Most cryptocurrency market participants are individual investors who mainly depend on information from social media and online blogs for research and, therefore, are more likely to follow the investment decisions of others. The online community of heterogeneous users equipped with different information has a significant impact on how investors process information and make buy and sell decisions in cryptocurrencies. Some cryptocurrency investors observe and mimic the trading strategies of big cryptocurrency holders known as ‘whales’, using designated whale-following websites and mobile applications. Reddit is a social news website where users can discuss different cryptocurrency topics with a community of over 600,000 digital currency subscribers. Menkhoff, Schmidt and Brozynski (2006) argue that herding behaviour increases with investors’ inexperience.

‡ Bouri et al. (2018) suggest that when some of the leading cryptocurrency developers—like Vitalik Buterin (the co-founder of ethereum) and Charlie Lee (the creator of litecoin)—express their own views on specific digital currency topics, they affect the prices of the related cryptocurrencies.

† We use proper traded prices to execute the topics under our investigation. Alexander and Dakos (2019) suggest that it is very important to use traded data from crypto trading venues rather than data from coin-ranking sites when examining market efficiency, hedging and portfolio optimisation and trading in cryptocurrency markets.

† Lewis and Linzer (2005) find a superior performance of the feasible generalised least squares regression (FGLS) compared to ordinary least squares (OLS) in cases where the explained variable is based on estimates.

† Pump-and-dump schemes in the cryptocurrency markets represents price manipulation that involves artificially increasing crytocurrency prices before selling the cheaply purchased tokens at higher price levels. When the tokens are ‘dumped,’ their price decreases and traders accumulate losses. These schemes are usually performed in microcap stocks trading but have recently become common in the cryptocurrency markets (Shifflet and Vigna 2018).

† Cryptocurrency markets are characterised by excessive price fluctuations, providing conditions for the creation of herding behaviour.

† Kraken (www.kraken.com), one of the biggest cryptocurrency exchanges, suggests transaction costs of 26 basis points per trade. We implement slightly higher transaction costs of 30 basis points in order to take into account any software and hardware trading-related expenses.

13 In other words, a bitcoin can be sent securely and one should not be able to spend the same bitcoin again without anyone else being able to facilitate a transaction and without one being able to chargeback the same bitcoin.