In Conversation

Assessing cryptocurrency with Yale economist Aleh Tsyvinski

In a new study, economist Aleh Tsyvinski and co-author Yukun Liu provide the first-ever comprehensive economic analysis of cryptocurrency and blockchain.
A stack of cryptocurrencies like Bitcoin and Ethereum represented as gold coins.


Since emerging a decade ago, Bitcoin and other digitally based cryptocurrencies have captured the imaginations of tech wizards, Wall Street bankers, and investors of all stripes.

Proponents argue that cryptocurrencies, which are decentralized and function outside the control of governments, could someday replace national currencies as the primary means of exchange. Skeptics believe that virtual currencies amount to smoke and mirrors and expect their value to crater.

In a new study, Yale economist Aleh Tsyvinski and Yukun Liu, a Ph.D. candidate in the Department of Economics, provide the first-ever comprehensive economic analysis of cryptocurrency and the blockchain technology upon which it is based.

Yale economist Aleh Tsyvinski
Aleh Tsyvinski

Tsyvinski, the Arthur M. Okun Professor of Economics at Yale, described their work and findings to YaleNews. An edited transcript follows.

What got you interested in studying cryptocurrency?

There is a lot of mystique surrounding cryptocurrency. It’s a new instrument, but what exactly is it? Is it an asset or just a fad? There is obviously broad interest in cryptocurrency because many people are investing in it. Everybody from your local bartender to Goldman Sachs executives is talking about it, but most of the research on cryptocurrency comes from a computer-science perspective. A comprehensive economic analysis is, however, lacking. 

We’ve done something very simple. We said: Let’s use textbook finance tools to help us better understand cryptocurrency. We looked at three major cryptocurrencies: Bitcoin, Ripple, and Ethereum. We wanted to identify their basic properties. We examined whether they behaved like other asset classes, specifically stocks, traditional currencies, and precious metal commodities. We also gauged their potential for benefiting or disrupting various industries.

What did you learn about cryptocurrency’s basic properties?

We documented a high return but with a lot of volatility. Does the high return compensate for the high volatility? This is called the Sharpe ratio, which measures the performance of an asset by adjusting for risk. Surprisingly, we found that cryptocurrency’s Sharpe ratio shows that the return is higher than the risk implied by its volatility. It’s higher than the Sharpe ratio for stocks and bonds, but not drastically so. There have been asset classes and trading strategies with Sharpe ratios that are either the same or similar to cryptocurrency’s. So if you just look at return versus volatility, cryptocurrency looks more or less normal.

Does cryptocurrency behave like other asset classes?

In my introduction to macroeconomics course, I teach my students that money has several functions. It can act as a unit of account, which is a function of traditional currency. Money can also be a way to store value, which is how gold and other precious metals function. You put it in a safe, and tomorrow you can use it for something else. Does cryptocurrency serve one of these two functions? Or is it is a bet on blockchain technology dramatically disrupting several industries, which is to say: Does it behave like stocks?

To answer these questions, we looked at whether cryptocurrency returns can be explained by the same factors that drive returns of stocks, currencies, or precious metal commodities. For stocks, we examined 155 potential risk factors in the finance literature and found that almost none of them account for the returns of cryptocurrencies. They are not like stocks.

Yale Ph.D. candidate in economics, Yukun Liu
Co-author Yukun Liu

We also found no similarities between the behavior of cryptocurrency and five major traditional currencies — the Euro, Australian dollar, Canadian dollar, Singaporean dollar, and the British pound. Finally, we saw no link between the behavior of cryptocurrency and gold, silver, or platinum. Our findings cast doubt on the popular narratives that cryptocurrencies derive their value from either serving as a unit of account, such as the usual currencies, or as a store of value, such as precious metals.

If cryptocurrency does not behave like these traditional assets, then is it possible to predict its performance?

While we discovered that cryptocurrency behaves differently than traditional asset classes, we also found that investors can better understand cryptocurrencies by applying common asset pricing tools to factors specific to them. We show that some of the factors people use to predict the performance of traditional asset classes can be used to meaningfully predict cryptocurrency’s behavior. 

The first is called the momentum effect, which basically means that when an asset increases in value, it will tend to rise even higher. That is a feature of just about every known asset class, and we found that it strongly affects cryptocurrency. To take advantage of momentum effect, we have designed a simple strategy that says an investor should buy Bitcoin if its value increases more than 20% in the previous week. This strategy generates outstanding returns and a very high Sharpe ratio.

The second factor strongly influencing cryptocurrency is the measure of investor attention. We asked the following: If there is an abnormally high number of mentions of the cryptocurrencies we studied in either Google search or on Twitter, will their returns go up? It turns out that they will. At the same time, we found that negative investor attention, such as an increase in the use of the search phrase “Bitcoin hack,” will generate negative returns for cryptocurrencies.

Were there potential factors you thought would predict cryptocurrency’s behavior but do not?

Yes. The first was the cost of mining, which is the price of producing cryptocurrency. We were surprised to see that it does not predict cryptocurrency returns.  The second is the price-to-“dividend” ratio, which is one of the most important factors in assessing stocks. Is the price of this stock too high compared to the earnings or the fundamental? Cryptocurrency obviously does not pay dividends, but one can still study a similar metric. We found that a proxy for a price-to-dividend ratio — asking whether the price of a cryptocurrency is too high for its fundamental — does not predict cryptocurrency returns.

The same thing is true for volatility, which is actually quite surprising. One would have thought that the more volatility, the higher the return to compensate that. That is not the case. Neither high nor low volatility strongly predicts cryptocurrency returns.

What are the chances that Bitcoin or other cryptocurrencies will completely collapse in value?

It is reasonable to consider the probability, in the view of the markets, that the value of Bitcoin will fall to zero and become useless. Our calculation is 0.3%.  If you are completely risk neutral, then based on the historical performance of cryptocurrency, you would assign a probability of 0.3% that its value will drop to zero. For comparison, we also calculated the crash probabilities for traditional currencies. Their crash probabilities are several degrees of magnitudes smaller. For example, Euro is about 0.009%, the Australian dollar is about 0.003%, and the Canadian dollar is about 0.005%.

What did you learn about cryptocurrency’s potential to change or disrupt industries?

People speculate that cryptocurrency could disrupt all kinds of industries, from music to finance to supply chains. We took 354 industries in the United States and 137 industries in China, and we asked the following question: Are the returns on the stocks in those industries affected by cryptocurrency?

We were trying to assess what the market thinks of cryptocurrency. People talk about which industries could be affected, but we were not asking a hypothetical question about what people think will happen. We sought to understand how the market perceives which industries could be affected by cryptocurrency.

We created an index of the potential disruption of cryptocurrency to every major industry. For example, we found that the healthcare and consumer goods industries have significant and positive exposures to Bitcoin returns, while the finance, retail, and wholesale industries have no exposure to Bitcoin at all. Most surprisingly, we found evidence that the market perceives Ethereum technology as a potential disruptor in the financial industry. We don’t give explanations, we just document this behavior, but one explanation may be that Ethereum is essentially based on smart contracts, distinguishing it from Bitcoin, which is intended to function as an alternative method of payment.

Based on your analysis, how much Bitcoin should a typical investor hold?

Keep in mind that we’re not offering investment advice, but it is a very basic question that one would ask about any asset class, and we approach the question at the end of our study. When you invest in your retirement, Vanguard or whatever platform you use will suggest how to best allocate your portfolio. We did the same for cryptocurrency. If you as an investor believe that Bitcoin will perform as well as it has historically, then you should hold 6% of your portfolio in Bitcoin. If you believe that it will do half as well, you should hold 4%. In all other circumstances, if you think it will do much worse, then you should still hold 1%. Of course, one has to remember that, as with any other assets, past performance is not a guarantee of future returns. Maybe cryptocurrency will completely change its behavior, but currently the market does not think it will.


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