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Bitcoin has unusual relationship with volatility

Too much hype could be the sign of a cryptocurrency bubble

Aaron Brown | Bloomberg 

Bitcoins, crytpcurrency
We can see what appears to be the effect of hype in the history of bitcoin volatility, but so far at least, prices do not display the long-term dynamics associated with bubbles. Reuters

are showing the signs of a bubble. Market capitalisation is $222 billion, 16 times as much as a year ago, with no significant change in tangible economic value. The virtual currencies elicit investment excitement and breathless news coverage; sober analysis treating both technical issues and economic fundamentals is rarer.
There is incessant cheerleading by people who own cryptoassets, manufacture them or sell associated services. A prominent example is the Amazon best-seller Cryptoassets, which is filled with classic financial hype and bubble logic. The book offers no clear evidence that investors will realise value from buying these assets today. There is no discussion of exit strategy, no speculation about who will pay to deliver profits to current investors.

The book begins with a graph showing rapid increase. It’s just powers of 2, the numbers don’t relate to anything. Cryptoassets is filled with upward graphs of Google searches for blockchain, FANG stock performance, US monetary base, world gold supply. These data are unrelated to cryptoasset fundamentals, and seek to create a mood of irresistible rapid growth. If virtual money crashes, this book could be a monument to hype like 36,000, which was published six months before the Nasdaq crash in 1999.
All bubbles are accompanied by hype, but hype is not proof we are in a bubble. One quantitative bubble test considers the relation between asset price and volatility. The mathematics get intimidating, but the general idea is that if volatility increases too fast as price goes up, an asset price has to go to either infinity or zero. Because it can’t go to infinity, it has to go to zero. It will shoot upward and then crash.
Bitcoin and volatility have an unusual relationship. At prices from $0.06 to $0.25 there is the rapidly increasing volatility associated with a bubble. But then volatility falls, only to repeat the process three more times. The overall trend seems to be down. The straightforward interpretation is that there are people willing to fund a bitcoin bubble at any opportunity, but in the past the price has always stabilised at a non-bubble level. I have never seen this kind of pattern in other assets, so it’s pure guesswork, but it fits my intuition that have solid economic fundamentals — and also a lot of wannabe bubble profiteers impatient to push the price up beyond those fundamentals. (Full disclosure: I own and other cryptocurrencies.)
At prices beyond $256 you could argue that volatility is rising with price, or that volatility has stablilised around 80 per cent to 100 per cent a year. But bitcoin trading doesn’t represent a lot of real money and liquidity is erratic, so it’s unwise to put too much faith in the numbers.
We’ll know more if bitcoin futures traded on Cboe Global and CME Group attract significant institutional interest, or if the clearing house LedgerX has continued growth in trading volume. If an influx of money causes price and volatility to rise, that suggests a bitcoin bubble. The price rise says that bitcoin price is determined by the ability to sell to new investors, not fundamentals. The rise in volatility accompanying a price increase suggests bubble dynamics that lead to accelerating price gains followed by a crash. If institutional money comes in without dramatic price and volatility increases, it’s evidence against a bitcoin bubble. If there is scant institutional interest and bitcoin prices are stable, it’s evidence of no bubble. But if bitcoin prices plunge, it suggests they were supported only by the hope of selling to greater fools.
There’s no doubt cryptocurrencies are surrounded by the kind of hype you see in a bubble, and that many boosters are talking their book (saying what will make them money rather than what they have good reason to believe is true). We can see what appears to be the effect of hype in the history of bitcoin volatility, but so far at least, prices do not display the long-term dynamics associated with bubbles. The next few months should bring important evidence to help us decide. 
© 2017 Bloomberg

First Published: Tue, November 21 2017. 22:38 IST