Synchronization of autonomous systems is common. The most spectacular can be seen in mangroves of Malaysia and elsewhere where fireflies flash in unison like a string of Christmas lights. If groups in nature can co-ordinate individuals’ inner beats, it is hardly surprising to find synchronization in markets which are the archetypal collective. Let me use cryptocurrencies to illustrate what markets term “co-movement”, where random moves of securities prices are co-ordinated like fireflies.
Despite a mountain of research, codifying markets’ mash of signals has proven fruitless, and there are no reliable market forecasting models. This means that even the most ‘expert’ views only work in their authors’ minds. Thus investors are forced to rely on qualitative judgements, which makes it handy to know which market firefly is likely to go first because that makes the others follow. That is the motivation of this article which seeks to draw some of the co-movement signals in the cryptocurrency market.
The accompanying charts flash brightly (poor pun intended) to depict price histories for Bitcoin, Ethereum and Litecoin. The left chart titled ‘Monthly Change’ is a conventional plot of the three cryptocurrencies’ – BTC/USD, ETH/USD and LTC/USD – US dollar price change each month since the beginning of 2017. The right chart plots ‘return’ (being the average monthly change during the same period) against the ‘volatility’ of return (given by the average of absolute monthly changes). What volatility ignores is the direction of change; instead it shows how much the cryptocurrency moved, which is a measure of risk with its sense of uncertainty.
What can the charts tell us about co-movement of Bitcoin, Ethereum and Litecoin?
First, it’s obvious that they do move together. The first chart shows irregular waves of price change with the timings roughly in step. Untangling leads and lags is complex and I used a statistical app which found that Ethereum and Litecoin tend to move about a month behind Bitcoin, but the lag/lead relationship with Ethereum and Litecoin is inconsistent.
Second, the scale of change varies, which is most obvious in the return peaks of Ethereum and Litecoin, which usually diverge from that of Bitcoin. Sharp differences in the quantum of price change underlie the ‘Return vs Volatility’ chart, which shows return and risk for 2017-8 in the upper center and right, and from the start of 2019 to November 2022 in the bottom left. This has two messages. First is finance’s classic truism that there is a risk-return trade-off which can be seen in both periods: the highest return came from Ethereum, but only with nail biting uncertainty and the widest swings in price. Conversely, Bitcoin had the lowest return, but also the least risk. The second message is finance’s only other truism which is that the past is no guide to the future. Returns enjoyed during the run up to price peaks in late 2018 were not repeated: they halved, although with commensurate decline in risk.
A third factor affecting price co-movement (which the charts ignore) involves the principal uncertainties for investors which are performance of counterparties and survival bias from collapse of weak cryptocurrencies. Cryptocurrencies discussed here include the two largest by market capitalisation, which virtually ensures they are amongst the best performers. Thus the analysis paints a biased picture of return in the sector by concentrating on large, good performers.
Comparable to the risk of survivorship bias is counterparty risk – the possibility that your counterparty does not perform as expected. All investors must give up their money in anticipation of a larger sum in the future, and thus they literally put it in the hands of a financial institution, exchange, or entrepreneur. The money is at risk until it comes home and, because money is portable and fungible and so offers a strong inducement to profit from it, finance is replete with failed investments. Crypto holdings are no different and involve at least one counterparty, which explains the scams that occur so regularly. Again these risks are not in the analysis above.
In summary, at least Bitcoin, Ethereum and Litecoin seem to move together, though they lack the precision of fireflies.
