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Diversifying Risks In The Crypto Market

2018-03-30 18:06:23.0

Uncertainties on tax and regulations, worries on system security combined to news that major social media channels are preparing to ban advertisement on cryptos have taken their toll on the crypto markets over the past couple of weeks. 

The confusion came after a significant price correction hit cryptocurrencies since the beginning of the year and enhanced the unwinds across the market.

Presently, Bitcoin trades lower than the half of its historical high of $19’511 reached on December 18th. On the other hand, altcoins offer limited alternative in periods of panic as well, given that the entire crypto-sector is shaken by the same set of risks.

The cryptocurrencies are interesting and certainly promising for investors seeking to take a bet on new technologies. However, the high market volatility is an entry barrier for many.

Though it is hard to call for the end of the bear market, it would be interesting to seek how to reduce the volatility of investments in cryptocurrencies. 

In our previous articles, we stressed out the need for investment in a diversified portfolio of cryptocurrencies for a better management of risk in a heavily volatile market. In this article, we investigate how well the diversification works for a portfolio of cryptocurrencies.

Before we start, it is important to note that the cryptocurrencies emerged recently. Therefore, there is only limited historical data for running a study on a portfolio of cryptocurrencies. 

Second, historical data may not be an accurate prediction of the future, given that a new market is expected to evolve rapidly through time, hence price and volatility patterns could change significantly in periods ahead.

Still, it is interesting to compare the performance of an investment in Bitcoin over the past three quarters versus a portfolio of major cryptocurrencies to comprehend the actual market dynamics and follow the evolution over time.

Which risks are diversifiable?
Finance experts assume that there are two types of risk in a given market: the systemic risk and the idiosyncratic (individual) risk. 

For example, the length of a coin’s blockchain time is an idiosyncratic/individual risk and could be diversified by including several altcoins in a portfolio. 

Regulation, on the other hand, is a systemic risk. All coins are concerned by changes in regulation on cryptocurrencies, hence the risk could hardly be diversified within the crypto-universe.

The idiosyncratic risk is the one that investors could diversify by holding different assets in their portfolios. The systemic risk cannot be diversified, as all assets in a given class are equally threatened by a sector-wide risk.

Diversification reduces risks
The empirical study performed on closing prices over the period of 24 July 2017 to 4 March 2018 showed that an equally weighted portfolio of five cryptocurrencies (Bitcoin, Ether, Ripple, Litecoin and Bitcoin Cash) reduced the average 10-day rolling volatility by 10.5% compared with the same investment only in Bitcoin over the same period. Meanwhile, the final portfolio of five cryptocurrencies performed only 4% less than an equal amount invested in Bitcoin alone. 

The diversification proved to improve the average return-to-risk ratio, although the correlation among cryptocurrencies remained relatively high compared to a portfolio of traditional assets.

Limits of diversification
As discussed earlier, the major risks in the crypto market are security and regulatory risks. Both represent systemic risks to the crypto market. 

Although the primary trend in the new-born crypto market is expansion, which is translated in a positively skewed market, the downside risks prevail. 

The cross correlation among cryptocurrencies tends to be higher due to the systemic risk. 

Moreover, in the same way than traditional assets, the cross-asset correlation increases even more during periods of heavy market unwinds. This is because major news is sometimes perceived as a threat for the entire market, which represents a systemic risk and could not be diversified across the assets of the same asset class.

It is obvious that higher correlation among cryptocurrencies has a negative impact on diversification. The question is to what extend could the negative impact be tempered with diversification?

Based on the above-described empirical study, during the period of aggressive downside correction between 16 December 2017 and 13 February 2018, the volatility of the equally weighted portfolio of five cryptocurrencies (Bitcoin, Ethereum, Ripple, Bitcoin Cash and Litecoin) was 6% less compared to an equal amount invested in Bitcoin, versus a decline in volatility down to 10% over the entire period of analysis. In other words, the diversification had less impact on volatility in times of destressed environment as expected, but the diversified portfolio fluctuated sensibly less than a single asset investment in Bitcoin.

On the other hand, the diversified portfolio and Bitcoin had a similar performance in average during the sell-off period. Therefore, the return-to-risk ratio was improved, though less than a period of no-crisis.

Conclusion and expectation
As a conclusion, the diversification is useful and recommended. But it is important to note that the crypto market is a high-risk market with and without diversification; the systemic risk remains elevated due to security issues and a lack of regulation in the market. 

Bitcoin and the portfolio of five cryptocurrencies lost up to 63% and 61% respectively during the December - February sell-off.

Although our study found that 70% of the time the volatility of an equally weighted portfolio of five major cryptocurrencies was lower than the volatility of an investment in Bitcoin alone, this ratio fell to 55% during the period of sell-off. 

In other words, there have been relatively more days where Bitcoin fluctuated less than the portfolio of altcoins in times of general panic, perhaps because Bitcoin is a more established asset than altcoins and/or has a larger basis of fundamental investors.

However, the cross-correlation could be expected to decline over time, along with a lower systemic risk in the future.

In this respect, regulation could be an important milestone for the crypto market, as it would offer more legacy to cryptocurrencies and bring investors to focus on individual risks and advantages of each cryptocurrency, allowing them to calibrate investment strategies to diversify their risk.