CryptoMarkets Maturity and Price Volatility
After attending a meetup with a few “crypto hedge-funds” in Silicon Valley I got multiple questions that remained unanswered, one of them has to do with “immature markets”. No matter who you ask today, if you ask someone (specially a hedge-fund manager) about the cause for price volatility in crypto-markets, she will most certainly give you some version of the “the market is still immature” answer, but what does that mean? Do they know exactly what an immature market is? If so, what exactly is the relation between immature markets and price volatility?
If we go for the standard definition of what an “Immature market” is, you can only say that it is one where there’s no price equilibrium(1). Now, since every market has some level of volatility and there’s seems to be a correlation between higher volatility in stock markets and immature (emerging) markets(2), we can assume that when someone says that cryptocurrency markets are volatile because they’re immature they are just implying (at least indirectly) that whatever is causing inefficiency in these markets is to blame for the volatility.
Now, you either can think that markets follow the Random Walk Hypothesis(3) (4) or not (2), but in any case, it’s hard not to argue that market efficiency is affected significantly by the amount or lack of the information available, so I thought it’d be interesting to analyze how is the information flow in cryptomarkets structured and how such structure is affecting their performance.
One common approach (based on the number of academic articles and papers on the subject) to evaluate the information flow in markets is trading activity, it’s also the base of the Efficient Markets Hypothesis and it’s strongly reflected in regulatory frameworks that punish insider information (5) and disincentivize dark pools (6), i.e. condemns any system that disrupts the information flow related with trading activity. In this specific area cryptocurrencies excel, blockchains are by nature public and easily accessible, and up until now trading information has been hyper-public, and it’ll most probably stay that way.
Another factor informing the market is the predictability of asset return characteristics (7), expectations about how a specific market will behave is usually reflected in the price as it influences the investor’s decision-making process, and it seems that it has been also an integral part of the dynamics of cryptomarkets trading, but there are some caveats in the case of ICOs, expectations are informed in great part by events related to industries and companies like quarterly reports, M&A, weather, competition, etc. factors that doesn’t seem to apply in cryptomarkets, where performance expectations seems to be more related to herd behavior where investors are betting on the general performance of the whole cryptocurrencies universe, we can assert this mostly because beyond the White Paper there’s little or no information about the companies doing the ICOs (8), so it may be said that even though expectations are informing the price, the expectations are not well informed themselves since it’s hard to know if these companies engage in market manipulation activities, or are in high risk of going out of business. This scenario is quite similar to the OTC markets for penny stocks (9), that are also very volatile and suffer from similar restrictions to the information flow (9), but are OTC markets “immature”?
Finally, arguably, the major cause of price changes is “new information”. When a new piece of information circulates in a financial market (whether true, or bogus), the prices of related assets move in response, and move again when the information is updated (10). How well suited are cryptomarkets to absorb shocks is hard to know, even so there’s evidence that suggest that both immature and mature markets respond similarly to anomalies (3).
So, in general, it seems to be that more than crypto-markets being immature, at best it can be said that they’re inefficient, something that may sound tautological when trying to explain price volatility, therefore it seems to be the necessity for better explanations about why such volatility exists.
In a world with complete and perfect markets, the price of the assets should depend only on how the cash flows covary with consumption, and there should be no need for financial intermediaries. However, because there are market imperfections, intermediaries play an important role in lending funds, underwriting security issuances, providing liquidity in markets, and spreading risks towards those investors most willing to bear; hence it can be assumed that the prices and liquidity of financial markets are potentially affected by the capital position of these intermediaries relative to their risks (11). In cryptomarkets these intermediaries are –except perhaps in the case of hedge funds- in many cases non existent- there are no banks and no securities broker/dealers or market markets- so it’s reasonable to think that since some of the channels where information usually spreads are not there, it’s not possible to have efficient markets and therefore the high volatility.
As an example, we can take short-selling. The fact that short selling makes markets more efficient is pretty well substantiated in academic literature, and there are many reasons:
Short-selling activities are considerably informative about future stock returns when there is a higher likelihood of private information in stocks. Short-sellers also bring considerable additional information to the market, especially for smaller stocks, that is not fully captured by contemporaneous insider trading. Overall, it seems that on average short sellers bring informational efficiency to the market rather than destabilize them (12).
Then in a similar fashion, shorting demand is an important predictor of future stock returns especially in environments with less public information flow, this suggests that the shorting market is an important mechanism for private information (13).
Another study focusing on price efficiency shows that lending supply has a significant impact on efficiency: stocks with higher short-sale constraints, measured by low lending supply, have lower price efficiency, and that relaxing short-sales constraints is not associated with an increase in either price instability or occurrence of extreme negative (14).
Finally a very interesting paper (15) that found that short-selling constrained stocks significantly underperformed during 1988–2002 and a seminal paper by Edward M. Miller (16) with some of the implications of markets with restricted short-selling are good examples of how this practice helps to inform the market.
Now, short-selling –as Vitalik Buterin pointed (17)- is “super-hard” to add to cryptomarkets but it’s extremely necessary for the same reason we’re discussing in this article, they bring important information to the market, perhaps critical and indispensable to maintain acceptable levels of volatility, and this can be said for lending and underwriting, or financial intermediaries in general.
In short, all points to the fact the cryptomarkets are inefficient because several critical agents that are usually present in traditional financial markets are not present there, and not until those agents become part of the ecosystem will be possible to reduce price volatility. It’ll require a significant amount of innovation to bring tools like lending and short-selling to decentralized markets, and when (and if) they are successfully incorporated, they will alter the landscape of what we now know as cryptomarkets and those who understand this process will most certainly be rewarded by better (though perhaps slower) returns on their investments.
(1) https://en.wikipedia.org/wiki/Mature_market
(4) https://en.wikipedia.org/wiki/Random_walk_hypothesis
(5) https://www.sec.gov/fast-answers/answersinsiderhtm.html
(6) https://www.sec.gov/news/statement/shedding-light-on-dark-pools.html
(7) https://www.bauer.uh.edu/departments/finance/documents/suzanneslee_info.pdf
(8) https://techcrunch.com/2017/12/07/6-red-flags-of-an-ico-scam/
(9) http://securities-law-blog.com/2017/02/21/sec-issues-white-paper-on-penny-stock-risks/
(10) https://arxiv.org/pdf/1004.4822.pdf
(11) http://siteresources.worldbank.org/INTMACRO/Resources/Pritsker.pdf
(13) http://www.econ.yale.edu/~shiller/behfin/2005-04/cohen-diether-malloy.pdf
(15) https://economics.mit.edu/files/3022
(16) https://www.jstor.org/stable/2326520?seq=1#page_scan_tab_contents
