Nick Chong · 12 hours ago · 2 min read
Guest Post › China › Adoption
Volatility Should Not Hold Investors Back from Accepting Cryptocurrency as an Asset Class in Asia
Asia’s traditional financial market has begun to recognize the investment merits of cryptocurrencies and its potential to be accepted as a formal asset class. Earlier this month, the Hong Kong’s Securities and Futures Commission (SFC) said that it will start to explore how to regulate the trading flows of cryptocurrencies.
In the United States, preliminary legal frameworks have already been put in place to introduce cryptocurrencies and future products based on such assets on one of the world’s oldest futures and options exchanges, the CME’s Chicago Board of Trade (CBOT). Most significantly, Bitcoin futures trading volumes have been on the rise with an increasing percentage (20 percent) of the non-US trades (40 percent) coming from Asia.
But why now? Until recently, volatility has held back many institutional players from investing into Bitcoin and the broader cryptocurrency asset class. However, greater participation in borderless crypto markets and interest, underpinned by blockchain technology, has sparked a paradigm shift among traditional investors.
Governments, in turn, have recognized the need to keep pace with market developments by introducing these currencies into a regulated trading venue – even though they do not fit under a traditional asset class – to give them greater credibility while managing the risks to investors.
Assessing cryptocurrency’s volatility
An investment in Bitcoin, or any other crypto asset, can be compared to exercising a call option on Bitcoin’s price, where the investment is equivalent to an option premium. If Bitcoin’s price increases in volatility, the value of the option would also increase, and vice versa.
This relationship can be reflected in a binomial tree real option pricing model, which could be developed for investment decisions related to bitcoin.
By applying a real option valuation model to value Bitcoin’s price, one would find that it is particularly steep. This is primarily driven by its high level of volatility with a jaw-dropping 30 percent monthly historical volume, which reflects the uncertainty that is typically associated with.
Merit behind the speculation
Volatility is not something that has just been introduced into the financial market. Dated as far back as 1841, Charles Mackay described the famous Holland Tulip-mania, a speculative bubble in tulip flower bulbs.
“Many individuals grew suddenly rich…one after another, they rushed to the tulip marts, like flies around the honey-pot…At last, however, the more prudent began to see that this folly could not last forever. Rich People no longer bought the flowers to keep them in their gardens, but to sell them again at cent percent profit. It was seen that somebody must lose fearfully in the end. As this conviction spread, price fell, and never rose again.”
There have been many scholars and literary works aiming to solve the puzzle of volatility, or “bubble”.
One of the oldest theories is price-to-price feedback theory. In a virtuous cycle, specular, upward price movements create “successes for some investors, attract public attention, promote word-of-mouth enthusiasm, and heighten expectation for future price increase.”
Under the feedback theory, the public would try to use “new era” theories and “popular models” to justify the increase in price and generate rounds after rounds of price hikes. Eventually, the growing expectation of future price increase becomes unsustainable, the bubbles burst, and prices are pulled back to reality by financial gravity.
This being said, cryptocurrencies should not be viewed as another tulip-mania. They are fundamentally an integral part of blockchain’s disruptive digital transformation which gives existing businesses and new ventures an opportunity to innovate their business models, achieve a strategic competitive advantage, or enter into new markets. Collectively, cryptocurrencies will likely capture a significant portion of economic value in the digital future.
More importantly, cryptocurrencies offer investors a new opportunity to diversify their portfolio and a way to hedge against fiat financial markets as a separate asset class. Taking Bitcoin as a proxy to the broad cryptocurrency market, our research indicates that over the last eight years, crypto assets have had a near zero average correlation with other asset classes and a very compelling capital return.
The extreme volatility with very fat tails, means crypto assets have a probability distribution that exhibits a large skewness or kurtosis, relative to that of either a normal distribution or an exponential distribution. This volatility-targeting strategy can add substantial value, resulting in similar returns with much less risk.
For these reasons, institutional investors who are experienced with embracing volatility for asymmetric return have started to accept crypto assets as a legitimate asset class. With this growing interest, it is unsurprising that the region has become a hub for key cryptocurrency exchanges like Chinese-led Binance, Huobi, and OKEx.
What lies ahead for crypto assets
The benefits of these new developments are three-fold. For one, institutional adoption will change the long-term supply and demand balance of crypto assets.
Secondly, additional capital from these typically traditional organizations would help to fund innovative startups, many of whom are on the brink of developing the next killer apps for mass adoption. Finally, as the price discovery process of this asset class becomes more institutionalized, we can expect the cryptocurrency volatility of crypto assets to decline over time.
The growing acceptance of this asset class is especially encouraging for Asia. No other foreign market has yet to develop a thorough framework to regulate crypto asset platforms. With countries like Hong Kong starting to take the lead, the region is becoming well positioned to set the benchmark for this new economy.