If Price Fundamentals are Determinants, Cryptocurrency is Here to Stay

December 13, 2019

Computing power and network may be the pricing forces that help legitimize the nascent form of exchange.

Though Bitcoin came into existence in 2009 and many other cryptocurrencies have followed, a still emergent marketplace of virtual exchange remains a topic of contention. Critics argue that digital currency based on blockchain technology lacks intrinsic value. Confidence in digital money may depend on determining if the currency follows basic financial expectations. Traditional asset pricing rests on fundamentals such as earnings, but do fundamentals drive cryptocurrency prices?  

In a working paper, the University of Miami Herbert Business School's Stefanos Delikouras and George Korniotis and Hong Kong University of Science and Technology’s Siddharth Bhambhwani answer this question by identifying two cryptocurrency pricing fundamentals: network and computing power. The researchers test the relationship between these two measures and the prices of five of the most established cryptocurrencies – Bitcoin, Ethereum, Litecoin, Monera, and Dash – and then extend the investigation to 34 smaller cryptocurrencies. The study uses pricing data from mid-2015 to early 2019. Findings indicate that cryptocurrency prices depend on the number of users (network) and computing power both at the individual level and overall marketplace.

Fiat money, the paper currency of any given country, derives its value from its acceptance by the people and their governing body and trust in its validity. Delikouras, Korniotis, and Bhambhwani posit that, just the same, cryptocurrency finds its value in acceptance, related to the transaction benefit conferred onto its users based on network size, and trustworthiness in the security of each transaction, related to computing power.

The transaction benefit or usefulness of a cryptocurrency grows with the number of users in the network, since more users allow for more transactions. Trustworthiness, meanwhile, relies on miners who expend computing resources (power) to record every transaction onto the blockchain, which acts as a shared ledger of activity. The greater the cryptocurrency’s computing power, the more secure from rogue players, hence the more trustworthy. As the network size and computing power fluctuate, so does the cryptocurrency price.

While cryptocurrency prices show adherence to these fundamentals, moments of price deviations, or “bubbles,” occur. “There will be periods in which prices will be unreasonable, because every market has those,” says Korniotis. “But at the end, where the market is headed, where the prices are headed, relates to what the fundamentals tell us.” Parallel to traditional markets such as real estate or stocks, bubbles in cryptocurrencies prove periodic, with the currency always returning to the course dictated by its fundamentals.

Illegal activity such as money laundering in the cryptocurrency marketplace presents another concern. Yet, in recent years, authorities have demonstrated the ability to trace transactions, significantly reducing the amount of illegality. Importantly, cryptocurrency price movement shows no correlation to illegal activity, with prices staying true to the measures of their fundamentals. Korniotis draws another comparison to a customary marketplace: “The equity market doesn’t work perfectly; you hear about scandals in stocks, too. And yet people still buy stocks.”

Korniotis points out, however, that cryptocurrency is a new asset class that needs to stabilize. On the path to stabilization, some regulation may be needed, but validation of the pricing structure gives shape to the cryptocurrency atmosphere. By finding that cryptocurrency prices follow financial doctrine and not speculative, unsystematic values, the study may help increase the legitimacy and likely staying power of the new form of exchange.

Bhambhwani, Siddharth and Delikouras, Stefanos and Korniotis, George M., “Do Fundamentals Drive Cryptocurrency Prices?” (November 5, 2019).

 

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