Can Cryptocurrencies Be a Future Safe Haven for Investors? A Case Study of Bitcoin

Abstract

Purpose: This study attempts to determine whether or not Bitcoin prices are affected by real economic activity, financial markets, and foreign exchange markets; and whether Bitcoin has the potential to be a safe haven for investors.

Background: Cryptocurrencies in general, and Bitcoin in particular, have generated a huge interest from both practitioners and academicians as an alternative mechanism for electronic payment systems. While some argue that “Bitcoin works in practice, but not in theory”, others argue that Bitcoin’s stability depends on unknown variables in unknown combination, and thus it is difficult if not impossible to model precisely, thereby raising doubts about the soundness of the system. The research community should assume the task of precisely identifying the factors driving Bitcoin prices, and develop some theoretical foundation to help understand how Bitcoin will be affected when the legal environment and practices change.

Significance of the Study: The extensive discussion of Bitcoin on blogs and in the mainstream financial media has primarily focused on the cryptocurrency’s technical, legal and safety issues. Even the limited academic research on the subject has focused on the technical and safety issues, leaving the question of financial and economic aspects largely untouched. The present study thus seeks to determine the extent to which Bitcoin is affected, if at all, by changes in economic growth, financial markets, and forex markets. The paper also seeks to determine whether Bitcoin behaves differently from forex markets and financial markets and if it has a hedging or diversification potential?

Design/methodology/approach: A Markov regime-switching regression model is employed in this study to determine the relationship between real economic activity (proxied by the Baltic Dry Index), financial markets (proxied by the Dow Jones Industrial Average Index), and foreign exchange markets (proxied by the USD-Euro & USD-Yen exchange rates).

Findings: The results indicate that, unlike USD-Euro and USD-Yen exchange rates, Bitcoin exhibits significantly different behavior in terms of its association with other financial and economic variables. While equity markets or forex markets are significantly related to each other in varying levels in both the bullish and the bearish regimes, real economic activity appears to be unrelated to either of them. Bitcoin meanwhile, is affected neither by real economic activity, nor equity markets, nor forex markets in either bullish and the bearish regimes. Indeed, it differs significantly in its behavior from forex markets. Furthermore, the results indicate that Bitcoin tends largely to exhibit a bullish trend and the probability of transition to a bearish trend is very small. Thus, it can be concluded that Bitcoin may offer potential for both hedging and diversification to varying degrees.

Originality/value: Although the technical, legal and safety issues in cryptocurrencies have been widely discussed, financial and economic aspects remain largely unexplored. The current study thus makes a modest contribution to the sparse literature on the subject.

Keywords: Cryptocurrency, Bitcoin, Blockchain, Digital Currencies, Financial Innovation

JEL Classification: C58, G11, F31