Cryptocurrencies and Finance Theories

Introduction

Cryptocurrencies (CCYs) have emerged as a new asset class that draws attention from investors seeking diversification and hedging opportunities. This innovative fintech can potentially offer investment alternatives with less information asymmetry and more efficiency than traditional commodities and currencies.

The paper investigates the theoretical framework connecting CCYs with financial theories, exploring questions about CCY applications at individual and business levels, safety, transparency claims, diversification potential, and capacity to replace traditional financial assets.

Methodology

This research applies an exploratory approach to identify literature connecting financial and investment theories with cryptocurrencies. The methodology involves:

• General search using CCY/DLT and finance theory keywords across SCOPUS, Google Scholar, books, conference proceedings, and relevant reports
• Funneling content specifically related to CCYs and finance-investment theories
• Drafting the study with a general outlook of CCY/DLT and finance theory relationships

The approach recognizes that CCY research is still emerging, limiting comprehensive literature reviews but providing groundwork for future theoretical development.

Cryptocurrency and Blockchain Background

Blockchain technology, introduced by Nakamoto (2008), provides a decentralized system for currency exchange and payments different from proprietary/central systems. DLT bases trust on users connected peer-to-peer with multiple public transaction copies, overcoming issues in centralized systems.

With rising e-commerce and digital transactions globally, cash usage may decline, encouraging CCY adoption due to benefits over fiat currency. At the time of writing, the CCY market exceeded US$300 billion with over 3,500 cryptocurrencies trading.

DLT applications extend beyond cryptocurrencies to potential uses in stock exchanges, voting processes, and various business operations requiring transparency and security.

Diversification Theories and Asset Pricing

The paper examines how traditional asset pricing models like CAPM, APT, and Behavioral Portfolio Theory (BPT) apply to cryptocurrencies:

• CAPM: May not adequately explain Bitcoin returns, suggesting alternative models are needed
• APT: More suitable for CCY analysis due to multiple macroeconomic factors influencing prices
• BPT: Provides framework for understanding CCY allocation in layered investment strategies

Research shows Bitcoin offers diversification benefits when combined with traditional assets like oil, gold, and stocks, though its high volatility limits exchange utility. Studies during COVID-19 present mixed evidence on CCYs as safe havens.

Efficient Market Hypotheses

EMH application to cryptocurrency markets yields mixed results:

Early studies found Bitcoin markets inefficient, but later research indicates improving efficiency over time. Different methodologies (Hurst exponent, GARCH models, etc.) produce varying conclusions about market efficiency.

DLT's transparency and speed potentially make information reflection more efficient than traditional systems. However, investor irrationality and herding behavior during price bubbles challenge pure EMH assumptions.

COVID-19 studies show varying efficiency across different cryptocurrencies, with Bitcoin demonstrating reduced efficiency during the pandemic compared to pre-COVID conditions.

Adaptive Market Hypotheses

AMH, which combines economic and behavioral aspects of decision-makers, may better explain cryptocurrency market dynamics:

Limited research specifically examines AMH in relation to Bitcoin, but existing studies suggest Bitcoin efficiency improves over time, validating AMH implications. Market participants adapt to changing conditions, with time-varying efficiency observed across different cryptocurrencies.

COVID-19 research shows certain cryptocurrencies provided better returns than traditional assets during the pandemic, though data limitations constrain robust conclusions.

Agency Theory - Governance and Transparency

Blockchain technology offers potential solutions to agency problems through:

• Improved transparency in corporate decision-making
• Enhanced contract execution through smart contracts
• Better oversight of firm activities and cash flows
• Reduced fraud through immutable transaction records

Applications in supply chain management, database systems, and operational oversight could significantly improve governance. However, CCYs currently lack formal governance structures, and implementation challenges remain.

Central bank exploration of DLT for currency issuance indicates growing institutional acceptance, though regulatory frameworks are still developing.

Risk-Return Trade-off and Herding

Cryptocurrencies exhibit extreme risk-return characteristics that challenge traditional finance theories:

Bitcoin's dramatic price surges (from US$100 to US$18,000 in 6 months) don't align with conventional risk-return expectations. Studies show significant herding behavior in CCY markets, with interconnectedness and spillover effects between different cryptocurrencies.

Research methodologies like GARCH and GAS models help predict CCY returns and risks, with heavy-tailed models performing better than normal distributions. Bitcoin shows the largest contribution to return/volatility spillover in CCY markets.

COVID-19 studies present mixed evidence on cryptocurrencies as safe havens or contagion amplifiers during the pandemic.

CCY Operational Aspects

Cryptocurrencies face operational challenges including:

• Regulatory uncertainty across jurisdictions
• Economic implications including potential deflationary effects
• Ethical considerations in mining and transaction verification
• Integration with traditional financial systems

For widespread adoption, CCYs must overcome financial, regulatory, societal, and technological barriers. International coordination among banks, governments, and fintech developers is needed to establish governance frameworks.

Despite challenges, DLT applications continue expanding across business sectors including accounting, management, supply chain, and information technology.

Summary and Conclusion

This research provides a comprehensive review of cryptocurrency literature in relation to financial theories, identifying significant gaps and future research directions.

Key findings include the need for:

• Stronger theoretical foundations connecting CCYs with finance theories
• Long-term data analysis as CCY markets mature
• Studies considering different shock periods (crises, pandemics)
• Multi-disciplinary research combining finance, technology, law, and ethics
• Examination of CCYs as medium of exchange with governance implications

DLT represents the future of financial technology, with cryptocurrencies as one prominent application. As regulators and institutions explore implementations, theoretical and empirical research must advance to support informed decision-making.

The COVID-19 pandemic highlighted both opportunities and limitations in cryptocurrency applications during crises, underscoring the need for continued research in this evolving field.