The purpose of issuing cryptocurrencies is to provide a convenient means of payment, which may be potentially attractive for investment purposes, and enable the anonymization of payments and bypassing regulatory restrictions by eliminating intermediaries (banks and payment systems) and transferring the verification function of transactions to a distributed accounting system.
Cryptocurrency prices are very volatile, they depend on user demand, investors’ reactions to statements from regulators, large companies and public figures. Due to the speculative nature of the industry, many people wonder if investing in cryptocurrencies is actually safe?
Cryptocurrencies – definition and taxonomy
After the world’s first Bitcoin cryptocurrency was issued in 2009, the market has evolved rapidly and now offers a wide range of different instruments, including those based on blockchain technology.
The broadest term relating to them is a crypto-asset, that is, an asset that exists in digital form or is a digital representation of another asset and created using a blockchain. It should be noted that this technology is already used not only in cryptocurrencies, but also in various financial market processes, e.g. to protect transactions and confirm title to assets of various types.
Price factors and investment in cryptocurrencies – what affects their value?
The market value of cryptocurrencies depends on two groups of factors. On the one hand, the market assesses the outlook for payment processing technologies in the economy (both in the legal and illegal sectors) and expectations for their further spread. On the other hand, these are speculative factors related to the high volatility of cryptocurrencies, the hype around them and the willingness of market participants to obtain quick returns.
Network analysis and dynamic cryptocurrency pricing models focus on customer use of cryptocurrencies and network effects: the more users join the system, the greater the benefits for them, and correspondingly higher cryptocurrency prices. Other researchers are checking if cryptocurrency exchange rates show any signs of a bubble. The overall conclusion is that the increase in cryptocurrency prices is associated with the wider adoption of cryptocurrencies, and the dynamics of cryptocurrency rates often testifies to the existence of a bubble in this market.
It is concluded that new addresses (an address is a unique string of numbers and letters in a blockchain identifying the payer or recipient) appearing in the blockchain ecosystem return an 8% difference in cryptocurrencies (i.e. more than in the case of company returns on the exchange – 5%). Moreover, by analyzing price movements before and after new users ‘joining’ the blockchain, market researchers found that this information translates quickly into prices as the data in blockchains is publicly available. Therefore, the following assumption was made: the price-to-new address ratio negatively predicts future returns from cryptocurrencies (the higher, the lower the future returns).
Investing in cryptocurrencies – how to identify a market bubble?
In economic theory, a bubble is the deviation of the market price from the fundamental value of an asset. However, since the fundamental value of cryptocurrencies cannot be reliably assessed, the bubble is identified using statistical methods. These methods were originally developed to detect explosive pricing behavior. The most common methods are:
- extended Dickey-Fuller test (it is used to check whether a given time series is stationary or not). This procedure provides the most accurate results for detecting explosive behavior when multiple episodes are present in the data. It was used to identify US stock market bubbles in 1871-2020,
- log-linear model. It assumes that prices show an increase in the law of force in the case of the bubble and predicts the tipping point at which the bubble will burst. This model was used to identify the bubble and its tipping point for the Shangai Composite Index in 2007-2008.
Research based on the first method analyzes the behavior of eight cryptocurrencies in 2017-2018. Trading volume, volatility (positive relationship to bubble behavior) and the VIX index (negative relationship) were found to be the main predictors of bubbles in cryptocurrencies. In turn, the analysis using the second method showed a correlation in the dynamics of prices of various cryptocurrencies and the effect of Bitcoin benchmarking, with speculative factors playing an important role in the market. In line with this, Bitcoin appears to have been in the bubble phase since mid-2015, but does that mean investing in cryptocurrencies at this stage is dangerous?
What should safe cryptocurrency investing look like?
So, is cryptocurrency investment a safe process? The answer is yes! However, starting your adventure with this industry must be preceded by appropriate education in the subject of digital assets. Otherwise, the potential investor is only exposed to unfavorable capital allocation and, consequently, its loss. You can always go to our exchange offices where you will also get the necessary help! Find the nearest Kanga exchange office!