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Research Finds Innovation Potential as Main Driver of Cryptocurrency Returns

Reading Time: 3 minutes by on January 16, 2017 Altcoins, Bitcoin, Finance, News

With interest in Bitcoin growing, cryptocurrencies are identified as lucrative investment opportunities and are researched as some kind of financial asset or commodity. The Winklevoss ETF looks to bring bitcoin to a wider investment audience and the German fund Acatis have stated how the cryptocurrency acts as a hedge against uncertainty, similar to a commodity such as gold.

While cryptocurrencies are valued because of their scarcity, a research paper published January 13 finds that the main factor driving the returns of cryptocurrencies is the innovation potential of the underlying technology. ‘Buzz Factor or Innovation Potential: What Explains Cryptocurrencies’ Returns?‘ envisions bitcoin and cryptocurrencies not as digital assets, but as technology and they should be treated as such. If innovations such as bitcoin are to be viewed as technology, and not as an asset or currency, then this implies that the microeconomic relationships will diverge from that of traditional money. This is evidenced in the results which show that the supply of cryptocurrency can have an unexpected influence on its price.

Cryptocurrencies have shown that scarcity exists in the digital world, provided by cryptography, and this means that these digital assets can potentially become valuable. But is this factor explaining the fluctuations in market value over time? The source of these fluctuations could instead be the innovation potential; since cryptocurrencies have many use cases and applications, fluctuations in value may be down to value creation and the resulting capture of the market share of existing industries and/or creation of new industries.

Demand and supply may provide an answer. In the long run, bitcoin’s (and other cryptocurrencies’) supply is highly predictable by the ecosystem’s stakeholders whereas in the short term, the supply can vary in unanticipated ways, as shifting patterns in mining may deviate from the long-term trend. Since the majority of the influence of supply can be factored into user expectations, demand is argued to be the primary driver of the value of cryptocurrencies.

Media visibility is argued by the existing research to cause large demand shocks, known as the ‘buzz factor’, whereby media reporting can attract new waves of users and push the demand and consequently the value of a digital asset higher. But this explanation masks the possibility that cryptocurrencies may also gain value and generate returns become they embody a true innovation potential.

Addressing an important gap in the research on blockchain technology, the study explored the factors explaining returns using data over the period of September 2014 to August 2015 for five cryptocurrencies, whose innovations are widely recognized by the community; bitcoin, litecoin, Peercoin, Ripple and Stellar. While prior research has focused on explaining the returns of bitcoin, these results show there is no evidence that greater visibility increases the profitability of a range of cryptocurrencies and is found to be negatively associated with returns, after controlling for various factors.

Perhaps media hype cannot boost the value of cryptocurrency as is purported by some in the mainstream media. The evidence suggests that those who choose explanations of media frenzies driving prices higher are overlooking the technological implications of Bitcoin.

It is not just a cryptocurrency or digital asset, but a network and protocol. For example, when comparing the speed, efficiency of bitcoin to Western Union, we see that bitcoin enables international transactions at very high speeds and at a much lower cost (less than one percent fees) compared to fees up to nine percent for Western Union. So not only are these new assets scarce, they are useful. Therefore, their value is expected to rise independent of the ‘buzz factor’.

Cryptocurrency innovation potential, ‘technology development’ was captured by using eight indicators sourced from CoinGecko and was found to be the most significant driver of higher returns. This variable includes the number of proposals merged into the core codebase, number of forks and the number of unique collaborators contributing to the core code project, with the study using a ‘proprietary’ weighting, one that is eagerly kept secret by CoinGecko.

One counter-intuitive results thrown up by the study is that upward variations in supply are positively related to returns which appears to be at odds with the Quantity Theory of Money and with explanations of why Bitcoin is considered a store of value. This surprising result suggests that an increase in supply increases a cryptocurrency’s returns. This points to something else driving the behaviour of cryptocurrencies, markedly different from fiat currencies, with two possible explanations:

  1. A short-term increase in supply might influence existing cryptocurrency holders to reinforce their position, and such display of confidence might induce outside buyers to enter the market.
  2. An increased supply in the short term could bethe result of a spike in mining intensity, which may be interpreted as a signal of the cryptocurrency’s increasing potential to be widely used as a medium of exchange. In both situations, unexpected supply growth will shift demand higher and drive returns higher too.

While other studies have framed bitcoin as either a currency or a commodity, the study departs from these exploratory analyses, acknowledging cryptocurrency is technology and therefore has the potential for innovation which takes on a value of its own. The findings of the strong relationship between technological development and asset returns for cryptocurrency should lead researchers to treat bitcoin and other cryptocurrencies as “technology platforms, and not just as financial or monetary instruments.“

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