What is the most effective proxy-hedging instrument for the Bitcoin/USD market? A recent study by Dominique Guegan, affiliated with Université Paris, Panthéon-Sorbonne, and two other scholars tackles this question. The study reaches no definitive conclusion, except the negative one that there is no way Bitcoin can be “fully hedged because the density forecasting capabilities of Altcoins are inadequate.” It also seems to favor Ethereum as the best of the available options, though the authors do not quite want to say so. Bitcoin is the matriarch of the altcoins family, and all the family members share some common features, so one might expect that the other coins could be used to hedge positions taken in the mother of them All vis-a-vis the dollar or another of the sovereignty-backed currencies. The problem, though, is that Bitcoin’s history shows “unusual volatility clustering effects” that are not among the econometric features of the other coins. Filling the Scholarly Void These authors are filling a void in the literature on the cryptos. There is a lot of discussion in scholarly journals about the cryptos’ prospects as mainstream investment options and currency units. There is also a fair amount of discussion of their utility as hedges. According to a much-cited paper by Anne Dyhrberg (2016), Bitcoin is an effective hedge against stocks in the FTSE, or against the fluctuations in the US dollar. But there is—or has been until now—very little about how a speculative play in Bitcoin itself may be hedged. So now there is this paper. The authors observe that there are at least four distinct classes of entity that have a pressing need for hedges against their Bitcoin positions: hedge funds that employ strategies based on a return relative to Bitcoins; individuals (“whales”) who own amounts so significant it would scare the markets were they to sell sizeable chunks of it quickly; miners and others who incur costs, such as electricity, that they need to pay in the fiat currencies; and ICO projects that don’t want to be seen selling off their tokens or crypto. Futures and Volatility One of the more popular methods of trying to hedge has involved the use of futures, either the Chicagoa futures or Bitmex, the Bitcoin Mercantile Exchange owned and operated by HDR Global Trading. Unfortunately, futures in general constitute “an ineffective risk hedge ... as futures markets are not liquid and are limited to a small number of significant coins (i.e., Bitcoin, Ethereum, Ripple)” and futures create basis risk, an additional layer. It was probably a bad sign that following the launch of Bitcoin futures on CME at the end of 2017, the cryptocurrency market experienced a massive crash. Guegan, et al., concur with a 2018 paper by Shaen Corbet et al (2018), who concluded in their study that the introduction of Bitcoin futures has significantly increased the volatility in the spot market and that overall, they are not a useful hedging tool. After examining that and other possibilities, they return to where they began: why not use the other Altcoins? Altcoins and Their Idiosyncrasies One problem here is that every major coin exhibits its own behavior due to idiosyncratic events. For example, some of the more important Altcoins are tethered to the US dollar. One of them is called Tether for just this reason. They “oscillate around the unity value and cannot be considered as an effective Bitcoin proxy-hedge.” The Altcoins most often used by market participants as hedging tools are: Ethereum, Bitcoin Cash, and Bitcoin Satoshi Vision. The authors ultimately agree with the market’s estimation that these are the best proxies available. They also concur that relationships change over time. Ethereum was “a poor proxy-hedging candidate before 2017, but the differences between Ethereum and Bitcoin’s distributions [attenuated] during 2018.” Ethereum is probably the best hedging tool available, when one considers the degree to which Bitcoin Cash and Bitcoin SV are subject to, and have been used for, market manipulation. Along with Guegan, the study’s authors include Marius Cristian Frunza and Rostislav Haliplii. Haliplii is a colleague of Guegan’s at the Sorbonne. Frunza is one of the founders of Schwarzthal Tech, a Fintech/AI start-up.
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