Do Cryptocurrencies Increase the Systemic Risk of the Global Financial Market?

• DOI: http://doi.org/10.1111/cwe.12314
• Author: Shiyun Li,Yiping Huang
• Published date: 01 January 2020
• Date: 01 January 2020

©2020 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 122–143, Vol. 28, No. 1, 2020

122

Do Cryptocurrencies Increase the Systemic Risk

of the Global Financial Market?

Shiyun Li, Yiping Huang*

Abstract

The advance of cryptocurrencies has sparked wide concern over their interplay with

the existing global financial market. This paper analyzes the risk spillover relation

between cryptocurrencies and major nancial assets, and unravels how cryptocurrencies

could influence global financial systemic risk. We find that cryptocurrencies function

as a separate risk source from traditional assets. Major legislative, financial and

technological events in the cryptocurrency market may affect risk spillover dynamics.

Although the overall penetration of cryptocurrencies is not yet deep, introducing

cryptocurrency can signicantly increase the systemic risk to traditional markets during

low risk level episodes.

Key words: cryptocurrency, dynamic risk spillover, systemic risk

JEL codes: E44, F36, G15

I. Introduction

Since the advance of the first cryptocurrency, Bitcoin, a decade ago, the world has

witnessed the tremendous expansion of the cryptocurrency market. By 20 October 2019,

there were 3000 different cryptocurrencies circulating in the market, and on 7 January

2018 the total market capitalization of cryptocurrencies hit a peak of over US$821.7bn.1

In addition to the best-known cryptocurrency, Bitcoin, the herald of innovation, others,

such as Ethereum, Ripple and Litecoin, are also actively traded and together account for

more than half of the total market capitalization.

Cryptocurrencies are digital or virtual currencies that are encrypted using

cryptography. Although initially designed to break the third-party “trust-based model”

*Shiyun Li (corresponding author), PhD Candidate, Institute of Digital Finance, Peking University, China.

Email: shiyun.li@pku.edu.cn; Yiping Huang, Professor, Institute of Digital Finance, Peking University, China.

Email: yhuang@nsd.pku.edu.cn. This work was supported by the National Social Science Fund Major Project

of China (No. 18ZDA091), the Swiss National Science Foundation (No. 100018_176387/1) and the Peking

University Institute of Digital Finance Project.

1Data obtained from: Coinmarketcap.com.

©2020 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Cryptocurrencies and Systemic Risk of the Global Financial Market 123

of electronic payment in online commerce (Nakamoto, 2008), cryptocurrencies have

aroused keen interest since their introduction, mainly as an investment asset (Baur, Hong

and Lee, 2018). However, given their volatile nature, the advance of cryptocurrencies

as a new investment asset can exert additional risk spillover on existing nancial assets

and has the potential to raise systemic risk level of the nancial market. Both aspects

have rarely been explored in the existing literature, but are of regulatory importance if

cryptocurrencies evolve as a new risk source to the global nancial system.

In this paper, we focus on the major financial assets that are most relevant and

discuss their intrinsic relation to cryptocurrencies. An intuitive rst class of assets, given

their name and functional design, is currency or currency-related precious metals, such as

gold and silver. There are particular similarities between cryptocurrencies and precious

metals. For example, both Bitcoin and gold are scarce and fixed in supply, should be

discovered through the “mining” process, are anonymous and decentralized and have

the capability to function as money (i.e. unit of measurement, medium of exchange and

store of value). Bitcoin is thus frequently referred to as “digital gold” and bears a close

resemblance to precious metals in this sense. Through their similar function as alternative

“money,” these two types of assets may also have a potential risk linkage. Dyhrberg (2015,

2016) and Baur, Dimp and Kuck (2018) discussed the resemblance among Bitcoin, gold

and the US dollar and the hedging potential of Bitcoin through volatility analysis.

As for currency, we focus on major foreign exchange rates. Cryptocurrencies

are useful for capital control circumvention in countries that either restrict the free

exchange of currency or limit the amount of money that can be transferred or transacted

across borders. Regulatory arbitrage using cryptocurrencies calls into question over the

effectiveness of capital controls and may increase the volatility of foreign exchange

rates of the countries involved. Aloosh (2018) found large price discrepancies (up to a

peak of 27 percent) of Bitcoin denominated in different currencies and suggested that

the pricing of Bitcoin is not uniform or consistent globally. Such discrepancies can lead

to extensive arbitrage trading and volatilize foreign exchange rates.

Another relevant class of assets are securities, particularly stocks. The creation

and sale of a digital coin or token to fund project development, that is, the initial

coin offering (ICO) process, bears a close resemblance to the initial public offering

(IPO) process that issues stocks instead. Although not all cryptocurrencies are tokens,

which are created through ICOs,2 there is much confusion among investors about the

2Cryptocurrencies are most commonly categorized as alternative cryptocurrency coins (altcoins) and tokens.

For a more detailed discussion of the difference, see: https://masterthecrypto.com/differences-between-

cryptocurrency-coins-and-tokens/ (online; cited November 2019).