Friday, January 12, 2018

Analyzing the cryptocurrency market using factor analysis

A mathematical tool called factor analysis can identify user experiences that appear to be important in determining prices of the more than 3,000 cryptocurrencies.
Price movements of individual coins versus in the total cryptocurrency market
Reporting and discussion of cryptocurrencies is often focused on abrupt large gains or losses of individual coins. Bitcoin's rise of 88 percent from Dec. 1 to Dec. 19 and then its fall of 23 percent by Dec. 30 is a good example. The net return for the month was 44 percent.
However, little attention was paid to the entire cryptocurrency market and what was happening in it. The market value of all non-bitcoin crypto assets rose 153 percent during bitcoin's upswing, and four percent more while bitcoin declined, for a return of 162 percent for December.
Factor analysis of the cryptocurrency market
Traditional financial metrics such as are used to evaluate stocks are of little use in evaluating cryptocurrencies. There are altogether more than 3,000 different cryptocurrencies, each with often overlapping but not identical technical underpinnings. Factor analysis is one way in which the market for these many different coins can be understood.
While hashing power, block size and supply control can provide some tools for evaluating individual coins, factor analysis can identify user experiences that appear important for setting prices according to Aaron Brown in a recent Bloomberg article.
Brown uses statistics to identify the main factors that appear to have driven most of the movement in the prices of cryptocoins during the month of December. The four factors are shown graphically in the article.
The four factors: mainstream, speed, community, ease
Each factor is a portfolio with long and short positions in many cryptocurrencies according to Brown which are determined solely by statistics. Brown chose the names for the four factors.
Mainstream
Brown does not explicitly define what he means by mainstream but it appears to mean the extent to which a coin would be accepted into the mainstream of financial investments. Over the month the factor declined in importance during the first couple of weeks but then recovered importance and became extremely important at the end of December.
The mainstream factor has given positive weights to coins such as Ripple, Cardiano and Stellar, all currencies that are so designed as to get along with regulations and institutions. Ripple has a payments system already used by some banks. Other coins such as Monero , Dash and Zcash are all designed for user privacy and these coins have negative weights in terms of mainstream.
Brown suggests that the mainstream factor declined over the first couple of weeks in the month because it was expected that bitcoin would go mainstream with the launching of the two futures markets. If regulators and institutions accepted bitcoin there would be less need for regulation-friendly currencies and some bitcoin users could switch to more private coins. Personally I don't see the logic in such reasoning. That one major coin bitcoin becomes more mainstream does not change the role of other coins such as Monero being just as useful for nefarious purposes as before and regarded as in need of regulation.
Brown says the factor drifted back up in importance as futures trading did not lead to large bitcoin holders transferring their exposure to financial institutions. He believes the sharp upward spike at the end of the month was based on optimism that bitcoin would remain a currency for libertarians and technophiles leaving the way open for inoffensive alternatives.
Speed and Ease
These factors relate to the convenience of transactions
Litecoin, Ripple, Monero and Ethereum are all positive with respect to the speed factor whereas Litecoin is negative. The high traffic and its failure to enlarge the size of its blocks has resulted in much slower transaction times for bitcoin as compared to many other coins.
Ease is regarded as positive for coins such as Litecoin and Dash which both have low transaction costs and are user-friendly, at least in relative terms.
The importance of the Ease factor drifted downwards until the middle of the month where it remained the rest of the month as the least important factor.
Speed also dropped in significance in the early part of the month but then rose considerably and briefly near the end of the month became the most important factor before the huge spike in the importance of mainstream.
Community
This factor refers to the size, quality, and enthusiasm of the developer and support community associated with a coin. A successful coin needs a broad base of sophisticated users to try the features of the developing platform and provide informed feedback. There needs to be long term capital invested. Bitcoin and ethereum are given the largest weight for this factor. This is not surprising given that they are the 1st and 3rd largest coins. However, one might think that the cohesion of the community is also an important factor as divisions can cause forks that can cause declines at least temporarily.
Ripple and Monero are said to have smaller but positive weights for this factor. Negative weights would apply to coins that have little or no active development or have had hacks or scandals or disputes in their past. Surely bitcoin has had disputes and also scandals at least indirectly connected to the coin. However, this happened in other months than that studied.
For the first half of the month, the importance of community rose to be the most important factor before declining to third place in the latter half of the month. Brown says of the movement of the factor: "My guess is that faith in established cryptocurrency communities was shaken by the sudden dollar flood; kind of like a rock band falling apart after having a hit. Some people fought the intrusion of Wall Street, others took the money and ran. Some felt cheated by how little they had to show for years of work on a group project, when others who had contributed far less were multimillionaires. When visionary idealists collide with big money, the results are hard to predict."
Tools for investing in cryptocurrencies
Brown notes that his analysis is not meant as investment advice. Based on the chart some people may decide to invest in mainstream currencies, while at the same time shorting privacy-linked coins such as Monero. However, to short Monero is probably unwise given its trend line and its usefulness, speed and its attraction to many groups because of its privacy.
Others may see that Ease can be bought cheaply and may buy coins with high Ease ratings hoping that they will increase in importance. However, as Brown puts it, the factors can filter out noise but cannot tell you what will happen in 2018. Indeed, Brown's analysis appears to be more useful at understanding what happened in the past rather than providing a tool for rational betting on the future.
While factor analysis may be of some help in investing rationally, such analysis can always be supplemented by other types of analysis. Technical analysis that can identify trend lines and likely directions of price movements is another such tool, as described in this article.
As well, there are certain facts about both an individual coin and of wider scope that have obvious linkages to the price of coins. The crackdown on cryptocurrency exchanges and initial coin offerings (ICOs) in China is an example of a fact of wider scope. An impending change in blockchain rules is an example of a fact that could have a negative effect on the price of an individual coin. Listing on an important exchange is another.
While there may be no way of assessing the value of cryptocurrencies as one can assets such as stocks, there are still other methods of analysis and many facts that are relevant to determining how prices of coins are liable to move. However, with cryptocoins in particular even the best analysis no doubt will remain uncertain and investment quite risky.


Published previously in the Digital Journal

No comments:

US will bank Tik Tok unless it sells off its US operations

  US Treasury Secretary Steven Mnuchin said during a CNBC interview that the Trump administration has decided that the Chinese internet app ...