The spillover effect of systemic risk on the traditional financial market

Crypto assets have emerged as an increasingly popular asset class among retail and
institutional investors. The advance of cryptocurrencies has sparked wide concern over their
interplay with the existing global financial market. Therefore, the growing range of
acceptance on the various fronts of cryptocurrencies and their started integration with more
traditional financial markets may make them develop more relationships, create
information flows, and induce shocks.

In fact, the global financial crisis of 2007–2009 (the “Great Recession”) has stimulated
considerable interest in defining, measuring, and monitoring connectedness among asset
classes, markets, and countries. As illustrated by this crisis, an important aspect of systemic
risk is the propagation of adverse shocks throughout the whole system. Therefore, a strand of
literature that aims at evaluating systemic risk importance and interconnectedness has
emerged. Some authors find a risk spillover relation between cryptocurrencies and major
financial assets and unravel how cryptocurrencies could influence global financial systemic
risk. Other results show no significant spillover effects between the nascent market of
cryptocurrencies and other financial markets.

Will the incorporation of cryptocurrencies significantly increase the systemic risk of the
present financial markets?
Given their volatile nature, the advance of cryptocurrencies as a new investment asset can
exert additional risk spillover on existing financial assets and has the potential to raise the
systemic risk level of the financial market (Li, Huang 2020)
They found that cryptocurrencies function as a separate risk source from traditional
assets because major legislative, financial, and technological events in the cryptocurrency
market may affect risk spillover dynamics. Indeed, they specified the considerable increase in
the systemic risk of the existing financial markets when the level of risk of the latter is low.
However, in periods of increasing market uncertainty or turmoil, cryptocurrencies can play a
bit of a hedging role that lowers the overall risk. Trabelsi (2018) has shown also that
volatility shocks in the cryptocurrency market may not propagate to other financial markets
and vice versa. Like many analysts, this low connectedness is due to different drivers of
returns in the crypto markets (e.g., investor adoption, legal and regulatory developments)
versus the stock and bond markets, which are driven more by factors such as economic
growth, interest rates, and corporate profits. Since cryptocurrency markets are relatively small
and lack economic forces, besides speculations, they will be less connected to conventional
markets.
While Matkovsky and Jalan (2019) investigate the relationship between the stock
exchange, currency markets, and BTC. The results show that the BTC receives shocks
from financial markets, suggesting evidence of contagion effects on BTC. The authors
show also that in the crisis period risk-averse investors prefer investment in financial
markets compared to risky BTC.

Are There Any Volatility Spillover Effects among Cryptocurrencies and Widely Traded
Asset Classes?

The empirical findings of Yermack (2015), Bouri et al. (2017), Baur et al. (2018), Lee et
al. (2018), and Corbet et al. (2018b) agree that Bitcoin and other cryptocurrencies are not
correlated with mainstream assets, such as gold, oil, bonds, and equity indices. Along the
same line, Bouri, Corbet, et al. (2018) analyzed the relationship between three
cryptocurrencies (BTC, XRP, and LTC) and different financial and commodity assets
(S&P500, FX rates, gold, VIX, bond, lite. and GSCI index), they find that the three popular
cryptocurrencies are relatively isolated from other financial assets and thus
cryptocurrencies benefit-risk diversification for investors.

Briere et al. (2013) provide a tentative first look at how Bitcoin might be a suitable
instrument for diversification. The researchers concluded that Bitcoin delivers high
diversification benefits as it correlates negatively with most of the analyzed stock market
indices. More recently, Gangwal (2016) wrote about the effect of including Bitcoin in the
portfolio of an international investor. Using mean-variance analysis, the author argued that
adding Bitcoin to portfolios always yields a diversification benefit (a higher Sharpe ratio).
This means that Bitcoin return offsets its volatility risk. Recently, Godfrey Uzonwanne 2021
verified the presence of returns and volatility spillovers across five major stock markets and
the Bitcoin market. A multivariate VARMA-GARCH model was used to model the
transmission mechanism of mean return, return spillovers, and volatility spillovers between
these market pairs. Significant return spillovers and volatility spillovers were observed across
these market pairs. Volatility spillovers in some markets were bi-directional and in other
markets, uni-directional. Thus, it explains that at the peaks and troughs of a stock market,
investors migrate between these market pairs to maximize returns and reduce risk exposure,
resulting in return and volatility spillovers between the market pairs. Conrad, Custovic, and
Ghysels (2018) explored the extent of volatility spillovers between bitcoin and the S&P 500
market and closely associated volatility patterns of bitcoin returns with movements in the
global business cycle. Bouri, Azzi, and Dyhrberg (2017) conducted a similar study where
volatility spillovers between bitcoin and several currency markets were explored. Other
studies, including Matkovsky (2019), examined the return volatility and interdependence of
bitcoin against several leading currencies (USD, Euro, and GBP) and found that the
decentralized bitcoin market had higher volatility than the centralized market.

There are many studies done by, among others, Kaul and Sapp (2006), Maurer and Dikeman
(2007), Baur and McDermott (2010), Baur and Lucey (2010), Beckmann et al. (2015),
Bouoiyour and Selmi (2017), Ranaldo and Söderlind (2010), Grisse and Nitschka (2013),
Botman et al. (2013), and Morley (2014), that account for spillover effects and
interconnectedness, but only among traditional assets classes. According to this strand of
research, Nader Trabelsi (2018) builds on and contributes to extending the literature on
Bitcoins by assessing interconnectedness within the cryptocurrency market and between
Bitcoin price changes and the volatility of traditional asset classes. A spillover index
approach with the spectral representation of variance decomposition networks is employed to
measure connectedness. Results show no significant spillover effects between the nascent
market of cryptocurrencies and other financial markets. The author suggests that
cryptocurrencies are real independent financial instruments that pose no danger to
financial system stability spillover effects within the Bitcoin markets and across Bitcoins and
other asset classes.

How strong are the spillovers between crypto and equity markets, and have they increased
over time?

Crypto assets have emerged as an increasingly popular asset class among retail and
institutional investors. Although initially considered a fringe asset class, their increased
adoption across countries in emerging markets, in particular amid bouts of extreme price
volatility has raised concerns about their potential financial stability implications.

Tara Iyer (2022) investigates the extent of interconnectedness and potential for spillovers
between crypto and global financial markets by focusing on equity markets. He examined the
extent to which crypto assets have moved to the mainstream by estimating the potential for
spillovers between crypto and equity markets in the United States and emerging markets
using daily data on price volatility and returns. Spillovers from the price volatility of the
oldest and most popular crypto asset, Bitcoin, to the S&P 500 and MSCI emerging markets
indices have increased by about 12-16 percentage points since the onset of the COVID-19
pandemic, while those from its returns have increased by about 8-10 percentage points.

In contrast to earlier literature, which has focused mostly on traditional crypto assets such as
Bitcoin, the analysis here also considers spillovers from the increasingly traded Stablecoin,
Tether. The spillover of this most traded stable currency on the above-mentioned indices has
also increased by about 4 to 6 percentage points. The results also show that spillovers in the
reverse direction from equity markets to crypto assets have increased in recent times.
Moreover, spillovers in both directions, that is, from crypto assets to equity markets and vice
versa tend to increase during episodes of market volatility.

These findings suggest that crypto assets may no longer be considered a fringe asset class and
could pose financial stability risks due to their extreme price volatility. Thus, regulators and
supervisors need to closely monitor activity in the crypto markets and the exposure of
financial institutions to these assets and design appropriate regulatory policies to mitigate
systemic risks emanating from crypto price spillover.

Is the bitcoin market inefficient?

The rapid growth of the crypto ecosystem, including traditional crypto assets (such as Bitcoin
and Ether, and Stablecoin) which are digital tokens pegged to a market reference has been
fuelled by technological innovation, the rise of decentralized finance, and increasing
institutional and retail investor interest.

The study of Trabelsi (2018) exhibits a time-varying pattern of connectedness within

cryptocurrencies. The decomposition of the total spillover index (TSI) is dominated by a
short frequency component (2–4 days). This shows that the market is mostly controlled by
speculative behavior. Besides, Baur et al. (2015), show that the value of Bitcoin (and
“cryptocurrencies” in general) is primarily forced by speculative investors who want to gain
experience in new markets and exploit the high return possible because of high volatility.

Bariviera (2017) further argued that daily Bitcoin returns become more efficient over time.
Later, Nadarajah and Chu (2017) considered a simple power transformation of the Bitcoin
returns and showed that the transformed Bitcoin returns are market efficient. Consistent
results on the efficiency of Bitcoin prices were also obtained by Tiwari et al. (2018). Along
the same line, Brauneis and Mestel (2018) considered several cryptocurrencies and found that
cryptocurrencies become more efficient as liquidity increases, with Bitcoin representing the
most efficient cryptocurrency. So, Is there a relationship between liquidity and efficiency?
Wei (2018) examines the relationship between liquidity and efficiency in 456 cryptocurrency
markets and shows evidence of a positive relationship, particularly for Bitcoin. The same
result is found by Brauneis and Mestel (2018). More precisely, the authors examine the
relationship between liquidity and market efficiency of ten cryptocurrencies and find a
decrease in market predictability when the liquidity degree increases.
Wei (2018) concluded that high liquidity with low volatility plays a significant role in the
market efficiency of cryptocurrencies. These results would allow cryptocurrency investors
to arbitrage away signs of return. Bouri, Azzi, et al. (2017) also explored the relationship
between price returns and volatility changes in the bitcoin market, using a US dollar-
denominated database and observed that in the period before the 2013 price crash, positive
shocks impacted the conditional volatility much more than negative shocks Baur (2012),
using an equity portfolio diversified with gold, showed that the volatility of returns in the
equity market tends to exhibit an asymmetric response to both positive and negative
shocks, consistent with a volatility feedback effect. In addition, the asymmetry term is
found positive for all cryptocurrencies. More recently, Katsiampa (2021) indicates that
negative shocks increase the volatility levels more than positive shocks of equal magnitude
suggesting that there is a statistically significant asymmetric effect between good and bad
news in the conditional volatility of the price returns of these four cryptocurrencies.
However, the asymmetry parameter estimate is not significant for Stellar Lumen, and hence
negative values of the residuals do not have a different effect in the current conditional
volatility than positive ones in the Stellar Lumen market.

The analysis here points to the need for further research to better understand the risks crypto
assets could pose to the financial system more broadly. Given the increased
interconnectedness between crypto and financial markets at large, these results signal that
regulators should be cautious, and suggest the necessity of special supervision and
monitoring of the cryptocurrency market during the “peaceful periods” of traditional asset
markets. The ground rule for supervising cryptocurrencies is to maintain the safety and
stability of the present financial system. This requires both controlling risk in the
cryptocurrency market and preventing risk spillover to other financial markets from the
cryptocurrency market.