The Crypto Multiplier

Summary

Focus

The exchange rates of cryptocurrencies are highly volatile. Announcements by large investors, celebrity endorsements or financial crises can result in substantial crypto price movements. This paper explains why.

Contribution

The paper develops the concept of a "crypto multiplier," which measures the response of a cryptocurrency's market capitalisation to the aggregate inflows and outflows of investors' funds. Building on the quantity equation, we derive the value of the crypto multiplier. The multiplier is likely to be larger than one so that an inflow or outflow of one dollar of investors' funds affects the market capitalisation of a cryptocurrency by more than one dollar.

Findings

The crypto multiplier takes particularly high values when a large share of a cryptocurrency is held as an investment rather than being used as a means of payment. Empirical evidence reveals that the share of coins that is held for making payments is rather small for major cryptocurrencies, suggesting that crypto multipliers are sizeable. Investor flows can therefore have a surprisingly strong effect on the market capitalisation of those cryptocurrencies. These results suggest that caution is advisable when investing in cryptocurrency and when accepting them as collateral from holders of large blocks.

Abstract

The exchange rates of cryptocurrencies are highly volatile. This paper provides insight into the source of this volatility by developing the concept of a "crypto multiplier," which measures the equilibrium response of a cryptocurrency's market capitalization to aggregate inflows and outflows of investors' funds. The crypto multiplier takes high values when a large share of a cryptocurrency's coins is held as an investment rather than being used as a means of payment. Empirical evidence shows that the number of coins held for the purpose of making payments is rather small for major cryptocurrencies suggesting large crypto multipliers. The analysis explains why announcements by large investors, celebrity endorsements or financial crises can result in substantial price movements.

JEL classification: E42, E51

Keywords: Bitcoin, cryptocurrency, exchange rates, monetary economics, risk management