Crypto risk premium?
Is there a crypto risk premium? Why isn't there one?
Take a well established risk premium - equities for example. Equities have a risk premium because investors require a higher hurdle rate to compensate for the risk. Or else, they'd just invest in the riskless rate. That drives the ERP.
For crypto, why cant the same thing work? Investors require a higher rate of return for crypto, which generates a crypto risk premium. Bundle this with crypto beta to get the crypto premium. Then add that to the riskless rate to get the return of crypto. CAPM. No?
Ofc, it's no shit that not all risks have premia. The risk of starting a business and the risk of working 100 hour weeks in IB have premia; the risk of jumping off a building has no premium. But I just wonder if crypto has a risk premium and why cant the same finance theory work.
Throw in the fact that classic (old) finance theory assumed that risk premia were constant, but we've now developed a more nuanced view and we now know that risk premia are time-varying. So why cant we develop a nuanced theory for the crypto risk premium?
If/when crypto shows long lasting excess returns over risk free rates economists will dig their heads out of the sand and start thinking about this problem. Until then it's same as a tulip bulb excess risk premium. My expectation is that the analysis never becomes relevant but maybe I'm old and not with the times.
That's the thing in estimating expected returns - you wish you have a few hundred more years of data, while when you're estimating risk you wish you got to see more black swans.
When crypto (or any other asset class) starts showing long term excess returns, it's already too late. Just cooking shit up in hindsight by then. Can ex ante even ever be truly determined?
Crypto produces no cashflows and never will, so it's incredibly hard to value with traditional methods. Obviously anybody who buys bitcoin today knows it's highly volatile and believes it may appreciate more than stocks yet knows there's a realistic chance it will collapse, and presumably that must be reflected in the price. So there's intuitive proof that a theoretical risk premium exists.
Sounds like you're looking for a mathematical "the observed risk premium of crypto is 23.41% over bonds" but in the absence of cashflows, there's no way to compute that. But logically, a risk premium exists, we just can't quantify exactly how large it is.
Respectfully, this is completely wrong. Your viewpoint that “crypto produces no cashflows and never will” is off by about… 2 years ago.
Decentralized Finance (DeFi) protocols produce cashflows. In fact, it is inherent to most DeFi protocols that they produce revenue from Day 1 of operation, otherwise the code behind those protocols would not work.
Yes, protocols that generate millions in revenue per day exist. Simply go to TokenTerminal.com and you will see. These fees typically come from take rates for yield, borrowing, lending, or simply facilitating transactions.
I have built many DCFs, SOTP, and other valuation analyses on crypto. Crypto valuation exists, it’s possible… the question is if it’s relevant.
And by that I mean that there’s probably a better theoretical framework to value crypto networks. Academics just haven’t invented/discovered it yet.
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No, it's only a cashflow if it pays you cash. A crypto token that pays you more crypto tokens is not the same thing as a cashflow. Here: give me $1000 dollar and I'll sell you the crypto token I just made up, plus the protocol automatically gives you guaranteed 100,000,000% annual return (paid in more of my made-up tokens, not in dollars. There's no way to get the dollars back unless you find someone else to buy the token from you). That's clearly not a cashflow.
Look, just because crypto will never pay cashflows doesn't necessarily mean it's a bad investment. Gold will never pay cashflows either, but lots of people invest in gold anyway. So you could rationally believe crypto is a good investment. But don't lie to yourself that crypto pays cashflows. It doesn't. The bull case for investing in crypto is that the price will go up, not that it will deliver a stable cashflow.
Since we are just talking crypto now - can someone give me a compelling argument on why bitcoin/crypto should be worth more $$$ than it is today at any point in the future? The only argument that ever made sense is the FOMO / enough people will see it being worth something (even though there is no reason for it to have value otherwise), so I am relying on a Soros-esque reflexivity situation where I am just betting with the herd, since the market's perception always trumps any self-proclaimed version of reality.
It is replaceable (anyone can make their own crypto), it sucks as a form of payment for the most part, it is becoming highly regulated and tracked, it doesn't produce cash flow, it is volatile (and thus not a great store of value), not an inflation hedge, etc.. For a hot second while less regulated and more "outside the system" it was more compelling, but to turn it back into $$$, for the most part you are being tracked and regulated again. The whole "cold storage" stuff is kind of nice (except that volatility again...). So you are relying on the "digital gold" argument, except real gold has a base cost and utility, and centuries and millennia of usage backing it as a store of value - and even then I don't like gold either. You buy it to speculate and not miss out as enough hype turns into enough reality, but you also have to recognize that it has only been around for a milisecond in the grand scheme of things, so not much of a track record here...
Although maybe this conversation is cancer and I just missed the conversation in 2018 when people argued this stuff.
I'm not a believer myself, but the bull argument for crypto is to look at countries with hyperinflation (like Venezeuela) and imagine that could happen here. If that happened, maybe people will use bitcoin to pay for things since it has more stable prices. (Yes the bitcoin protocol has some inflation built-in, but it's predictable and limited so politicians can't inflate it up a billion percent like they could with fiat currency).
To answer OP's question, you can technically define a risk premium for any repeatable trade/transaction. However, I think there are a few things to consider
- Do we have a long enough history to back out some form of steady state
- Is the premium derived from the data nonzero and statistically significant
- Is the premium positive or negative (take scratch off as an example of negative risk premium)
I think there is plenty of research on this subject, and as other have alluded to, they might have limitations due to the lack of maturity of the industry and other issues. Take for example,
Zhang and Li (2020) found that idiosyncratic volatility is positively related to the expected return of cryptocurrencies. This means that cryptocurrencies with higher volatility tend to have higher expected returns.
Dobrynskaya (2020) found that downside risk is priced in cryptocurrency markets. This means that investors demand a higher return for holding cryptocurrencies that have a higher risk of losing money.
There are other studies that have found no evidence of a risk premium, and others have found that the risk premium is not as high as it is for other asset classes, such as stocks and bonds.
So to sum it up, defining a risk premium for crypto on its own does not make the asset class any more (or less) attractive as an investment I think.
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