The Role of Trading Volume in Cryptocurrency Markets

Economic theory posits that trading volume should provide valuable information about unobservable market conditions, such as the presence of heterogeneous beliefs, incomplete information and difference in trading purposes among market participants. In particular, existing empirical evidence in traditional markets suggests that what we can learn from trading volume could possibly depend on the market microstructure.

Even though the role of trading volume has been widely investigated in the empirical finance literature, cryptocurrency markets provide a unique playground to better understand the relationship between market activity and subsequent price changes. Cryptocurrency markets have a highly fragmented, multi-platform and decentralized structure which by construction generate heterogeneous beliefs due the opaqueness of information flow. In addition, they are arguably populated by vastly different participants with trading that is mostly originated by retail investors and small-scale institutional investors, unlike more traditional asset classes. Finally, the lack of effective regulation makes the cryptocurrency markets highly exposed to fake trading activity and manipulation on single cryptocurrency pairs and exchanges.

All these aspects mean that total trading volume is the aggregate of trades which reflect very different and continuously updated information sets, skills, trading motives and both market and regulatory conditions.

Dr Daniele Bianchi (Queen Mary, University of London) and Alexander Dickerson (Warwick Business School) investigate whether the dominant view of the aggregate trading activity in cryptocurrency markets, predominantly consisting of speculative trades, has any evidence from a pure empirical asset pricing perspective. More prominently, they investigate whether the link between current returns, trading volume and future returns is related to informed trading in a manner that is consistent with existing theoretical predictions in financial markets.

The main empirical results of their paper show that while trading volume per se does not correlate with future returns, there is a positive, statistically significant relation between the interaction of lagged returns and past volume and future realised returns. Such relationship holds by controlling for aggregate measures of risk and liquidity in cryptocurrency markets.

Delving further into the economic meaning of the statistical results, the authors show that a simple reversal strategy that conditions on cryptocurrency pairs which experience low volume tend to deliver superior risk-adjusted performances with respect to more traditional momentum, liquidity and volatility-based strategies as well as buy-and-hold market portfolios, while maintaining a market beta that is close to zero.

As a whole, the authors argue this research should contribute to a better understanding of the economics of cryptocurrency markets through the lens of existing research designs normally applied to more traditional markets.

The full paper can be found here.

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