leaders in the price discovery process, due to their low execution costs, inherent leverage and the absence of short-selling constraints (Fassas, Papadamou, and Koulis, 2020; Kapar and Olmo, 2019). This idea is furthermore supported by the liquidity, centralisation and relative transparency of futures market (Corbet, Lucey, et al., 2018; Fassas, Papadamou, and Koulis, 2020). The introduction of futures contracts might, lastly, broaden the investor base of an asset, since it becomes more widely accessible to sophisticated institutional investors (Baur and Dimpfl, 2019; Corbet, Lucey, et al., 2018). Alexander et al. (2020) showed that this influx of informed traders in a particular market results in a concentration of liquidity traders, which in turn attracts more informed trader and leads to that more information creation occurs in this market.
A recent strand in this literature has, however, concluded that the spot market’s contribution to price discovery is in fact important, especially in certain types of market.
One study of particular interest is Dimpfl, Flad, and Jung (2017), who examined the price discovery process of spot and futures prices in agricultural commodity markets and found that the considered futures markets31 account for less than 10% of price discovery, respectively. In relation to these findings, they discuss how speculative trading can decouple futures prices from fundamentals in the short run. In these instances the futures market will have a limited impact on the price discovery process, which regards long-run equilibrium prices. In certain markets, the spot market investors might also be better suited to determine prices in the long run, i.e. have an informative advantage. A description of agricultural commodities, that is highly applicable to bitcoin markets as well, is provided by Dimpfl, Flad, and Jung (2017):
"traders (who might even coincide with producers) might be better able to assess the market fundamentals (better than speculative futures traders at least) and will therefore quickly agree on the fundamental value, the best price now, of the commodity, by matching demand and supply" (p. 61).
As discussed in the previous section (see section 2.4), the bitcoin spot market is unconventional also in its structural design: it is constructed as a decentralised and globally distributed P2P network and can hence not be regulated by neither a single
31Wheat, corn, soybeans, soybean meal and oil, lean hogs and feeder and live cattle (Dimpfl, Flad, and Jung, 2017).
country nor any international union. This stands in stark contrast to the centralized and highly regulated conventional financial markets, including the spot markets of a wide variety of asset classes and future markets, including bitcoin. For all the above reasons, as concluded by Entrop, Frijns, and Seruset (2020, p. 817), "the analysis of bitcoin price discovery may be somewhat different from other asset classes". However, other features that distinguish the bitcoin markets from most asset classes are in fact traits that bitcoin share with gold, in particular the absence of a commonly accepted pricing model. For gold, empirical research generally find that the futures market dominates in the price discovery process (Baur and Dimpfl, 2019; Entrop, Frijns, and Seruset, 2020).
Academic literature on price discovery in the bitcoin spot and futures prices is scarce, albeit growing. To the best of our knowledge, there are seven studies published within the area, of which five32 also address the cointegrating relationship between the two markets and have been presented in section 2.4. Overall, results are contradicting.
Corbet, Lucey, et al. (2018) were the first to compute the IS, CS and ILS measures for the bitcoin spot and futures markets, used as a part of exploring whether the introduction of bitcoin futures has improved bitcoin’s functioningas a currency, rather than a speculative asset. They use one-minute data on the CBOE futures contracts, obtained from Thomson Reuters Tick History, and bitcoin price data sourced from Thomson Reuters Eikon, reaching from the introduction of futures trading (December, 2017) to February, 22, 2018. Contrary to results in other asset classes, they find that price discovery almost exclusively takes place in the spot market. According to the estimated ILS, the bitcoin spot prices reflect 97% of the information driving the fundamental value of bitcoin, while the contribution of the futures market is only 3%. Their estimated spot market IS is 85% and spot market CS is 82%. They attribute their results to the immaturity of the bitcoin futures market.
Moreover, they argue that the type of investors that are attracted to bitcoin might not be willing to trade in a regulated and registered futures markets. The majority of all bitcoin investors may therefore be classified as uninformed and unsophisticated noise traders, impeding the futures market’s contribution to price discovery (Corbet, Lucey, et al., 2018).
Considering an almost identical time period but extending the analysis to include
32Fassas, Papadamou, and Koulis (2020), Kapar and Olmo (2019), Entrop, Frijns, and Seruset (2020), Baur and Dimpfl (2019), and Alexander et al. (2020).
the CME bitcoin futures contract, Akyildirim et al. (2019) computed the IS, CS and ILS for data on 1-, 5-, 10-, 15-, 30- and 60-minutes frequencies sampled between December 18, 2017 and February 26, 2018. Data for the CME and CBOE bitcoin futures is obtained from Tick Data LLC and Bitcoin price data from Thomson Reuters Eikon. In stark contrast to Corbet, Lucey, et al. (2018), they find that the bitcoin futures dominate price discovery relative to the bitcoin spot market. Comparing their results to Corbet, Lucey, et al. (2018), the authors conclude the following: "While earlier research found that information flows and price discovery were transmitted from spot to futures markets, this research verifies that this relationship has since reversed, most likely explained by the influx of institutional and sophisticated investors" (Akyildirim et al., 2019, p. 8).33
The results of Kapar and Olmo (2019), using daily data from December 2017 to May 2018, strongly indicate that price discovery is transmitted from the futures market to the spot markets. They estimated that the futures market, represented by the CME futures contracts, has a 89% information share. Furthermore, they quantify the Gonzalo and Granger (1995) permanent component (see equation 3.45) driving the bitcoin spot and futures prices, respectively, and find that they in fact are identical. Fassas, Papadamou, and Koulis (2020, p. 7) likewise concluded that the "bitcoin futures markets, while in their relative youth, have portrayed evidence of price discovery leadership compared to the spot market". Based on data between January 1, 2018 and December 31, 2018, they found that the CME bitcoin futures exhibited a 97% information share, a 77% component share, and a 77% information leadership share.
In contrast, Baur and Dimpfl (2019) found that the bitcoin spot market dominates both the CME and the CBOE futures market, respectively, using five-minute data for eleven futures contracts until October 2018. They attribute their results to the relatively high trading volume and easy accessibility of the bitcoin spot market (represented by the Bitstamp exchange), compared to the US-based futures market. However, they find significant variation in the price discovery leadership across time: the futures market contributed considerably more to the price discovery process shortly after their introduction,
33Since this sample period only includes four additional days compared to Corbet, Lucey, et al. (2018), this conclusion is surprising. Discrepancies in the results might arise from differences in the underlying estimated VECM, in which Corbet, Lucey, et al. (2018) use 200 lags and Akyildirim et al. (2019) uses 20.
Interestingly, Corbet co-authored both papers.
when bitcoin prices were high, compared to subsequent periods when prices had fallen to below $8,000. Their results also indicate that the role of the futures markets in the price discovery process, as measured by IS, increased as the futures contract neared maturity and trading intensified.
Comparable results were documented by Entrop, Frijns, and Seruset (2020), who studied both the conventional price discovery measures and their possible determinants.
The former analysis demonstrated that the leading market had changed during their sample period, spanning from the introduction of the CME futures in December 2017 until March 2019. They describe:
"In particular, our results show a clear price leadership of the futures market from the start of the sample until the middle of 2018. On the contrary, we find evidence that the spot market is the leading market at the end of our sample"
(Entrop, Frijns, and Seruset, 2020, p. 831).
Next, they regress their computed component shares across time on various variables such as ‘market quality’, ‘uncertainty’ and ‘macro news’. Their results indicate that market quality, as proxied by i.e. high trading activity and low trading costs, positively affects the contribution of a market to the price discovery process. The relative bid-ask spread is shown to have a strong negative effect on price discovery. Moreover, they "document a negative relation between spot market volatility and price discovery, which [they] attribute to the hedging demand of informed investors in times of high spot market volatility." Entrop, Frijns, and Seruset (2020, p. 831) In line with findings regarding the disconnection of the bitcoin markets from traditional markets (see section 2.3), they find that macroeconomic news do not significantly explain the time variation of the component shares.
The last of the related studies is by Alexander et al. (2020), who contribute to existing literature by studying an unregulated derivatives market (BitMEX perpetual swaps) in relation to three bitcoin spot exchanges on data from July 2016 to January 2019. They discover that the bitcoin derivatives market lead the spot prices. Among the markets studies, the BitMEX perpetual swap market is found to have a component share fluctuating around 50%, with considerable variation. The dominance of the swap market is, however, consistent across the full sample period. In addition, they showed that
"the strength of price discovery in BitMEX is positively (negatively) associated with the
relative bid–ask spread (trading volume) of the spot markets, consistent with findings in equity derivatives markets" (Alexander et al., 2020, p. 24).
3 Methodology
After having discussed the relevant academic literature in the previous chapter, the current chapter is concerned with outlining the methodology that will be applied in the subsequent analysis. In particular, the first and second sections contains a brief note about philosophy of science and methodological approach, respectively. The third and fourth sections extensively discuss the theories that are central to this thesis: cointegration and price discovery.