China and World Economy - 2020 - Li - Do Cryptocurrencies Increase The Systemic Risk of The Global Financial Market

122 China & World Economy / 122–143, Vol. 28, No.
1, 2020
Do Cryptocurrencies Increase the Systemic Risk

of the Global Financial Market?
Shiyun Li, Yiping Huang*
Abstract
The advance of cryptocurrencies has sparked wide concern over their interplay with
the existing global financial market. This paper analyzes the risk spillover relation
between cryptocurrencies and major financial assets, and unravels how cryptocurrencies
could influence global financial systemic risk. We find that cryptocurrencies function
as a separate risk source from traditional assets. Major legislative, financial and
technological events in the cryptocurrency market may affect risk spillover dynamics.
Although the overall penetration of cryptocurrencies is not yet deep, introducing
cryptocurrency can significantly increase the systemic risk to traditional markets during
low risk level episodes.
Key words: cryptocurrency, dynamic risk spillover, systemic risk

JEL codes: E44, F36, G15
I. Introduction
Since the advance of the first cryptocurrency, Bitcoin, a decade ago, the world has
witnessed the tremendous expansion of the cryptocurrency market. By 20 October 2019,
there were 3000 different cryptocurrencies circulating in the market, and on 7 January
2018 the total market capitalization of cryptocurrencies hit a peak of over US$821.7bn.1
In addition to the best-known cryptocurrency, Bitcoin, the herald of innovation, others,
such as Ethereum, Ripple and Litecoin, are also actively traded and together account for
more than half of the total market capitalization.
Cryptocurrencies are digital or virtual currencies that are encrypted using
cryptography. Although initially designed to break the third-party “trust-based model”
*Shiyun Li (corresponding author), PhD Candidate, Institute of Digital Finance, Peking University, China.
Email: shiyun.li@pku.edu.cn; Yiping Huang, Professor, Institute of Digital Finance, Peking University, China.
Email: yhuang@nsd.pku.edu.cn. This work was supported by the National Social Science Fund Major Project
of China (No. 18ZDA091), the Swiss National Science Foundation (No. 100018_176387/1) and the Peking
University Institute of Digital Finance Project.
1
Data obtained from: Coinmarketcap.com.
©2020 Institute of World Economics and Politics, Chinese Academy of Social Sciences
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Cryptocurrencies and Systemic Risk of the Global Financial Market 123
of electronic payment in online commerce (Nakamoto, 2008), cryptocurrencies have

aroused keen interest since their introduction, mainly as an investment asset (Baur, Hong
and Lee, 2018). However, 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 systemic risk level of the financial market. Both aspects
have rarely been explored in the existing literature, but are of regulatory importance if
cryptocurrencies evolve as a new risk source to the global financial system.
In this paper, we focus on the major financial assets that are most relevant and
discuss their intrinsic relation to cryptocurrencies. An intuitive first class of assets, given
their name and functional design, is currency or currency-related precious metals, such as
gold and silver. There are particular similarities between cryptocurrencies and precious
metals. For example, both Bitcoin and gold are scarce and fixed in supply, should be
discovered through the “mining” process, are anonymous and decentralized and have
the capability to function as money (i.e. unit of measurement, medium of exchange and
store of value). Bitcoin is thus frequently referred to as “digital gold” and bears a close
resemblance to precious metals in this sense. Through their similar function as alternative
“money,” these two types of assets may also have a potential risk linkage. Dyhrberg (2015,
2016) and Baur, Dimpfl and Kuck (2018) discussed the resemblance among Bitcoin, gold
and the US dollar and the hedging potential of Bitcoin through volatility analysis.
As for currency, we focus on major foreign exchange rates. Cryptocurrencies
are useful for capital control circumvention in countries that either restrict the free
exchange of currency or limit the amount of money that can be transferred or transacted
across borders. Regulatory arbitrage using cryptocurrencies calls into question over the
effectiveness of capital controls and may increase the volatility of foreign exchange
rates of the countries involved. Aloosh (2018) found large price discrepancies (up to a
peak of 27 percent) of Bitcoin denominated in different currencies and suggested that
the pricing of Bitcoin is not uniform or consistent globally. Such discrepancies can lead
to extensive arbitrage trading and volatilize foreign exchange rates.
Another relevant class of assets are securities, particularly stocks. The creation
and sale of a digital coin or token to fund project development, that is, the initial
coin offering (ICO) process, bears a close resemblance to the initial public offering
(IPO) process that issues stocks instead. Although not all cryptocurrencies are tokens,
which are created through ICOs,2 there is much confusion among investors about the
2
Cryptocurrencies are most commonly categorized as alternative cryptocurrency coins (altcoins) and tokens.
For a more detailed discussion of the difference, see: https://masterthecrypto.com/differences-between-
cryptocurrency-coins-and-tokens/ (online; cited November 2019).
124 Shiyun Li, Yiping Huang / 122–143, Vol. 28, No. 1, 2020
difference, and many simply transact cryptocurrencies as an alternative to stocks,

holding them for a price rise and selling them out sometime later. Because investors
merely perceive the expected returns as the distinguishing character between the
two assets, stock investment can be a potential source of funds for cryptocurrency
investment, meaning that sentiment and risk in the cryptocurrency market likely
spillover to the stock market.
Using the relevant classfication of traditional assets (i.e. precious metals, foreign
exchange and stocks or bonds), we investigate the risk spillover relation between
cryptocurrencies and these assets. An essential topic related to risk spillover is the
notion of systemic risk, which arises through interlinkages between the components
of the financial system, so that individual failure or malfunction has repercussions
across the financial system (IMF, BIS and FSB, 2009). Few studies have examined the
linkage between cryptocurrencies and systemic risk, but this has significance as the fast
growing yet volatile cryptocurrency market may introduce additional risks to existing
financial markets, triggering potential turmoil in a broader market scope. By examining
the volatility spillover relation, we attempt to show to what extent risks within
the cryptocurrency market can be transmitted to traditional markets, and whether
regulations that control risk contagion from the cryptocurrency market are critically
required.
In terms of econometric strategy, we follow and extend Diebold and Yilmaz’s
(2014) research by constructing volatility spillover measures that explore the
“connectedness”3 across various asset classes, from pairwise to system-wide. These
measures have wide application for analyzing risk spillover relations of different
subjects, ranging from financial products to financial entities in a certain country
or across the globe (Diebold and Yilmaz, 2009, 2012, 2016; Demirer et al., 2018).
We also take the dynamics of connectedness into account using the rolling window
approach, and identify key events in the cryptocurrency market that may shape the
pattern of cross-market risk spillover.
In this paper we seek to answer the following questions: What is the risk
spillover pattern between cryptocurrencies and traditional financial assets, and how
can major events in the cryptocurrency market affect such a pattern? How deep have
cryptocurrencies penetrated into our financial system and will the incorporation of
cryptocurrencies significantly increase the systemic risk of the present financial markets?
Based on our findings, we discuss implications for cryptocurrency supervision.
3
That is the volatility spillover relation. We do not differentiate between the two terms and use them
interchangeably throughout the paper.
The rest of paper is organized as follows: Section II introduces the data and methods
we use. Section III presents our main empirical results. Section IV offers a robustness
check. Section V concludes.
II. Data and Methods
We focus on major cryptocurrencies whose market capitalization is over US$10bn

as of end May 2018. Further, to obtain as long a data series as possible, we restrict
our analysis to cryptocurrencies with available data back to 4 August 2013: Bitcoin
(BTC), Litecoin (LTC) and Ripple (XRP). We collect our cryptocurrency data from
Coinmarketcap.com.
Other traditional assets examined are: (i) the gold and silver spot price as US dollar
per troy ounce to represent currency-related precious metals in the commodity market;
(ii) the exchange rates of the British pound (GBP), Chinese yuan (CNY), euro (EUR),
Hong Kong dollar (HKD), Japanese yen (JPY), Korean won (KRW), Swiss franc (CHF)
and Singapore dollar (SGD) denominated in US dollars; and (iii) the stock indices of
the Chinese mainland (CHN), Chinese Hong Kong (HK), France (FRA), Germany
(GER), Japan (JPN), South Korea (KOR), Switzerland (SUI), Singapore (SIN), the
United Kingdom (UK) and the United States (US). Data on these assets are collected
from Bloomberg.
Daily data for the whole sample is from 4 August 2013 to 11 October 2019. Because
volatility is latent and cannot be directly obtained, we need to estimate the daily series.
Existing approaches include generalized autoregressive conditional heteroskedasticity
(GARCH), stochastic volatility, realized volatility and implied volatility. We choose
daily range-based realized volatility as adopted by Diebold and Yilmaz (2009) and
Demirer et al. (2018) to analyze volatility spillover, which makes full use of the daily
high, low, open and close prices available, but does not require data at a higher than
daily frequency. Following Garman and Klass (1980), we estimate the daily volatility
for asset i as:4
4
Although the formula does not look intuitive or straightforward with the given parameter value, the idea
behind Garman and Klass’ (1980) method is simple. They used the “normalized” high, low and close prices
(relative to open prices) to construct a quadratic-form volatility estimator that could be considered the “best”
by simultaneously satisfying the minimum variance, unbiased, invariant and scale-invariant conditions.
These conditions impose restrictions on the form this estimator can take (“quadratic” in arguments) and state
equations of parameters that should be satisfied. The formula can then be obtained by minimizing the estimator
w.r.t. parameters under the geometric Brown motion assumption.
σ it2 0.511( H it − Lit ) − 0.019 ( Cit − Oit )( H it + Lit − 2Oit ) − 2 ( H it − Oit )( Lit − Oit ) 
2
=
− 0.383 ( Cit − Oit ) ,
2
(1)
where Hit, Lit, Oit and Cit are the logs5 of daily high, low, open and close prices6 for asset
i on day t, respectively.7 Range-based realized volatility is nearly as efficient as realized
volatility based on high-frequency intra-day observations, yet it requires only four
readily available inputs per day, and it is robust to certain forms of microstructure noise
(Alizadeh et al., 2002).
While cryptocurrencies are traded 24/7 every week, other traditional financial assets
involved are transacted only on weekdays and non-holidays. We compute the volatility
series for each asset, and use daily observations when data are available for all assets
examined; that is, we keep only observations of dates that are not weekends or holidays
and those without missing values. The use of Monday-to-Friday data is a common
practice to unify asset data obtained from different trading mechanisms and has its
ground because observations of Monday prices incorporate information of weekend
transactions. The total number of observations is 1251.
Moreover, we note that our price data comes from markets located in different time
zones.8 Although this could potentially affect empirical results, the use of volatilities
rather than returns and the adoption of a vector autoregression (VAR) approximating
model tend to mitigate the potential impact (Demirer et al., 2018).
5
Garman and Klass (1980) assumed asset prices followed a diffusion process that is a monotonic time-
independent transformation of the Brown motion (sufficiently general to cover the usual hypothesis, like the
geometric Brown motion), and dealt with volatility parameter estimation, σ, in the original Brown motion
using transformed prices. Thus the logs here come from applying inverse transformation of the geometric
Brown motion on high, low, open and close prices.
6
For cryptocurrencies, the open prices are the earliest data in the range (00:00 of a day) and the close prices are
the latest data in the range (24:00 of a day).
7
We may also include sovereign bond indices (e.g. the Citi-FTSE world government bond index) for a more
complete examination, which assess the overall credit-worthiness of governments worldwide and can be
of interest as decentralized cryptocurrencies directly challenge the government-based centralized monetary
system. However, these indices generally use close prices only, and using other proxies for volatility that rely
only on close prices marginally affect the estimation results. Thus, for simplicity we omit bond indices in our
analysis.
8
One way to deal with the time zone problem is to follow Forbes and Rigobon (2002) and use two-day rolling
averages of daily volatilities, as in Yang and Zhou (2017). However, because of the continuous trading of
cryptocurrencies, even on weekends, simply taking rolling averages of the volatilities constructed using the
Friday and Monday high, low, open and close prices (to comply with the rolling averages taken by traditional
asset volatilities) would omit the Saturday and Sunday data. This “two-day” averaging may actually sometimes
involve averaging over four days and is thus not satisfying. Therefore, we trade-off between the time zone and
trading day problem, and keep the original volatility series as constructed.
We take logs of the range-based volatilities estimated, as suggested by Diebold and

Yilmaz (2015), because volatilities tend to distribute asymmetrically with a right skew,
and taking natural logarithms can help series approximate normality, a good property for
VAR modeling. As different asset classes may have different scales of volatilities, we
then compute the Z-scores of volatilities. This not only standardizes the results but also
illustrates more clearly when large volatility jumps appear.
We follow Diebold and Yilmaz (2014) in computing volatility spillover measures
based on variance decompositions in the VAR framework. This measurement is closely
linked to the modern network theory and recently proposed measures of various types of
systemic risk, such as marginal expected shortfall (Acharya et al. 2017) and conditional
value at risk (CoVaR) (Adrian and Brunnermeier, 2016), and is flexible and handy for a
variety of financial and macroeconomic scenarios.
A volatility spillover index based on variance decompositions is intuitive and
simple. It calculates the percentage of asset i’s future uncertainty resulting from
shocks on asset j at horizon H. It also allows for the construction of different volatility
spillover indices from pairwise to system-wide, at a properly chosen horizon of interest.
Different horizons represent short or long-term effects of volatility spillover among
assets, implying that the state of the system is either still evolving or already stable,
respectively.
Our basic model is an N-variables VAR(p) process:
∑
p
=Xt i =1
Φi X t −i + ε t ,(2)
where Xt is the vector of assets described previously and εt ~ WN(0, Σ) follows a
white noise process. {Φi }i =1 are N × N matrices of dynamic coefficients but cannot be
p
straightforwardly interpreted. In order to summarize the dynamic structure and provide

appropriate economic interpretation, we transform the VAR(p) process into its infinite
moving average representation:
X t = ∑ i =0 Ai ε t −i ,(3)
∞
where the N × N coefficient matrices Ai can be obtained recursively using the formula
=Ai Φ1 Ai −1 +Φ2 Ai − 2 +…+Φp Ai − p for all i > 0. A0 is an N × N identity matrix and Ai = 0
for all i < 0.
Based on the MA(∞) model, we then perform variance decompositions that
measure the fraction of the H-step-ahead forecast error variance of Xi resulting from
shocks on Xj, ∀ j ≠ i for each i. The underlying shocks are typically assumed to have
recursive contemporaneous causal structures using Cholesky decomposition. However,
because economic theories rarely provide guidance for such recursive causal ordering,
the imposed restrictions are rather arbitrary. Spillover indices constructed as such also
depend on the order of variables, making the measures less robust.
In order to overcome the order-dependent problem, we follow the generalized VAR
identification framework posited by Koop et al. (1996) and Pesaran and Shin (1998),
which uses generalized variance decomposition (GVD) that is invariant to ordering.
Instead of requiring orthogonalized shocks, the generalized approach allows and
accounts for correlated shocks. Specifically, asset j’s contribution to asset i’s H-step-
ahead generalized forecast error variance θij ( H ) is:
g
σ −jj1 ∑ h = 0 ( ei' Ah Σe j )
H −1 2
θ g
( H=) H 1, 2, …, (4)
,=
∑ ( e A ΣA e )
ij H −1 ' '
h=0 i h h i
where Σ is the covariance matrix of the disturbance vector ε in Equations (2) and (3),
σjj is the standard deviation of the disturbance of the jth equation and ei is the selection
vector with ith element unity and zero elsewhere.
In the generalized VAR framework, the variance shares of each row do not
∑ ( H ) ≠ 1 . Thus, we normalize each

N
necessarily add up to 1; that is, in general
g
j =1 ij
θ
entry of the generalized variance decomposition matrix by its row sum and obtain the
ˆ
θijg ( H )
pairwise directional spillover index from asset j to asset i: θij ( H ) = N g
g
. By
∑ j =1θij ( H )
∑ θˆ (H ) =1 ∑ θˆ (H ) = N .
N g N g
construction, j =1 ij
and i , j =1 ij
Besides the pairwise directional spillover index, we also compute the total
directional spillover index to (or from) asset j from (or to) asset i, as suggested by
Diebold and Yilmaz (2014). However, we directly examine the systemic risk using the
system-wide total spillover index (TSI), defined as the sum of all individual asset shares
of contribution to all other assets’ forecast error variance divided by the sum of all
forecast error variance shares (i.e. N times 100 percent) in the whole system:
(5)
In this paper, we are also interested in the intergroup volatility spillover between
cryptocurrencies and other non-crypto traditional assets. Therefore, we innovatively
extend Diebold’s volatility spillover index family by designing an intergroup directional
spillover index, as follows:
=
θˆAg ←B ( H ) θˆ ( H ) , A ∩ B
∑ ∑= i∈ A j ∈B
g
ij Φ ,(6)
where sets A and B represent indices of two groups of assets. This index can be very
useful in assessing the group-to-group volatility spillover patterns for two broad asset
classes, and the classification of assets may be based on various criteria (e.g. assets with
high pairwise volatility spillover can be grouped together, as they have high asset-level
connectedness in risk spillover pattern). In this paper, we are interested in the intergroup
volatility spillover relation between all cryptocurrencies and all other traditional assets
examined, thus we construct the two groups of assets as B ={cryptocurrencies} and A =
{noncrypto traditional assets}.
Given the large number of assets to examine in our paper, we need the VAR model
to be estimable in high dimensions. Traditional approaches that apply pure shrinkage
(e.g. informative-prior Bayesian analysis and ridge regression, etc.) or pure selection
(based on information criteria) provide methods for high dimensional VAR estimation.
The least absolute shrinkage and selection operator (LASSO) method introduced in
Tibshirani’s (1996) seminal work combines the two ideas together and is particularly
appealing in practice.
To understand LASSO, we consider least squares estimation:
(X −∑ ) ,(7)
2
Φˆ arg min ∑ t
T p

= = t
1= i 1
Φi X t −i
Φ
subject to the constraint:
∑ i =1 Φi ≤ c ,(8)
p

equivalently, reformulate the problem as a penalized estimation:
( )
2
ˆ arg min ∑ T X − ∑ p Φ X
Φ
= + λ ∑ i 1 Φi . (9)
p
=t 1 = t i 1 i t −i =
Φ
Concave penalty functions non-differentiable at the origin result in selection,

whereas smooth convex penalties result in shrinkage. Hence penalized estimation nests
and blends both selection and shrinkage. The LASSO method resembles constrained
least squares estimation in construction, and can be estimated alike.
III. Empirical Results
1. Range-based Volatility Estimation

Figure 1 displays the time series of range-based volatility estimates of the selected
cryptocurrencies (Bitcoin, Litecoin and Ripple) after taking the natural logarithm but
before standardizing these series using Z-scores to keep their original scale. The three
series have similar patterns and magnitude in general, although Bitcoin and Litecoin
appear to be more alike than Ripple.
Figure 1. Range-based Estimated Volatility Series of

Bitcoin, Litecoin and Ripple, 2013–2019
Source: Coinmarketcap.com.
Notes: BTC, Bitcoin; LTC, Litecoin; XRP, Ripple.
Table 1 shows the summary statistics of the range-based volatility estimates after
taking natural logarithm and Z-scores. The volatility estimators obtained as such
are negative in sign after transformations. As expected, logarithms assist the normal
distribution of volatility series, as their skewness is close to 0 and kurtosis close to 3.
Normality can be a useful property when we build a VAR model using the constructed
volatility series. Moreover, after taking Z-scores, the volatility estimators of different
assets are of a similar scale. Among all, the three cryptocurrencies are more volatile than
other assets, as they have a higher mean of estimated volatilities, indicating their more
volatile nature than traditional assets.
2. Volatility Spillover: Individual Assets

Using an augmented Dickey–Fuller (ADF) test with an intercept but without a time
trend,9 all volatility series reject the null assumption of the existence of a unit root and
are thus stationary; therefore, we can use these series directly to build a VAR model.
9
There is no obvious time trend given the pattern of all estimated volatility (see Figure 1 for cryptocurrencies
as an example), thus we do not include a trend in ADF testing, although the test results are robust when neither
intercept nor trend is included, or when both are included.
Using Schwarz information criteria, we choose p = 1 and establish a VAR(1) model in

the LASSO framework using the full sample, and obtain the volatility connectedness
based on variance decomposition. Table 2 displays the pairwise directional volatility
spillover indices, representing volatility spillover from assets in the first row to assets
in the first column. The result is for horizon, chosen as h = 30, when the variance
decomposition results fully stabilize.
Table 1. Summary Statistics for the Range-based Volatility Estimates

BTC LTC XRP EUR GBP CHF SGD JPY
Mean –7.75 –7.10 –7.28 –10.99 –10.84 –10.94 –11.96 –10.92
Standard 1.71 1.76 1.85 0.91 0.86 0.90 0.85 0.93
deviation
Min –12.98 –12.18 –12.19 –13.85 –13.76 –13.39 –14.37 –13.77
Max –1.97 –1.52 –1.53 –7.16 –5.34 –3.29 –8.22 –6.06
Skewness 0.00 0.03 0.15 0.32 0.27 0.84 0.27 0.21
Kurtosis 2.85 2.93 2.78 3.90 4.48 7.65 3.32 3.84
KRW CNY HKD Gold Silver US UK GER
Mean –11.73 –13.53 –17.07 –9.93 –8.89 –10.86 –10.43 –10.03
Standard 0.80 1.48 1.69 0.84 0.83 1.12 0.90 0.99
deviation
Min –14.31 –19.33 –23.26 –12.65 –11.56 –13.99 –13.44 –13.90
Max –8.70 –9.82 –11.13 –5.95 –4.61 –7.13 –5.67 –6.36
Skewness –0.12 –0.49 –0.04 0.30 0.35 0.33 0.29 0.00
Kurtosis 3.22 3.56 3.13 3.41 3.34 3.19 3.68 3.10
FRA SUI JPN KOR CHN HK SIN
Mean –10.13 –10.49 –10.39 –10.73 –9.64 –10.20 –10.93
Standard 0.97 0.86 1.00 0.79 1.15 0.84 0.80
deviation
Min –12.84 –12.83 –13.69 –13.33 –12.67 –12.49 –13.33
Max –6.09 –4.87 –6.44 –7.06 –5.52 –6.13 –7.47
Skewness 0.21 0.59 0.47 0.43 0.53 0.49 0.23
Kurtosis 3.20 4.86 3.51 3.87 3.45 4.16 3.21
Sources: Coinmarketcap.com and Bloomberg.
Notes: The range-based volatility estimates displayed have been preprocessed by first taking natural logarithm
and then Z-scores, and are thus negative. See Section II for all abbreviations used in the table.
As shown in Table 2, the cryptocurrency market is quite isolated, in a volatility

sense, from other markets such as foreign exchange, commodity and stock markets, as
shown by the first three rows and columns of value except the upper-left 3 × 3 block.
The largest volatility spillover from cryptocurrencies (the first three columns) is the
Ripple-to-Chinese yuan pairwise connectedness of 1.84 percent, and the largest volatility
132
Table 2. Volatility Connectedness among Different Asset Classes, h = 30

BTC LTC XRP EUR GBP CHF SGD JPY KRW CNY HKD Gold Silver US UK GER FRA SUI JPN KOR CHN HK SIN From
BTC 53.11 21.96 17.74 0.22 0.22 0.65 0.46 0.22 0.84 1.44 0.63 0.08 0.04 0.15 0.34 0.40 0.57 0.28 0.07 0.04 0.08 0.23 0.22 2.04
LTC 23.25 49.94 17.65 0.57 0.69 0.23 1.53 0.57 0.99 0.56 0.06 0.28 0.08 0.10 0.46 0.66 1.07 0.47 0.06 0.14 0.26 0.12 0.28 2.18
XRP 15.37 13.16 54.72 1.36 0.73 0.90 1.83 0.59 0.89 0.83 0.05 0.75 0.20 0.46 1.26 1.62 2.03 1.56 0.11 0.12 0.53 0.56 0.38 1.97
EUR 0.10 0.13 0.36 32.61 6.93 18.21 10.46 6.19 1.44 0.72 0.77 3.12 2.79 1.74 1.66 2.70 2.95 2.51 0.30 0.72 1.75 1.05 0.79 2.93
GBP 0.29 0.76 1.00 11.12 46.58 7.68 8.02 6.84 1.16 0.41 1.20 2.55 2.21 1.35 2.96 0.82 1.35 1.16 0.83 0.38 0.06 0.50 0.76 2.32
CHF 0.43 0.07 0.19 19.51 4.97 33.82 8.67 6.77 0.99 0.59 1.38 3.92 3.01 2.15 1.67 2.31 2.47 3.61 0.16 0.43 1.59 0.80 0.50 2.88
SGD 0.66 0.88 0.32 12.22 6.65 9.10 35.93 8.15 2.73 0.93 0.57 5.15 3.15 1.44 1.06 1.56 2.13 2.10 0.41 0.52 0.61 0.64 2.09 2.79
JPY 0.19 0.50 0.26 7.63 5.71 7.49 9.04 36.66 1.65 0.96 1.45 6.34 3.73 3.42 2.17 1.57 2.99 2.33 2.31 1.04 0.06 0.64 1.88 2.75
KRW 0.69 0.68 0.92 4.29 2.38 2.54 7.06 4.37 52.81 0.44 1.14 1.77 1.66 2.29 2.08 2.67 3.24 2.00 1.57 0.87 0.47 2.06 1.99 2.05
CNY 1.75 0.29 1.84 0.72 0.34 0.68 2.23 1.79 0.80 82.45 0.51 1.54 0.52 0.83 0.15 0.24 0.50 0.20 1.69 0.05 0.37 0.33 0.19 0.76
HKD 0.35 0.09 0.24 0.98 0.85 2.50 2.14 2.85 0.31 0.35 81.09 1.87 1.29 0.31 0.65 0.37 0.94 0.90 0.79 0.38 0.09 0.25 0.41 0.82
Gold 0.04 0.15 0.29 4.49 2.26 5.12 6.39 7.14 0.46 0.57 0.77 41.57 19.80 2.35 1.45 0.94 1.17 1.73 1.03 0.68 0.39 0.35 0.86 2.54
Silver 0.02 0.08 0.24 4.49 2.35 4.53 4.30 4.38 0.51 0.36 0.93 22.16 46.35 1.67 1.78 0.66 0.92 1.60 0.54 0.62 0.24 0.65 0.64 2.33
US 0.06 0.03 0.24 1.77 0.87 2.03 1.35 3.49 0.61 0.37 0.50 1.89 1.18 41.94 7.12 7.67 6.83 7.21 3.99 3.63 2.19 3.04 1.97 2.52
UK 0.41 0.63 1.18 2.38 1.99 2.23 1.87 2.64 1.25 0.13 0.87 1.55 1.54 9.33 31.25 9.21 10.96 9.99 2.67 2.70 1.63 1.76 1.84 2.99
GER 0.21 0.39 0.98 2.83 0.59 2.49 1.72 1.84 1.06 0.07 0.29 0.96 0.58 7.24 8.66 29.22 19.43 13.00 1.44 1.94 2.21 1.61 1.22 3.08
FRA 0.22 0.38 0.82 2.82 0.71 2.47 1.66 2.93 1.26 0.06 0.52 1.22 0.77 6.38 9.70 18.86 28.49 13.43 1.30 1.96 1.54 1.23 1.26 3.11
SUI 0.08 0.20 0.54 2.31 0.34 3.51 1.51 2.11 0.57 0.02 0.69 1.43 0.89 8.14 8.64 12.95 14.18 32.60 1.98 2.07 2.13 1.44 1.68 2.93
JPN 0.03 0.04 0.25 1.01 1.21 1.07 2.03 4.70 1.27 1.53 1.85 1.97 1.03 7.98 3.57 3.13 2.86 4.37 45.59 5.49 1.87 3.35 3.82 2.37
KOR 0.36 0.60 0.06 1.44 0.31 0.85 0.91 1.85 0.59 0.04 0.08 0.93 0.78 5.85 2.90 2.84 2.89 2.78 4.98 58.63 4.34 4.30 1.69 1.80
CHN 0.09 0.32 0.66 2.96 0.17 2.06 1.95 0.14 0.49 0.37 0.14 0.59 0.56 4.50 2.29 3.79 2.60 3.66 1.32 2.90 57.59 9.01 1.82 1.84
Shiyun Li, Yiping Huang / 122–143, Vol. 28, No. 1, 2020
HK 0.12 0.07 0.46 2.08 0.55 1.06 2.14 1.25 1.39 0.12 0.14 0.83 0.91 5.28 2.24 3.35 2.40 2.43 3.78 4.50 10.34 48.83 5.76 2.22
SIN 0.27 0.41 0.99 2.43 1.75 1.98 5.17 4.30 1.38 0.19 0.75 1.87 1.18 4.99 3.16 2.78 2.76 4.26 3.52 2.16 2.14 5.37 46.20 2.34
To 1.96 1.82 2.10 3.90 1.85 3.45 3.58 3.27 0.98 0.48 0.66 2.73 2.08 3.39 2.87 3.52 3.79 3.55 1.51 1.45 1.52 1.71 1.39 53.57
Notes: The number in each cell represents the pairwise directional volatility spillover index value from the asset in the first row to the asset in the first column. The darker
the cell color, the larger the pairwise volatility connectedness of the two assets involved and the stronger the magnitude of volatility spillover. The diagonal elements are
not of interest in our analysis, and we intentionally use a light color to display their value. See Section II for all abbreviations used in the table.
spillover to cryptocurrencies (the first three rows) is the French stock-to-Ripple pairwise
connectedness of 2.03 percent. Interestingly, the Chinese yuan is the only asset that
has larger than 1 percent pairwise connectedness with Bitcoin, consistent with the fact
that China was previously the market where cryptocurrencies (especially Bitcoin) were
most actively traded, and Ripple is more connected with traditional assets than Bitcoin
and Litecoin. For most of the pairwise connectedness involving cryptocurrencies, the
magnitude of the spillover indices is less than 1 percent and similar for both from-
cryptocurrency and to-cryptocurrency volatility spillover indices. Such intermarket
relation resembles the cross-market volatility spillover patterns among foreign exchanges,
commodities and stocks, which are also quite small and generally less than 3 percent.
While the volatility spillovers between cryptocurrencies and other assets are small,
spillovers within the cryptocurrency market are much stronger. As shown in Table 2,
Bitcoin shocks explain significant portions of variation in Litecoin (23.25 percent) and the
reverse is also valid (21.96 percent). Similar results hold for the Bitcoin−Ripple pair and
the Litecoin−Ripple pair. The results are intuitive as these cryptocurrencies are similar in
technological design and trading behavior. In addition, large from-spillovers tend to go
hand in hand with large to-spillovers within each cryptocurrency pair, indicating that the
volatility sender is simultaneously the volatility receiver, and each pair is closely linked
within the cryptocurrency market by bidirectional volatility spillover.
From the above analysis, we find that the cryptocurrency market, given its low
volatility spillover connectedness with existing major financial asset markets and
high internal asset spillover connectedness, is rather isolated in the volatility sense
and essentially performs as a separate risk source from traditional asset markets, and
possibly shares less common risk features with traditional assets, such as foreign
exchange, precious metals or stocks.
3. Volatility Spillover: Cryptocurrency and Non-cryptocurrency Asset Groups

In addition to the pairwise directional volatility spillover index between cryptocurrencies
and major financial assets, we also calculate our innovative intergroup volatility
spillover index between the cryptocurrency group and the non-cryptocurrency traditional
asset group. In order to compute the intergroup to-spillover index, we add up elements
from the fourth row (EUR) to the last row (SIN) in the first three columns (from BTC
to XRP) of each volatility spillover table estimated (Table 2) to measure the volatility
spillover connectedness from the cryptocurrency group to the non-cryptocurrency
group. The intergroup from-spillover index can be similarly constructed when we add
up elements from the fourth column (EUR) to the last column (SIN) in the first three
rows (from BTC to XRP) of each volatility spillover in Table 2.
To account for the dynamics of such an intergroup spillover pattern, we use the
rolling window method with a window length of w = 100, which helps us to capture
variation in a timely manner without bringing in too much noise, and use a horizon of
h = 30 when the variance decomposition fully stabilizes. Figure 2 displays the rolling
estimation result of intergroup directional volatility spillover indices, where “to” stands
for volatility spillover from the cryptocurrency to the non-cryptocurrency asset group,
and “from” the reverse. The vertical axis measures one asset group’s overall contribution
in explaining H-step-ahead variation of the other asset group and shows the magnitude
of the two intergroup spillover indices.
Figure 2. Rolling Window Estimation of Intergroup Volatility Spillover to and from

the Non-cryptocurrency Asset Group, 4 August 2013–11 October 2019, w = 100 and h = 30

Notes: The initial period is from 5 August 2013 to 13 February 2014.10 The solid line represents the intergroup
directional volatility spillover index from the cryptocurrency to the non-cryptocurrency asset group, and
the dashed line represents the reverse. Major events in the to-spillover dynamics are marked out in the
figure. ETF, exchange traded fund; h, horizon; ICO, initial coin offering; SEC, the US Securities and
Exchange Commission; w, window of length.
In Figure 2, we find that the overall magnitude of intergroup volatility spillover

from and to the non-cryptocurrency market is comparable but small (as the two markets
are rather isolated), and both measures are quite volatile, exhibiting varying patterns
over time. In addition, the changes in patterns of the from and to measures are generally
in opposite directions. That is, the cryptocurrency market is more likely to receive high
volatility spillover when it is a weak volatility sender, and to send much volatility out
10
Omitting non-tradable days, holidays and days with missing values of any variable selected.
when it receives less volatility, indicating the two asset groups’ complementary role in
intergroup risk transmission.
We are also interested in how important events in the cryptocurrency market may
affect the intergroup volatility spillover pattern. We focus on the to-spillover (black solid
line in Figure 2) because it represents the contribution of shocks in the cryptocurrency
market to variation of non-cryptocurrency traditional assets. Major events help to
explain the to-spillover dynamics and are marked out in Figure 2.
Starting from early 2014, the overall acceptance of cryptocurrencies, especially
Bitcoin, boomed for approximately half a year. Many famous technology and data
companies, as well as exchanges, competed to provide cryptocurrency-related functions
in services to meet investors’ growing interest. For instance, Microsoft updated the Bing
search engine for Bitcoin currency conversions; Google search integrated a Bitcoin price
calculator to better serve interested users; Bloomberg began listing Bitcoin prices on its
financial terminals; Nasdaq entered the Bitcoin market for the first time by providing
trading technology to the Bitcoin marketplace; and the New York Stock Exchange
launched the first global security-exchange-issued Bitcoin pricing index to meet their
customers’ investment needs. Furthermore, large companies in various industries like
REEDS, Dell and Whole Foods announced their acceptance of payment in Bitcoin,
and California was the first state in the US to legally approve the use of Bitcoin. These
measures strengthened the cryptocurrency market, enabling it to spill further volatility
out. Nevertheless, as a result of the notorious manipulation scandal of the Mount Gox
exchange (Tokyo) and the DOS/STONED virus issue in the Bitcoin blockchain, the to-
spillover from the cryptocurrency market later slumped, indicating negative market
sentiment and weakened market power.
Late 2014 witnessed fluctuating volatility transmission from cryptocurrencies to
other assets as the market was still nascent, although overall the to-spillover trended
upward until mid 2015. This upward trend became clear from the start of 2015, as the
major cryptocurrency exchange Bitstamp quickly resumed service after a hot wallet
hack stole approximately 19,000 Bitcoins. The trend paused after an unconfirmed
internal incident report revealed details of a US$5mn hack suffered by Bitstamp, whose
findings were notable as they illustrated the risks typical cryptocurrency exchanges
could face. The cryptocurrency market experienced another plunge in spillover power
in early 2016 when another exchange, Cryptsy, claimed insolvent after alleging being
hacked of approximately 13,000 Bitcoin and 300,000 Litecoin. A core member of
the blockchain society asserted that the Bitcoin experiment would fail because the
decentralized system was controlled by centralized mining powers, while the fork issue
that raised controversy over consensus also contributed to the spillover downturn. The
market rebounded quickly after the Commonwealth of Nations called on its 53 member
countries to speak out about the legality of cryptocurrencies.11
In mid 2016, expectation over Brexit led the cryptocurrency market to be a strong
volatility sender and its to-spillover soared. When Britain’s exit from the EU (Brexit)
was eventually announced at the same time that Bitcoin’s mining reward was cut in
half, the market cooled down and spillover dropped. In late 2016, the market again
experienced a sharp decline in to-spillover as the new Bitcoin Core version 0.13.1 was
released and officially introduced Segregated Witness (SegWit), a proposed soft fork that
technically made Bitcoin’s protocol rules more restrictive. Starting from 2017, China
tightened its regulations on cryptocurrency exchanges after inspection, and its largest
three exchanges12 were forced to begin charging fees for cryptocurrency transactions in
January and finally to close down in September. Also since mid 2017, the overall trend
of to-spillover from the cryptocurrency market began trending downwards for the first
time, as the US, the UK and Korea tightened their regulations over the cryptocurrency
market, making cryptocurrencies less appealing as an instrument for speculation. Many
other countries are also on their way to implementing supervisory regulation of this
emerging market, and a less fervent trading atmosphere contributed to this spillover
power reversion. Starting from mid 2018, the cryptocurrency market strengthened,
although frequent hack events typically led the market’s spillover power to plummet
significantly.
4. Volatility Spillover: Total System-wide Risk

Besides the intergroup spillover relation between cryptocurrencies and traditional assets,
in Figure 3 we display the rolling window estimation result of system-wide TSI among
all assets examined, which provides a measurement of systemic risk in a given financial
system, using a window length of w = 100 and horizon h = 30, as before. The TSI can be
computed by adding up all non-diagonal entries in a given rolling estimated spillover in
Table 2 and then dividing by the number of assets, N, in the system, which measures the
overall magnitude of risk transmission. Specifically, we distinguish between a system
that solely includes traditional assets and a system that also incorporates the three
cryptocurrencies (Bitcoin, Litecoin and Ripple), to uncover whether the cryptocurrency
market can transfer additional systemic risk to the existing financial market.
11
Data in this paragraph are obtained from: Coinbase.com.
12
For example, BTC China, Huobi and OKcoin. All are Chinese exchanges, but were very active and
facilitated the majority of global transactions at that time. A graphical illustration can be obtained from: http://
data.bitcoinity.org/markets/volume/all?c=e&t=b (online; cited October 2019).
Figure 3. Rolling Window Estimation of Total Spillover Index in the System of Assets Examined,
with or without Cryptocurrencies, 4 August 2013–11 October 2019, w = 100 and h =30

Notes: The initial period is from 5 August 2013 to 13 February 2014. The solid line represents the total
spillover index with cryptocurrencies included in the system of assets examined, and the dashed line
represents the total spillover index without cryptocurrencies included. h, horizon; w, window of length.
Although the TSI with cryptocurrencies in general exhibited similar trends as the TSI
without cryptocurrencies, it is noteworthy that in periods when the traditional market’s
TSI was low, the cryptocurrency market exerted a significant influence on the existing
financial market. Those periods include the year and a half starting from 2014 and the last
three quarters of 2017, as well as the latest year. One explanation may be that when the
systemic risk level of traditional assets is low, expected high returns of cryptocurrencies
make the market especially appealing compared to the low returns of traditional assets,
and the risk also spills over to traditional investments with the shift of investment attention
and funds of cryptocurrency traders. As the cryptocurrency market has been more volatile
and immature with more idiosyncratic risks than traditional markets, the additional risk
induced by cryptocurrencies can be significant, raising the overall systemic risk level.
In periods when the systemic risk of traditional markets was high, the inclusion
of cryptocurrencies marginally affected the overall risk level, and sometimes even
mitigated the systemic risk. Typical episodes include that after the Brexit vote on 23
June 2016 and after Donald Trump’s election triumph on 8 November 2016, as displayed
in Figure 3, during which the systemic risk significantly increased. This suggests that in
periods of immense market uncertainty or turmoil, especially during political events that
significantly influence global market expectations, cryptocurrencies can play a bit of a
hedging role and help lower the overall risk level, given that their idiosyncratic features
are largely different from the risk drivers of traditional assets.
IV. Robustness Check
In this section, we examine the robustness of our results by choosing different sets of
model parameters in estimation. One method is to select a larger window length in rolling
window estimation (e.g. w = 120) that captures longer term intergroup and systemic
spillover relations. The initial period is from 5 August 2013 to 14 March 2014.13
As shown in Figure 4, the general patterns of the to-spillover and from-spillover
are similar to those in Figure 2 where the window length is w = 100, although these
volatility spillover indices become less volatile and have a smaller overall magnitude,
indicating some smoothing of volatility spillover when longer time length is considered,
deemphasizing a number of temporary shocks in the cryptocurrency market while
highlighting key events concerning the safety and stability of the cryptocurrency
infrastructure and major economies’ attitudes toward the cryptocurrency system. By
comparison, the choice of w = 100 reflects fast market changes and better captures the
evolving inter-market relation driven by major events in both markets.
Figure 4. Rolling Window Estimation of Intergroup Volatility Spillover to and from

Non-cryptocurrency Asset Group, 4 August 2013–11 October 2019, w = 120 and h = 30

Notes: The initial period is from 5 August 2013 to 14 March 2014. The solid line represents the intergroup
the dashed line represents the reverse. h, horizon; w, window of length.
Figure 5 shows the TSI with or without cryptocurrencies considered. The estimation
results are largely the same in both scale and trend, with some slight difference as the high
systemic risk period after Trump won the US election is extended. The use of a shorter
window length helps to reflect what is going on in the market in a timely manner, and
13
Omitting non-tradable days, holidays and days with missing values of any variable selected.
post-shock information will not be overemphasized by its repeated involvement in rolling

sample estimation.
with or without Cryptocurrencies, 4 August 2013–11 October 2019, w =120 and h = 30

Notes: The initial period is from 5 August 2013 to 14 March 2014. The solid line represents the total spillover
index with cryptocurrencies included in the system of assets examined, and the dashed line represents the
total spillover index without cryptocurrencies included. h, horizon; w, window of length.
Moreover, we can also choose a smaller horizon of forecast, h = 20 (instead of

the initial h = 30), when the variance decomposition results are close to stable but still
changing. Figures 6 and 7 show that the intergroup volatility spillover indices and TSI
are almost identical to those in Section III, respectively.
Figure 6. Rolling Window Estimation of Intergroup Volatility Spillover to and from the Non-
cryptocurrency Asset Group, 4 August 2013–11 October 2019, w = 100 and h = 20

Notes: The initial period is from 5 August 2013 to 13 February 2014: . The solid line represents the intergroup
the dashed line represents the reverse. h, horizon; w, window of length.
with or without Cryptocurrencies, 4 August 2013–11 October 2019, w = 100 and h = 20

Notes: The initial period is from 5 August 2013 to 13 February 2014. The solid line represents the total
spillover index with cryptocurrencies included in the system of assets examined, and the dashed line
represents the total spillover index without cryptocurrencies included. h, horizon; w, window of length.
V. Conclusion
In this paper, we explore the risk transmission relation between cryptocurrencies and
major financial assets such as currencies, precious metals and securities, and analyze
the linkage between cryptocurrencies and systemic risk, a rarely studied topic in the
literature. Our main findings are as follows.
First, cryptocurrencies mainly evolve as a separate risk source from foreign
exchange, precious metals or stocks and share less common risk features with these
traditional assets. This underlines the fundamental role of technological factors and
the “zero-fundamental” expectation-based characteristic in shaping cryptocurrencies,
as well as their special function in regulation circumvention and illegal transaction,
which differentiate them significantly from traditional assets, as mentioned. Therefore,
legislation and regulation, in addition to fighting against illegal use of cryptocurrencies
to maintain market order, should focus on new risk features of cryptocurrencies,
because merely following the legislative design for traditional currencies or securities
can be problematic.
Second, the intergroup volatility spillovers between cryptocurrencies and traditional
financial assets are comparable in magnitude but “complementary” in trends. In addition,
major events in the cryptocurrency market can shape the intergroup volatility spillover
pattern. Legislative approval of usage, information provision in major technology and

data companies, and acceptance by large exchanges and famous companies may help
to develop the cryptocurrency market, which will in turn gain greater spillover power
(Xu, 2017). On the other hand, hacks and attacks on major cryptocurrency exchanges,
manipulation scandals and controversy over the credit and technological basis of
cryptocurrencies, as well as stricter government regulation, can make the cryptocurrency
market less appealing to investors and weaken its spillover power. Hence, regulatory
policies that fight against crime in the cryptocurrency market and standardize the daily
operation of major institutions in its system may help to stabilize the risk contagion
from cryptocurrencies.
Third, the introduction of the cryptocurrency market can significantly increase
the systemic risk of existing financial markets when the latter’s risk level is low. This
means that in times of moderate financial uncertainty, the cryptocurrency market may
introduce idiosyncratic risks into traditional markets, a source of systemic risk that
cannot be neglected. However, in periods of increasing market uncertainty or turmoil,
cryptocurrencies can play a bit of a hedging role that lowers the overall risk. 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.
Of course, there is room for extension of our current study. For instance, our
discussion about major events in the cryptocurrency market and their impact is largely
descriptive and intends to offer some intuition of spillover pattern changes. Future work
can focus on key events and more precisely unravel their impact on volatility spillover
from the cryptocurrency market, especially those concerning the safety and stability
of the cryptocurrency infrastructure, as well as the attitude and regulation of major
economies.
This paper has implications for Chinese regulators who have been cautious yet
active in devising a framework for cryptocurrency application and supervision, and have
the power to shape the global cryptocurrency market through their past experience. 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. Specifically, we suggest that regulators should: (i) understand the nature of
cryptocurrencies (i.e. if they should be considered as currency, securities, commodities
or something else); (ii) design supporting legislation that matches their function and
specify situations where they can circulate; (iii) issue licenses to allow only eligible
financial institutions to enter the cryptocurrency market; and (iv) actively monitor the
daily operations of institutions involved and the state of the cryptocurrency system.
Moreover, multinational cooperation in information sharing and monitoring is required
to fight against illegal activities and crimes.
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(Edited by Zhinan Zhang)

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122 China & World Economy / 122–143, Vol. 28, No.

Do Cryptocurrencies Increase the Systemic Risk

Key words: cryptocurrency, dynamic risk spillover, systemic risk

of electronic payment in online commerce (Nakamoto, 2008), cryptocurrencies have

difference, and many simply transact cryptocurrencies as an alternative to stocks,

II. Data and Methods

We focus on major cryptocurrencies whose market capitalization is over US$10bn

We take logs of the range-based volatilities estimated, as suggested by Diebold and

straightforwardly interpreted. In order to summarize the dynamic structure and provide

∑ ( H ) ≠ 1 . Thus, we normalize each

subject to the constraint:

Concave penalty functions non-differentiable at the origin result in selection,

III. Empirical Results

1. Range-based Volatility Estimation

Figure 1. Range-based Estimated Volatility Series of

2. Volatility Spillover: Individual Assets

Using Schwarz information criteria, we choose p = 1 and establish a VAR(1) model in

Table 1. Summary Statistics for the Range-based Volatility Estimates

As shown in Table 2, the cryptocurrency market is quite isolated, in a volatility

Table 2. Volatility Connectedness among Different Asset Classes, h = 30

3. Volatility Spillover: Cryptocurrency and Non-cryptocurrency Asset Groups

Figure 2. Rolling Window Estimation of Intergroup Volatility Spillover to and from

Sources: Coinmarketcap.com and Bloomberg.

In Figure 2, we find that the overall magnitude of intergroup volatility spillover

4. Volatility Spillover: Total System-wide Risk

Sources: Coinmarketcap.com and Bloomberg.

IV. Robustness Check

Figure 4. Rolling Window Estimation of Intergroup Volatility Spillover to and from

Sources: Coinmarketcap.com and Bloomberg.

post-shock information will not be overemphasized by its repeated involvement in rolling

Sources: Coinmarketcap.com and Bloomberg.

Moreover, we can also choose a smaller horizon of forecast, h = 20 (instead of

Sources: Coinmarketcap.com and Bloomberg.

Sources: Coinmarketcap.com and Bloomberg.

pattern. Legislative approval of usage, information provision in major technology and

(Edited by Zhinan Zhang)

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