How hacking affects the bitcoin market

Is there more than just market forces behind crypto price fluctuations?

The price of bitcoin has reached new highs during 2021, with financial heavyweights such as BNY Mellon announcing in February that they would be providing custody services for digital assets by the end of the year. It was an announcement that pushed the price of a bitcoin above $48,000.

“Whatever your opinions on cryptocurrencies . . . the fact remains that these digital assets are becoming a more important part of the payments world,” Mastercard's head of digital assets Raj Dhamodharan said on the company's blog.

While Mastercard has also said that it only plans to handle currencies that are sufficiently stable to be used for buying things (other than a new Tesla), the huge price fluctuations have attracted the attention of other actors in the field.

Attracting thieves

Research from the University of Vaasa highlights that 1.1 million bitcoins were stolen between 2013 and 2017, which at today’s value would put that heist at around the $44 billion mark.

The paper highlights how vulnerable cryptocurrencies are to hacking as the majority of them try to control the private keys of customers, which makes these exchanges highly attractive to hackers.

Break into the exchange and you have the keys of every holder of the currency.

"In an attempt to avoid hacking incidents (referred to here as hackings), about 90% of the exchanges use some type of cold storage system where they keep their keys offline," the author explains. "Notably, the number of bitcoin wallets has increased more than four times from 8.2 million in 2013 to 35 million in 2016."

Hacking bitcoin

The author specifically examines 29 individual hacking incidents that unfolded across the bitcoin market between 2013 and 2017. He highlights that despite the prolific nature of these attacks, the uncertainty they create in the market doesn’t seem to be reflected in the price of the currency. At least not in the immediate aftermath of any attacks, with any response generally coming at least five days after the attack occurred.

It suggests that the bitcoin market is not especially efficient nor effective at processing information such as this and reflecting it in the price of the currency. It’s a marked contrast to fiat currencies that tend to react to crucial events in seconds. What’s more, the impact of the attacks seems to “infect” other cryptocurrencies as well.

"While earlier literature documented co-movements of cryptocurrency returns, a novel finding of the current research is that hackings in the bitcoin market also affect other cryptocurrency markets," the researcher explains. "Our evidence suggests that there is a contagion effect in volatility associated with hacking incidents."

Contagious risk

The analysis found that after a hacking incident on bitcoin, there was also an increase in volatility in the Ethereum market (albeit after the same time-lag seen on bitcoin). The level of volatility seen on these other exchanges was virtually identical to that seen in the bitcoin market itself, which seems to suggest that people are pricing in the security and risk of cryptocurrencies as a whole rather than bitcoin specifically.

What’s more, neither bitcoin nor Ethereum displays asymmetries in their volatility even though in more traditional financial markets, volatility responses tend to be stronger for negative news than for positive news.

The paper highlights how the very fact that cryptocurrency exchanges both store and trade virtual currency makes them particularly vulnerable to attacks. Yet, despite this vulnerability, the crypto markets don't appear to be efficient in processing and pricing in any such attacks into the currencies themselves.

The author suggests that this is often because attacks may happen in smaller exchanges with lower security standards than the larger exchanges have in place. This in turn slows down the diffusion of information throughout the market.

"Furthermore, exchanges trade multiple cryptocurrencies and if an exchange was hacked, thieves could steal both bitcoin and Ethereum, which could be a possible explanation for volatility spillovers found in the current study," the author continues. "Another possible explanation for this phenomenon could be that thieves are using one cryptocurrency to cash out on their theft of the other, thus shifting the demand for cryptocurrencies from the one that was hacked to the other."

As the price of bitcoin continues to surge, the frequency of such attacks is only likely to continue. If the currency wishes to reduce its volatility and become a more respectable currency, then it has to get better at processing and pricing in the theft of bitcoins from people.