Liquidity spillovers between cryptocurrency and foreign exchange markets

Market liquidity spillover has been studied using fiat and digital currency (cryptocurrency), though separately. In today's globally connected financial markets, there is interconnectedness among financial assets, as economic agents make decisions involving multiple asset classes. In this paper, we construct daily liquidity measures for five major cryptocurrencies and seven major fiat currencies and examine their interdependence in the time-frequency domain. We find that liquidity connectedness is event-driven and varies with time. Notably, there is an increase in liquidity spillover at the peak of the COVID-19 pandemic, reflecting heightened uncertainty and market instability. We also find that, at the peak of the pandemic, the total spillover index is stronger in the long run than the short run, highlighting a possible flight-to-liquidity during periods of stress. The Euro stands out as the principal net transmitter of liquidity shocks in the short run, while Ethereum plays this role in the long run. Further analysis highlights the role of some economic and financial variables in driving the dynamics of liquidity spillovers and reveals some heterogeneity in the identity of drivers between the short and long run. The results enrich the academic literature by providing evidence of liquidity spillovers between cryptocurrencies and foreign exchange markets during times of stress, which is insightful for traders, investors, and policymakers.

Automated summary

This paper constructs daily liquidity measures for major cryptocurrencies and fiat currencies, and examines their interdependence in the time-frequency domain. The study finds that liquidity connectedness is event-driven and varies with time. Notably, liquidity spillover increases during the peak of the COVID-19 pandemic, indicating heightened uncertainty and market instability. The results also show that the spillover index is stronger in the long run compared to the short run, suggesting a flight-to-liquidity during periods of stress. The Euro and Ethereum are identified as the principal transmitters of liquidity shocks in the short and long run, respectively. The findings contribute to the academic literature by providing evidence of liquidity spillovers between cryptocurrencies and foreign exchange markets, which is valuable for traders, investors, and policymakers.