When the stock market falls drastically, as it did on Monday during the Evergrande crisis, bitcoin and other cryptoassets typically fall as well.
This constantly catches folks off guard. Skeptics emerge from hiding, shaking their heads and cynically remarking, “I thought cryptoassets were meant to be uncorrelated.”
This perplexes me.
If there’s one thing that everyone agrees on when it comes to cryptocurrency, it’s that it’s a high-risk investment. So why are we surprised when crypto drops in value during risk-off periods?
I understand that crypto is marketed as an uncorrelated asset, and it is: the correlation between crypto and the stock market is roughly 0.2 over any meaningful length of time, which is incredibly low. However, just because there isn’t a general lack of correlation doesn’t mean crypto will zig when the market zags in the short run. It implies that it will provide uncorrelated returns across months and years, as it has in the past.
Those who expect crypto to perfectly counter the market are unaware of what drives crypto’s performance. In truth, there are three key factors that influence cryptocurrency returns. If you want to understand why different crypto assets behave the way they do, you must first comprehend how these three major forces interact.
Risk-On/Risk-Off Appetite is the first driver.
The first key factor influencing cryptocurrency returns is risk appetite. Cryptoassets, such as bitcoin, are, as previously stated, high-risk investments. When investors become jittery, they sell high-risk investments. They purchase when they become bullish.
That is true of all hazardous investments, as evidenced by the fact that crypto fell in line with stocks on Monday. The similar effect may be seen in other hazardous areas of the market, such as Cathie Wood and ARK Invest’s “disruptive technology” ETFs.
Industry-wide variables are the second key driver of crypto gains. This refers to news and events that have an impact on the entire crypto business or specific segments of the industry.
A good example is regulation. Stablecoins, crypto exchanges, and the DeFi space are all being debated by regulators in Washington and elsewhere today. Positive regulatory news would boost the price of the crypto market as a whole, while concerns about governmental overreach may drive the market lower. As the market reacts to China’s crypto trading ban, you can see that now.
Education is another example. For the past two weeks, I’ve been speaking about crypto at numerous conferences to literally thousands of institutional investors and financial advisers. This type of instruction has an industry-wide benefit and is a long-term driver of returns when compounded by all the other people doing the same thing. Confidence comes from knowledge.
Asset-Specific Drivers (Driver #3)
Factors affecting individual cryptoassets and their use cases are the third driver of returns.
The price of ether, for example, has risen dramatically this year, thanks in part to a surge in interest in non-fungible tokens (NFTs), which are linked to the Ethereum network. Bitcoin’s price has risen less because it is not affected by the NFT boom.
Because bitcoin’s core use case is as digital gold, its price is more responsive to central bank activities and inflation fears than ether’s.
Different cryptoassets and the blockchains that support them offer different services and are aimed at different markets. The returns of the individual asset are affected by their success or failure, as well as the growth or ebb of those markets.
What Does This Imply for Investors?
Understanding how these three factors interact is crucial to understanding how cryptoassets perform.
Investor risk appetite was the only criteria that mattered in the early days of cryptocurrency. At the time, cryptography was exceedingly speculative, and application cases were purely hypothetical. As a result, risk-off sell-offs (and risk-on bull runs) were at an all-time high. On any given day, cryptoassets would fluctuate by 10% or more.
Today, industry and asset-specific drivers have largely taken over. Risk considerations can overwhelm the market on some days, as as Monday, but for the most part, crypto is driven by variables such as legislation and institutional adoption. This is why, when assessed over time, crypto has modest correlations with equities and other markets, even if correlations might surge to 1 during risk-off periods.
Longer term, I expect asset-specific forces to become the main or at least a major driver of returns as markets mature. Markets are already demonstrating this, with assets like Solana delivering remarkable gains (up more than 9,000 percent year-to-date) as investors increasingly consider them as a viable alternative to the overcrowded Ethereum blockchain. As the diverse properties and use cases of different cryptoassets become more apparent, I predict correlations between them to decline. Over the long term, there is no reason why bitcoin (which operates as digital gold) should be highly connected with ethereum (which serves as a platform for DeFi, NFTs, and other applications).
Because they are both buffeted by large industry-wide factors and risk-appetite dynamics, they are now. They should, however, have quite distinct return patterns in a mature, steady condition.
Meanwhile, don’t be fooled by short-term gains: Cryptoassets trading lower on risk-off days serve as a reminder that crypto is still in its infancy and that it is a risky investment. In the short run, this risk factor may overpower the industry and asset-specific drivers. However, crypto has shown a minimal association with other assets throughout time, and this lack of correlation appears likely to continue.