Source: Building Blocks – Crypto asset developments in the wake of COVID-19. Would you like to read our Building Blocks magazine? Please sign up for your digital copy via the form at the bottom of the page.
For investments in digital assets, institutional investors are still right at the beginning. In this liquid, alternative asset class, the same strategies can be used in principle, which can also be used for other liquid asset classes. However, crypto assets differ signiﬁcantly from traditional investments. Michael Zbinden, CIO at Crypto Fund AG, and Simon Tobler, Head of Trading at Crypto Broker AG, explain in the following article about the advantages of crypto assets, whereupon the considerations that need to be reviewed more closely.
What happened to bitcoin’s digital gold narrative?
The crypto markets and bitcoin’s digital gold safe haven narrative are worth a closer look. In a crisis, safe haven assets, such as gold, get attention. We saw this expressed in the line-up at the Degussa gold depository next door to our Crypto Finance Group offices. The irony: today, access to one of the world’s oldest assets, gold, is right next door to access to the world’s youngest: bitcoin and crypto assets.
In March 2020, as bitcoin crashed in tandem with the stock market, did this new digital gold fail us in this crisis? We argue that this remains to be seen. This has also been the professional investment position even before this market move. In the context of bitcoin’s usual volatility and relative to its usual price moves, it was much more stable than traditional asset classes.
Originally, bitcoin rose from the uncertainty of the 2008 ﬁnancial crisis as a macro hedge: “When the ﬁnancial system and monetary policy fail again, where do I invest?” Since then, banks have built up capital buffers and liquidity reserves to prevent a USD shortage or appreciation. However, the USD has become even more dominant than before the 2008 crisis: nearly two-thirds of global FX reserves are in and in 2016, 88% of all FX transactions involved USD.
Then enters bitcoin in 2020: conceived as an alternative liquidity asset in 2008 – not a safe haven asset such as gold – bitcoin has evolved into a growing ﬁat currency alternative. As stocks reset since March 2020, bitcoin has weathered the ﬁrst wave of this crisis as a secure, reliable, liquid asset that can recover value quickly and offer separation from both traditional markets and monetary systems are currently so shaken by the coronavirus. National governments and international groups have not been able to stop this virus from giving rise to an apparent global economic crisis. Investors scrambled for liquidity in March, and the massive USD deﬁcit spending as the response revealed a new crisis risk. Whatever this will bring, government deﬁcit spending has not led currencies to hold their value in the past.
Bitcoin and crypto markets did not have an advantage in the sheer panic-sell-off situation we saw in 12 March 2020. Crypto markets have not matured to this stage, with retail investors still dominating versus the institutional investors that manage liquidity professionally. With massive market uncertainty and a sell-off spiral effect, investors needed liquid dollar funds to secure margin calls. At that point, bitcoin was just another risk-on asset to sell and cover margin calls on bitcoin derivative positions.
In an institutional investor’s world, other liquid assets are on hand to hedge these needs. In a crisis, the markets shift in two steps: a reaction to the liquidity needs for margin calls, and then a risk-minimisation response as the demand for safe haven assets emerges. This demand for safe haven assets could include old model standards, e.g. treasuries and gold, and we think it will also include bitcoin and other crypto assets.
Bitcoin value growth vs other assets
What is the explanation for the correlation between bitcoin and traditional assets?
The recent correlation between crypto assets and traditional markets can be understood as a response to risk: to the extent that systemic negative economic news and uncertainty around coronavirus continues, this correlation will persist and volatility will remain elevated (a risk-off environment). However, we are seeing signs that crypto assets are breaking out of this correlation already. The majority of crypto assets are not yet linked to real economic output: this is one rationale to explain limited correlation to traditional asset classes. Nevertheless, there have been periods of strong correlation between equities previously, e.g. S&P 500 and bitcoin. The chart on the top-right rolling correlation between them (blue line = 30 day correlation of daily time series). Levels close to 1 represent phases of high correlation; levels close to -1 represent phases of negative correlation. The grey line shows the S&P 500: high correlation is not uniquely linked to bear equity markets. In general, the long-term correlation between crypto assets and traditional assets is expected to stay low. There will always be phases of high positive and high negative correlation that average out over time to a low correlation between crypto assets and traditional assets.When will bitcoin decouple from traditional assets again?
The correlation regimes shift from time to time as noted above, and this is dependent on the focus of the crypto market. During the recent market correction, the dominant focus was on deleveraging and risk reduction. However, in crypto markets there are many active players with various motivations to participate in crypto trading and investing:
- Long-term investors, who do not really care about correlation and volatility.
- Short-term active traders taking long or short positions.
- Tech nerds buying or selling, based on technological expectations.
- Investors, who have lost faith in governments.
- Investors looking for alternatives to diversify systemic risks.
- Market participants looking for long-term inﬂation protection after years of quantitative easing and recent additional cash injections to ﬁght recession in the real economy.
- People who prefer to be their own bank in times of general uncertainty.
Crypto assets, as a very young and dynamic asset class, might be dominated by one or several of these groups in the short term, and decouple from the performance of traditional assets.
Is this technology ready yet for institutional money, as long as exchanges and other providers are not able to remain operational in volatile markets?
The quality, professionalism, and ﬁnancial structure of infrastructure providers is highly heterogeneous. For institutional money, it is key to ﬁnd the partners who provide the highest quality, fully abide regulations, and are able to deliver services under adverse market conditions. As an example, CME Group, with its global derivatives marketplace for traditional assets, also provides access to listed bitcoin derivatives.
In addition, investments in crypto assets are connected to high volatility, and as a consequence, must be viewed as long-term investments. Thorough calibration of each allocated position in a multi-asset approach is key and avoids uncontrolled trading during market stress.
Central banks are buying up shares and bonds. Who should buy bitcoin?
Central banks buy shares and bonds as a steering mechanism to support and inﬂuence their economies indirectly. In contrast, investments in bitcoin are linked to a single investment case. In particular, ﬁntech and venture capitalists with a deep technological understanding are fascinated by blockchain-related investments. A diversiﬁed multi-asset portfolio will beneﬁt from independent sources of return, and the additional rationale for investing in bitcoin, which we have pointed out earlier in this article.
In general, bitcoin’s total supply is ﬁxed. Bitcoin’s purchasing power will continue to grow over time if demand continues to increase. This commodity-like feature offers investors the opportunity to diversify both systemic risk that is connected to government-controlled ﬁat currencies and inﬂation risk linked to expansive monetary policy. Bitcoin also provides access to an alternative source of performance that is not connected to pure economic output.
There is a possibility for a deﬂationary phase before any inﬂation would take hold. How will bitcoin behave in that market environment?
Right before the recent crisis, bitcoin was highly uncorrelated to other asset classes, and therefore also uncorrelated to factors that greatly inﬂuenced those asset classes. From this perspective, we can conclude that “bitcoin doesn’t care”.
If the recent higher, statistically signiﬁcant correlation to equities and gold persists, bitcoin should be expected to behave similarly to those asset classes. Neither gold nor stocks are expected to perform well in a deﬂationary environment, bringing possible headwinds for crypto assets. The main questions: “What other factors will inﬂuence the price of bitcoin?” and “Which factors will dominate?” Bitcoin should perform better in an inﬂationary environment ceteris paribus, than in a deﬂationary one.
Can bitcoin be a safe haven when inﬂation strikes?
Bitcoin and crypto assets can be a safe haven against inﬂation, geopolitical strife, and issues stemming from central bank actions. Crypto assets have the potential to transform the ﬁnancial industry, with bitcoin even being billed as a hedge against coronavirus-related risks, even before the market correction in March. However, crypto assets are not a safe haven against everything, as we have seen since then.
In this respect, crypto assets offer a longer-term horizon rather than an immediate store of value. This is the basis for regulated, professional, and secure access to crypto assets that enables a bridge between the traditional and crypto asset markets.
The rationale for bitcoin and crypto assets as a hedge against inﬂation truly strikes at the root of inﬂationary problems, as both assets and a store of value outside of any national monetary system. Wealth is dissociated from the core: government or centralised governance actions are not simply symptoms, rather the tip of the inﬂationary iceberg. In our current phase, when political leadership is more centralised and may destabilise as an economic crisis intensiﬁes, bitcoin and crypto assets can act as the ultimate hedge. This destabilisation could include currency debasement, rampant price inﬂation, central bank and ﬁscal policies gone wrong, and actions leading to nations or governments seizing, freezing, or grossly taxing citizens’ ﬁat currency wealth.
Are any of these ahead for us? Possibly. Against this backdrop, an allocation to crypto assets has become more relevant today to diversify portfolios.
Crypto assets as a portfolio building block
Derived from the previous remarks, a direct link to the real economy is generally lacking so far, which underlines the attractiveness of crypto assets as an uncorrelated investments that could be included in a traditional portfolio.
This is because market events are dominated in the short term by one or other of the groups involved. For example, the expectation of a technological innovation or even a regional crisis situation, in which assets are protected from hyperinﬂation, may increase demand for a particular crypto asset independent of the economic performance of other asset classes. On the other hand, when the corona pandemic recently hit the world markets in March 2020, a „risk-off” scenario was observed in which both crypto assets and traditional investments were sold blindly. Crypto assets are not suitable as a tail hedge but much more for medium to longer-term diversiﬁcation. From an analytical perspective, the correlation with various traditional investments have moved close to zero in the long term (see the previous chart: rolling 30-day correlation – BTC vs S&P 500). However, a short-term view shows that this value is much more volatile: it is composed of periods of very high positive and negative correlation, which can be seen in the rolling correlation measurement.
In other words, in the long run there is no systematic link between crypto assets and traditional investments. In the short term, however, periods with a high positive correlation as well as time windows with a strong negative correlation are apparent.
On the other hand, the correlation within the crypto market, i.e. between the tradable tokens and coins, is still very high. Bitcoin’s dominance often determines the overall direction of the crypto market. However, as individual projects develop further and the ﬁrst blockchain solutions arrive in the real economy, we can expect to see the crypto asset market taking on an increasingly independent life of its own. However, it will likely be some time before this happens.
1 Bitcoin currently makes up about 65% of the total market capitalisation of all crypto assets.
About the authors
Michael Zbinden is CIO at Crypto Fund AG. Prior to joining the firm, Michael worked as a portfolio and fund manager at UBS, Julius Baer, Swiss & Global Asset Management, and GAM. He has over 14 years of experience in the investment industry, specialising in multi asset strategies, derivatives, and risk management. Michael holds a Master of Science ETH from the Swiss Federal Institute of Technology, Zurich. He is also a Financial Risk Manager (FRM) and holds a charter in technical analysis (CMT).
Simon Tobler is Head of Trading at Crypto Broker AG. He is a passionate and experienced trader with a track record in FX derivatives of over ten years. Prior to his role at Crypto Broker, Simon acted as a market maker at Credit Suisse for plain vanilla and exotic options in emerging market currencies. As sole owner of the corresponding trading books, he applied multiple strategies to manage risks and generate alpha. Simon has successfully applied his knowledge to crypto asset trading by building up a top-notch crypto execution platform together with his dedicated team of specialists. Simon completed post-graduate studies in risk management at the Zurich University of Applied Sciences and a Master of Arts in Economics and Business Administration, with a major in Finance, from the University of Zurich.Weiterlesen