Bitcoin and other cryptoassets can also be sold when the stock market falls sharply, as Monday’s Evergrande meltdown.
This is always surprising to people. Skeptics are quick to jump out of the woodwork, pointing sarcastically at their mistaken belief that cryptoassets should be uncorrelated. “
This is a puzzle to me.
Crypto is a risky investment, that’s what everyone agrees on. Why is it that crypto often sells at risk-off times?
It is common to say that crypto is uncorrelated. However, over any meaningful time period, the correlation between crypto-stock market is only about 0.2. This is very low. However, a lack of correlation does not mean that crypto will be able to zig and zag with the market in the short-term. This means that it will provide uncorrelated returns over months or years. It has historically done so.
People who believe that crypto will completely offset the market do not understand what drives crypto performance. There are three main factors that drive crypto returns. Understanding how these three drivers interact will help you understand why different crypto assets behave in the same way.
Driver 1: Risk-On/Risk Off Appetite
Risk appetite is the first driver of crypto returns. Cryptoassets such as bitcoin can be risky investments. Investors sell risky assets when they feel anxious. They buy when they become bullish.
This is true for all risky assets. We saw this Monday when crypto traded in line with stocks. The same effect can be seen in other areas of risk, such as the ETFs that offer disruptive technology (ARK Invest) and Cathie Wood.
Crypto can respond to both risk-on and risk-off dynamics.
Driver 2: Industry-Wide Factors
Industry-wide factors are the second driver of crypto returns. This means that news and developments impacting the entire industry or specific sectors will be important.
One example is regulation. Today, regulators in Washington and other places are discussing issues such as how to regulate stablecoins and crypto exchanges and the DeFi sector. Positive news from the regulatory front could lift the overall price of the crypto market, but concerns about excessive regulation could cause the market to fall. As the market reacts against China’s ban on crypto trading, you can see this today.
Education is another example. For the past two weeks, I have been traveling around speaking to thousands of financial advisors and institutional investors about crypto at various conferences. This education, multiplied by the thousands of other people doing the exact same thing, has a huge industry benefit and is a long-term driver for returns. Confidence breeds knowledge.
Driver #3: Drivers who are Asset-Specific
The third driver of returns are factors that have an impact on individual cryptoassets or their use cases.
The booming interest in NFTs (or non-fungible tokens) has led to an increase in the price of ether this year. These tokens are tied to Ethereum’s network. Bitcoin’s price has not risen much due to its inability to be exposed the NFT boom.
Bitcoin’s price, by contrast, is more sensitive to central bank activity than ether’s. This is because bitcoin’s primary purpose is as digital gold.
Different cryptoassets offer different services and are targeted at various markets. The returns of each asset are affected by whether they succeed or fail, and how those markets change.
What this means for investors
Understanding how these three factors interact is crucial to understand cryptoassets performance. Crypto was highly speculative and the use cases for it were not clear. Risk-on bull runs and sell-offs were extreme as a result. On any given day, cryptoassets moved by 10% or more.
Today, asset-specific drivers and industry drivers are dominant. While there are times when market risk factors can overwhelm, such as Monday, most crypto is driven by regulatory factors and institutional adoption. When compared over time, crypto has low correlations to stocks and other markets. However, correlations can spike up to 1 in risk-off times.
Long-term, asset-specific drivers will become more dominant, or at the very least, a greater driver of returns as markets mature. This is already evident in markets where assets such as Solana are showing remarkable returns (up over 9,000% year to-date), as investors increasingly view them as an alternative to the overcrowded Ethereum Blockchain. As each cryptoasset’s unique characteristics and uses become more apparent, I expect that correlations between them will decrease. Over the long-term, there is no reason why bitcoin, which acts as digital gold, should be high correlated with Ethereum (which is the platform to DeFi, NFTs and other applications). Because they are both subject to significant industry-wide risks and appetite dynamics, it is currently. They should however have distinct returns in a stable, mature state.
Don’t let the short-term returns fool your eyes: Cryptoassets trading lower on risk-off days is just a reminder of how risky cryptoassets are. In the short-term, this risk factor could overwhelm the industry and asset specific drivers. Over the long-term, however, crypto has shown a low correlation to other assets and this lack of correlation is likely to continue.