When we look at the cryptocurrency market becoming so unstable, we need to understand that it is connected to the events in the real world and many factors can affect this market, much like the stock market.
The two cryptocurrencies Bitcoin as well as Ethereum can be currently listed among the world’s top 20 assets that are traded the most. Their market cap is greater than some of the largest corporations in the world. Their growing recognition and participation in the crypto community is the reason for their rapid growth in the wake of the epidemic. However, how are market decentralization affecting traditional markets with all the crypto mania? The latest IMF working paper says the key is in the correlations.
- A brand new IMF working paper explores the relationship between crypto and equity markets in the wake of a twentyfold increase in the market cap of decentralized assets in the course of the epidemic.
- They find fluctuations in the return on the market daily of Bitcoin and Tether could account for six percent of the variance in the daily returns for the S&P500 index, which is up from one percent pre-pandemic.
- In combination, the volatility in the two crypto assets can contribute to a fifth of the volatility in daily price movements within EM capital markets.
Up to at most the beginning phase of the pandemic there was a belief that the scarcity of Bitcoin could make it an inflation-hedging asset. However, the consensus changed when inflation began to increase in May 2021. Bitcoin was proving to be another play on risk markets – it was most correlated with US and Chinese equities. This linkage with equity markets that the IMF paper considers because that’s the place where the $3 trillion cryptocurrency market will probably have the biggest impact. The paper provides the following.
- The connection between Bitcoin price volatility and the volatility of the S&P500 rose over fourfold from prior to and post-pandemic.
- Bitcoin is the main reason for 17 percent of the day-to-day fluctuation in US equity prices.
- Crypto assets are also increasingly tied to EM equity.
- Bitcoin and Tether can explain almost 20% of the variations in every day MSCI markets in emerging (EM) rates. By comparison, the S&P500 explains 30%.
Since the beginning of the epidemic, the connections between cryptos and stocks have increased. The volatility in prices of two main cryptocurrency assets – Bitcoin and Ethereum are now four to eight times higher with volatility on major US equity market indexes (the S&P 500, Nasdaq and Russell 2000) versus 2017-19 (chart one). Similar trends are evident in the relationship between equity markets in emerging market economies, captured in The MSCI EM index.
The intra-day returns are also more closely linked – although the increase has been particularly noticeable for Bitcoin (chart 2.). The correlation between Tether and equity prices also grew in the course of the pandemic – implying people were using it as a risk diversification asset during that time.
The growing correlation between crypto assets and equity has been much bigger than other important asset classeslike 10 years of the US Treasury ETF, gold and certain foreign currencies (the dollar, euro and US dollar).
However, the connection with Bitcoin returns and high-yield bonds (HY CDX) and investment-grade bonds (IG CDX) has strengthened substantially – as is typically be the case for more risky asset classes. In contrast, the opposite holds for Tether, again implying the need for risk diversification (chart 3).
More complex correlations
To determine the exact extent of crypto’s link to asset markets, the authors run a VAR model to capture bi-directional correlations. They refer to these correlations as’spillovers.’ In addition, they look at the volatility and returns of each day to determine the degree of diversification and connection strategies across different asset classes in the course of time.
Similar to the correlations that are simple, spillovers have also increased in the course of the pandemic, which means that they have shifted from equity to crypto prices and vice versa. For example, volatility in Bitcoin prices now explains 17% of the volatility in the S&P500 (chart four). However, volatility in S&P500 prices now also accounts for 15 percent of the volatility in Bitcoin prices. This indicates a growing bi-directional connection, resulting in increased spillovers.
The connection between Bitcoin and Tether intensified since the start of the pandemic. Volatility in Bitcoin prices accounts for over one quarter of the Tether price volatility. In the opposite direction, Tether has only a small effect on the volatility of Bitcoin (12 percent). Tether is also only able to explain six-percent of the volatility in the S&P500.
Return spillovers also increased during the pandemic. The patterns are broadly similar to the volatility spillovers but smaller. The most striking finding is that the daily returns of Bitcoin and Tether combined explain 66% of the variation in the daily S&P500 return. They also explain 15percent of variance within Russell return in 2000. This is quite impressive considering that their contributions were practically non-existent prior the outbreak. It shows just how much cryptocurrency assets have an impact on equity markets.
The growing relationship between cryptos and equities extends over the US. Bitcoin accounts for 14 percent of the volatility within the MSCI EM index during 2020-21 and 8 percent of its return fluctuation. These are up twelve points and 7.5pp from pre-pandemicand. Together with Tether, both crypto assets account for almost 20% of the price fluctuations that occur daily of the MSCI EM index (chart six). Similar to the S&P500 is responsible for 30% of the day-to-day MSCI EM prices’ volatility.
To finish they examine the spillovers during times of market stress. In general, spillovers are higher when market volatility is high. For instance the market collapse led to a pronounced and relatively extended spike in bi-directional volatility spillovers between crypto and equity markets.
The bottom line
The pandemic’s macroeconomic implications have been enormous. They have altered decade-long trends in labor markets, the supply of goods and services, consumer habits in the form of inflation and inflation.
As this paper illustrates, the pandemic may have accelerated the integration of decentralized markets into centralized ones. This means that policymakers, regulators and investors are no longer able to dismiss the significance of crypto within the macroeconomic environment of the world. Events in crypto are now also happening in equity markets , and reversed – the speed of change is shocking.