What We Know About Cryptocurrencies as Assets

Cryptocurrencies Assets

The buy-side is engaging collateral management more than ever, taking advantage of technological developments to meet their expanding requirements.

March 2022

The origins of the “modern” global securities market date back to Venice in 1172 when the city state imposed an enforced five percent loan on its wealthier citizens.

Some 850 years later, a five percent government bond yield may still look attractive, but there are now approximately US$245 trillion worth of “traditional” equity and debt securities to choose from. As fast as everything is moving today, it is with this longer-term lens that we should judge the emergence of crypto assets which began with the Bitcoin ledger on January 3, 2009. A mere 13 years later, we have learned a lot about the properties of these assets, where they have delivered on promises and where they have not, but there is still much to resolve.

Sentiment has changed
Since most crypto assets do not involve future cash flows, the case for cryptocurrency valuations tends to center around expectations of future value; itself closely related to the rate of cryptocurrency adoption either for transactional, investment or other purposes. An indication of these expectations can be derived from flows and specifically from changes in realized, as opposed to actual, market capitalization. Realized market capitalization values coins at their purchase price rather than their mark-to-market so changes in this metric capture the net inflow into a Bitcoin; inflows that have surged in the past year.

As Figure 1 shows, average weekly net inflows into Bitcoin have for the past year rivalled or at least been on a similar scale to inflows into US equity mutual funds and ETFs or their fixed income equivalent. While the net inflow into Bitcoin doubled between 2019 and 2020, it rose five-fold in 2021 (by end of November). In short, there has been a noticeable change in sentiment that is pushing crypto assets into the mainstream.

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Lifting the cap
In response to this sentiment shift, many cryptocurrencies have grown exponentially in the past three years. After the first large scale cryptocurrency crash in early 2018, market capitalization has grown from a low of US$122 billion at the end of 2019 to a high of close to US$3 trillion in November 2021. Just under half of this market capitalization is in Bitcoin, making it one the largest single assets in the world depending on how it is classified. By ‘currency’ in circulation, it currently ranks 14th, tucked in between the Swiss franc and Russian ruble.

And looking more narrowly at currency futures, the average open interest in Bitcoin in the past six months across all exchanges is higher than all but the EUR and USD futures. By equities, it is in the top 20 US equities by market capitalization and would similarly be in the top 10 issuers if it were a government bond. We can say with confidence, then, that Bitcoin and even a number of the crypto coins below it have reached what one might think of as critical or even credible mass in terms of size.

The mainstream challenge
Critical mass does, however, come with challenges. As Figure 1 notes, the surge in inflows into both traditional and crypto assets in the past year coincided with the arrival of US fiscal stimulus which boosted consumer savings. However, this coincidence or potential common driver brings with it a potential contradiction. The more Bitcoin becomes part of mainstream investing, the more it risks losing what is often touted as its key differentiator; diversification from traditional assets and perhaps also inflation. This is certainly true over the past year. Correlations with equities and the tech sector in particular are positive and have increased (Figure 2).

And as Mark Kritzman and our colleagues at State Street Associates have observed in a recent paper, these positive correlations increase further at the worst possible time; i.e., when equities fall. This is shown by the conditional correlations listed in Figure 2, and the effect is particularly prevalent for tech stocks; when tech is down, so is crypto. That means the case for holding crypto to diversify the risk of a portfolio has yet to be made conclusively.

A similar question surrounds holding crypto as an inflation hedge. Our partnership with PriceStats allows us to look at high-frequency changes in the annual inflation rate and compare this to changes in Bitcoin prices. The results are mixed. Over the past three years, using weekly data, there is no correlation between changes in inflation and Bitcoin prices, but short-term correlations of the past six months do at least show some degree of co-movement. One challenge with both the links to investing and inflation, however, is volatility.

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Outsized volatility
As much as the market for Bitcoin has grown, the fact is that crypto market cap is, at the time of writing, almost 30 percent down from its high in a month, a testimony to the persistence of volatility. This is not unique to Bitcoin, of course. Traditional currencies or assets are also prone to sharp down draughts. However, the bigger financial assets get, typically, the less they move. Starting with a comparison of other traditional currencies, the one-year volatility of Bitcoin is still multiples of the most volatile freely tradeable emerging market currency, the Turkish lira. The lira offers the enticement of a 14-percent interest rate to help compensate for annualized volatility close to 25 percent. So while there may be a similar amount of Bitcoin in “circulation” compared to the Swiss franc or Russian ruble, its volatility does not fit on the same scale as other currencies.

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Nor does it compare too favorably with most equities. As Figure 4 demonstrates for the current members of the S&P 500, bigger stocks tend to be less volatile on average. Yet Bitcoin’s nine-fold increase in market capitalization still comes with a 70 percent-plus annualized volatility. This is not unheard of at the stock level, but is unusual — only Tesla has a similar size and volatility.

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The crypto conundrum
In some cases, cryptocurrencies have lived up to or sometimes exceeded their promise. They have attracted billions in inflows, and market capitalization has surged to heady levels. But higher market capitalization has yet to lower the volatility of crypto assets, and evidence of diversification is weak. This gets to the two biggest unknowns for Bitcoin. If size and greater adoption do not reduce volatility, what will? And if nothing reduces the volatility, will that in turn matter? A clue to answering the first question may lie in market structure; who holds and in particular who trades Bitcoin.

This is a question that State Street Associates Partner, Antionette Shoar, and her co-author take on in a recent paper using a large number of public and proprietary sources. The results are striking. Compared to the exponential growth in market capitalization, the growth in volume of economically meaningful transactions is far from it. Volumes have rebounded smartly this year, but are still below their prior peaks in 2016 and 2018. Meanwhile, the change in underlying market structure shows similar inertia. Today exchanges, and entities assumed to be exchanges, over-the-counter brokers and trading desks account for 60 percent or more of all volumes just as they did in 2015.

So given similar trading volumes and similar entities dominating them, it is perhaps folly to expect a different result in terms of either liquidity or volatility. Finally, it is worth considering that if Bitcoin were in the future to be adopted on a more significant scale by long-term asset managers/owners, this would potentially exacerbate this liquidity challenge by taking even more coins out of circulation. This creates a troubling circularity; the volatility and liquidity criteria that many of these investors will likely have for adopting Bitcoin in the first place could be worsened if they actually choose to hold it.

As with any 13-year-old currency, however, these current issues are subject change. In traditional asset markets a combination of regulation, central banks, exchanges and large financial institutions all play a role in making markets liquid, which in most cases means that volatility is to some degree managed, most of the time.

The decentralized structures of crypto have not been able to produce similar levels of stability. But given the growth in market capitalization that has occurred anyway, perhaps they have not been compelled to do so yet. Adaptation as with those Venetian loans 850 years ago will likely prove key to greater adoption and evolution. But if size alone will not deliver enough liquidity to bring volatility down, the development of crypto as an asset class may steer more toward stable coins as settlement tokens, central bank digital currencies, or simply a different, more levered, way to invest in the technology sector.


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