When we look at the crypto market being so volatile we must understand that is has connections to what is happening in the real world . numerous factors can impact the market in the same way as the stock market.
The two currencies Bitcoin as well as Ethereum are currently listed among the world’s top 20 most traded assets. Their market capitalizations are higher than some of the largest corporations around the world. The growing popularity and involvement in the crypto industry is responsible for the growth of the crypto ecosystem during the pandemic. However, how are these markets that are decentralized influencing the traditional ones amid all the hype about crypto? An upcoming IMF working paper suggests that the crucial factor is in the relationships.
- A new IMF working paper explores the connections between crypto assets and equity markets, following an increase of twentyfold in the market capitalization of decentralized assets during the epidemic.
- The researchers have found that fluctuations in the monthly returns from Bitcoin and Tether can account for around a sixth of the variance in daily S&P500 returns, up from just one-percent pre-pandemic.
- In combination, the volatility of both crypto assets could cause a fifth the price movement that occurs daily on EM the equity market.
For at least the initial part of the pandemic people believed that Bitcoin’s lack of supply would make it an inflation-proof asset. But the perceptions changed when inflation began to rise in May 2021. Bitcoin turned out to be another strategy to take advantage of risk markets. it was the most strongly linked with US and Chinese equity markets. This connection to equity markets that the IMF paper considers because this is the location where the $3 trillion crypto market is likely to have the most impact. The paper concludes that the following are the most likely implications.
- The correlation between Bitcoin price volatility and the volatility of the S&P500 increased by fourfold between pre- to post-pandemic.
- Bitcoin is at present responsible for 17 percent of the volatility of US equity prices.
- Crypto assets are also increasingly tied to EM equities.
- Bitcoin and Tether can explain about 20% of variations in everyday MSCI emerging market (EM) price. By comparison the S&P500 accounts for 30%.
Since the beginning of the pandemic, connections between cryptos and stocks have increased. The volatility in prices of two main crypto assets that include Bitcoin and Ethereum are now 4-8 times higher and the volatility the main US equity market indexes (the S&P 500, Nasdaq and Russell 2000) versus 2017-19 (chart one). Similar trends are evident in the relationship with equity markets in emerging market economies, as reflected with The MSCI EM index.
Intra-day returns have also become more interconnected – but the rise has been especially noticeable with respect to Bitcoin (chart two). While the correlation between Tether and equity prices also increased but it weakened during the pandemic – implying people used Tether to diversify risk asset during that time.
The growing correlation between crypto assets as well as equities is much greater than other important asset classeslike 10 years of the US Treasury ETF as well as gold and some currency pairs (the dollar, euro and US dollar).
However, the correlation between Bitcoin returns and high-yield bonds (HY CDX) and investment-grade bonds (IG CDX) has strengthened substantially – as is typically be the case with risky asset classes. Meanwhile, the reverse holds for Tether as well, which suggests the need for risk the diversification (chart 3).
More complex connections
To quantify crypto’s connection to asset markets, the authors employ a model called a VAR to identify bi-directional correlations. These correlations are referred to as spillovers. In addition, they study daily returns and volatility to measure the extent of diversification and connection strategies across different asset classes throughout time.
Like the simple correlations, spillovers have also been increasing during the pandemic, that is that they have shifted from equity to crypto prices, and the reverse. For example, volatility in Bitcoin prices is now responsible for 17 percent of the volatility of the S&P500 (chart four). But volatility in S&P500 prices is also a reason for 15 percent of the volatility observed in Bitcoin prices. This indicates a growing bi-directional connection, resulting in the spillovers are getting bigger.
The connection with Bitcoin and Tether was heightened since the beginning this pandemic. The volatility in Bitcoin prices accounts for over 25% of Tether’s price volatility. The reverse is also true. Tether’s volatility is only limited to a minimal influence on the volatility of Bitcoin (12 percent). It also can only account for six-percent of the volatility in the S&P500.
Return spillovers also increased throughout the pandemic. The patterns are broadly similar to spillovers of volatility, but are less. The most striking finding is that the daily returns of Bitcoin and Tether when combined account for about six percent of the variance in daily S&P500 returns. They also explain 15% of the variance within Russell 2000 returns. This is remarkable given the fact that their contribution was nearly not present prior to the pandemic and shows just how significantly crypto currencies impact the market for equity.
The increasing connection between cryptos and equity trading extends well to the US. Bitcoin is responsible for 14 percent of the volatility of the MSCI EM index during 2020-21 and 8-percent of its returns change. This is an increase of from 12pp, and 7.5pp from pre-pandemiclevels, respectively. Together with Tether, the two cryptocurrency assets account for almost 20% of the daily price movement of the MSCI EM index (chart six). The S&P500 accounts for 30 percent from the average daily MSCI EM fluctuation in price.
For the last part this, the authors analyze these spillovers during periods of market stress. The spillovers tend to be higher when market volatility is high. For example the March 2020 market crash led to the most significant and prolonged rise in bi-directional volatility spillovers between equity and crypto markets.
The effects of the pandemic on the macroeconomic landscape have been huge. They have reshaped the patterns of the last decade in labor markets, goods and services, consumption patterns along with inflation and other aspects.
The study shows that the pandemic is also believed to have helped accelerate the transition of decentralized markets with centralized ones. As such, the regulators, investors and policymakers cannot afford to ignore the importance of crypto within the macroeconomic environment of the world. Crypto-related events are also happening in the equity markets and vice versa. The rate at which this has changed is awe-inspiring.