Crypto is losing its hedging role

The big question now on everyone’s lips in the cryptocurrency markets is: where will this brutal sell-off end?

In addition, many people wonder what happened to the supposed zero correlation between crypto and traditional assets – the idea that bitcoin and other currencies provided a hedge against declines in stocks such as stocks and bonds. They point out that we have recently seen crypto and stock markets crash in the face of the same macroeconomic headwinds. Are these markets ultimately correlated?

A flight to quality occurs during times of economic uncertainty, when investors are shifting their portfolios away from volatile (high-risk, high-return) assets, such as stocks, in favor of low-risk, low-risk assets, such as bonds or cash.

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Even before the latest turbulence, the correlation between bitcoin, the major cryptocurrency, was not zero, but low to medium.

Research shows that this relationship has now shifted to a very positive correlation, from 0.5 to 0.8 in mathematical terms. Indeed, today, when stock prices fall, bitcoin also falls.

What caused this sudden change and what does it mean for investors? I think bitcoin as an uncorrelated asset class is clearly a victim of its own success. Over the past 12-18 months, we have seen a surge in institutional capital invested in digital assets.

A 2021 study by Fidelity’s digital asset arm indicated that 70% of surveyed institutional investors plan to buy or invest in digital assets in the future, and more than 90% of those interested in digital assets expect to have an allocation in their institutions or client portfolios within the next five years.

An investment opportunity originally powered by innovative retail investors has now gone mainstream and therefore experiences the same market swings as other risky investments. This means that these institutional buyers buy and sell cryptos because they are other high-risk investments.

As long as institutions remain involved, there is a good chance that this relationship will continue – crypto will continue to correlate with risky assets. It is unlikely to be a hedge against equities in times of economic uncertainty.

It should be noted that there are thousands of different crypto tokens and not all of them are created equal. Most structured investment products and indices used by institutional investors will be based on “blue chip” assets such as bitcoin and ether, the largest crypto markets by capitalization.

In times of high volatility, it makes sense to move to more stable assets. Within the crypto ecosystem, an investor can basically exchange a volatile token for, say, a stablecoin, which allows the holder to link their capital to a real-world asset such as fiat currency, including US dollars, pounds and euros, or a precious metal such as gold.

But if a flight to safety is the goal, why continue using crypto instead of transferring capital to cash, where it is secured in a bank?

A good reason is that you are making your crypto holdings work for you in terms of earning returns by lending the stablecoin through a platform. These platforms can be centralized (managed by a core team) or decentralized – built and maintained by a community of core contributors – and they can offer a much higher return on a loan – about 10% per year for the stablecoin – than a traditional bank.

While this is fine in theory, in practice a major problem has arisen in the recent market turmoil with the collapse of a stablecoin called UST – the US dollar-pegged stablecoin, a token based on a native algorithm of the terra blockchain.

In addition, Celsius, a crypto lending platform with more than $20 billion in assets, froze stablecoin withdrawals from customers due to liquidity issues.

As with any investment in any other asset, it is essential to conduct your own due diligence to understand the risks involved.

Unfortunately, most of the industry is currently unregulated and the protections we take for granted when buying financial services are generally not provided in the crypto world.

This is changing as governments and financial services regulators recognize the acceptance and importance of the promise technology brings to society at large. In the UK, the Financial Conduct Authority is developing new guidelines and safeguards to protect consumers.

But in the meantime, investors are largely alone in the face of drastic price drops and pressures that now threaten the financial stability of some individual crypto firms.

They also run the risk of market turmoil revealing more about the criminals operating the crypto markets, as often happens in hard times in the financial world, when liquidity suddenly disappears.

Investing in crypto can be done safely as long as you are reasonable and follow guidelines like those on the Take Five – Avoid Scams site, which is backed by the industry association UK Finance.

Investors should invest cautiously. This new ecosystem is growing in real time with many new products and services being distributed over the internet that anyone can use at any time and without restrictions.

It is frankly impossible to say at this point whether the crypto world will go to zero and a financial disaster will follow. It is also impossible to say whether prices will recover from current lows, as they have after previous crypto sell-offs.

As with any high-risk asset, investors should not invest more than they can afford to lose. And if they are careful, they should only hold crypto as a small part of a diversified investment portfolio.

Regulators and policymakers rightly focus on protecting consumers from harm and ensuring financial stability.

But such shocks can lead to reactive policies that can have unintended consequences. As the British government has said, fintech has a great future in Britain. And crypto is a central part of fintech. Therefore, it is extremely important to recognize both the benefits and the risks of crypto and take a proportionate and balanced approach in regulating the industry.

Ian Taylor is Executive Director of CryptoUK, the Trade Association

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