The correlation of crypto & traditional financial markets

As demand for exposure to cryptocurrencies rises, it’s important to understand their behaviour in relation to traditional investments such as shares and bonds.

The finance industry uses a statistic called correlation to measure the relationship between two asset classes. It’s a key concept in investing because it’s the basis for portfolio diversification, a risk management strategy which involves holding assets that respond differently to market conditions.

This article explores how correlation works, the potential benefits of diversification, and how bitcoin fits into a portfolio.   

A Brief History of Cryptocurrencies

Before exploring correlation, let’s briefly review the history of the two leading cryptos and their status as asset classes.   

Bitcoin was the original crypto, first discussed in a whitepaper published by pseudonymous founder Satoshi Nakamoto in October 2008. Satoshi processed the first batch of transactions- known as mining- at the start of January 2009, famously including a headline from that day’s UK Times newspaper, which strongly alluded to bitcoin’s mission:

 “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”

Ethereum was also announced in a whitepaper, this one published by Vitalik Buterin in November 2013. Buterin introduced greater functionality to blockchain technology by pioneering the use of smart contracts, programs which automatically execute when the terms of an agreement are met. The protocol carried out an initial coin offering (ICO) in 2014, raising $18 million in ether, its native token, before going live at the end of July 2015.  

While Satoshi designed bitcoin to serve as a medium of exchange that disintermediates third parties like banks, it has experienced widespread adoption as an investment asset. Its market capitalisation has grown to $717,496 billion (as of November 9th 2023), making it the biggest cryptocurrency by some distance. To put this into perspective, bitcoin dominance, a metric measuring bitcoin as a percentage of the total market cap of all cryptos, stands at 53,32% (as of November 9th 2023).

Bitcoin also ranks thirteenth out of the top 100 assets ranked by market cap, ahead of major players in the financial industry such as Visa, JP Morgan and Mastercard. Incidentally, gold tops the list at $12,886 trillion (as of November 9th 2023), demonstrating bitcoin’s potential value given its growing reputation as ‘digital gold’ . 

Meanwhile, ether is the second biggest crypto with a market cap of $230,565 billion (as of November 9th 2023). It ranks sixty-third among the top 100 assets, ahead of Wells Fargo, HSBC and Morgan Stanley. 

Understanding Correlation 

When applied in finance, correlation measures the degree to which two assets move compared to each other. It’s expressed as a coefficient, a numerical value showing whether the assets move in the same (positive correlation) or opposite directions (negative correlation). The method for calculating the coefficient is outside the scope of this article, but the score ranges between 100%, indicating perfect positive correlation, and minus 100%, indicating perfect negative correlation. The closer the score to perfect correlation, the stronger the effect. A score of zero means there’s no relationship between the two assets.

Negative correlation allows investors to construct diversified portfolios that are more resilient to market fluctuations.

Various forces could affect the correlation between crypto and traditional asset classes: 

• Macroeconomic factors shape investor’s decisions. When inflation rises, they typically move capital into assets known to preserve value. And when interest rates fall, they favour riskier assets. In both scenarios, shares and crypto benefit.

• Investors also make decisions based on emotions like fear and greed. During periods of economic expansion, they usually turn to riskier assets. But during spells of market turbulence caused by economic or geopolitical instability, they tend to shift capital into government bonds which are considered less risky, especially those issued by developed countries.

• The adoption of crypto by institutional investors amplifies the influence of the forces mentioned above due to the sheer volume of capital they control. This influence should increase considerably if the US Securities and Exchange Commission (SEC) approves applications from several major financial institutions for spot bitcoin exchange-traded funds (ETFs).

• Regulatory clarity should help reduce crypto volatility to levels more commonly associated with the stock market, and it should also encourage institutional adoption.

   

  Correlation patterns

  Given the rapid increase in bitcoin’s market capitalisation since it launched, its growth trajectory has resembled a disruptive tech stock. One of the similarities includes an immense upside should bitcoin fulfil its potential. To reinforce this relationship, as interest rates rose in 2022, rate-sensitive assets including tech stocks and bitcoin fell.
  

  Source: CoinShares

   

  However, these two assets are sensitive to rates for different reasons: tech stocks due to squeezed margins and bitcoin due to its fixed supply. This explains why the correlation has shown signs of declining as rate hikes slow.

  As bitcoin matures, it’s becoming more like a store of value . To support this thesis, it’s increasingly correlated with gold and less correlated with the US dollar (gold is priced in dollars, so its price is inversely related to the dollar). Bitcoin’s increasing financialisaton (recognition as an asset class) further strengthens its classification as a store of value, as demonstrated by the $37 billion of capital held in bitcoin investment products and its growing acceptance as collateral.

  To learn more, read CoinShares’ recently updated report A Little Bitcoin Goes A Long Way..

   

  Benefits of Diversification

  While bitcoin has exhibited a certain degree of correlation with tech stocks, albeit temporary, its correlation is typically highly varied relative to to most traditional asset classes. For example, the S&P 500 tracks the performance of the 500 biggest companies in the US and is frequently used as a proxy for the US stock market. As shown by the chart below, bitcoin has a positive correlation with the index in price shock events, but it’s relatively low at 34%.

  
  Source: CoinShares

   

  To demonstrate the impact of a small bitcoin holding, CoinShares monitors the performance of several model portfolios:

  • Standard allocation (60% shares and 40% bonds)

  • Standard allocation with 4% gold

  • Standard allocation with 4% bitcoin

  • Standard allocation with 4% bitcoin not rebalanced

  The first three portfolios are rebalanced (returned to their original asset allocation) each quarter.
  

  Source: CoinShares

   

  While the portfolio with bitcoin that isn’t rebalanced generates the highest return and exhibits the least correlation with the standard portfolio, it also experiences the greatest drawdown (decline in value from peak to trough) and volatility. In contrast, the other bitcoin portfolio nearly doubles the standard portfolio’s returns and still improves diversification.

  Bear in mind, this isn’t investment advice. Each investor should allocate assets according to their goals and risk appetite.  

   

  Conclusion

  Correlation, a statistic used to measure the degree to which two assets move in the same direction, is the basis for diversification, a key risk management strategy.

  While bitcoin has shown signs of positive correlation with tech stocks since launching in 2009, it seems to be fading as interest rates peak. As bitcoin matures, it’s displaying a greater correlation with gold as it shares many of the same characteristics as a store of value.

  Research by CoinShares shows a standard allocation with a 4% bitcoin holding (rebalanced) delivers better returns than one with a similar allocation to gold or with a bitcoin holding which isn’t rebalanced.