Bitcoin ‘flash crash’ shatters the crypto illusion

Stephen Bartholomeusz: Bitcoin ‘flash crash’ shatters the crypto illusion

7/12/2021 4:22:00 AM

Stephen Bartholomeusz: Bitcoin ‘flash crash’ shatters the crypto illusion

Last weekend’s crypto meltdown has shown that the new asset class has an exaggerated correlation with other risky assets. That’s not what was supposed to happen.

AdvertisementThe “flash crash” in crypto assets last weekend challenged one of the convictions investors hold about the behaviour of assets supposedly uncorrelated with conventional asset classes. It seems they are highly correlated, and in an extreme fashion, with the riskiest of assets.

It was only a month ago when the price of Bitcoin was almost touching $US70,000. After dropping nearly 20 per cent in an hour at the weekend it is now (after a modest recovery on Monday) about $US48,490. That’s a fall of more than 28 per cent.The market capitalisation of all the crypto assets was around $US3 trillion a month ago. It’s now about $US2.3 trillion, having shrunk to $US2.1 trillion at the weekend.

The “mainstreaming” of crypto is a double-edged sword.Credit:APAssets that were supposed to be a hedge against inflation and behave differently to shares were caught up in the sell-off of risky assets that occurred last Friday after US employment data fuelled expectations that the Federal Reserve Board would accelerate the pace of its withdrawal of liquidity from the US system, and perhaps bring forward the date of its first interest rate in this cycle. headtopics.com

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The US market has lost about two per cent of its value over the past month – it was down closer to four per cent at one point last week – before Monday’s bounceback.The Nasdaq index, laden with technology stocks, is down more than five per cent over the past month and had fallen as much as six per cent at one point last week. Tech stocks like Facebook’s new parent, Meta Platforms, were down as much as 8 per cent.

LoadingMonetary policy and the emergence and spread of the Omicron variant of the coronavirus have been the major influences on markets over recent weeks and have driven a big increase in volatility and risk-aversion.Omicron, which threatens to prolong the supply chain chaos that has plagued economies this year and underwritten persistent and historically high levels of inflation, has shattered increasingly complacent investor attitudes towards the pandemic.

AdvertisementMeanwhile, the Fed’s abrupt dumping of its conviction that high inflation rates were “transitory” has further contributed to the sudden unease.The VIX index – which measures volatility and is sometimes described as the “fear index” -- had been broadly flatlining below 20 per cent through November but suddenly spiked above 30 per cent last week.

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No-one would sensibly accept Bitcoin in exchange for real goods or services when the price can move 20 per cent in an hour.The plunges in the value of crypto assets reflected that wider volatility and risk-aversion but magnified it, in spades.There are a number of possible strands to the explanation for why the movement in cryptos was so much more violent than in conventional assets, even those – like technology companies, whose high priced-earnings multiples make them more sensitive to shifts in risk appetites. headtopics.com

One is that the market, even when it was at $US3 trillion, remains relatively small and illiquid. The US equities market is valued at more than $US50 trillion and has deep liquidity.A function of the shallow levels of liquidity in crypto markets is that the price movements, in both directions, will be magnified by any increase in trading activity. While the increased involvement of institutional investors and hedge funds in crypto markets this year is a longer-term positive for their credibility and depth, it brings derivative and leveraged exposures into small, immature and not particularly transparent markets.

There does appear to have been significant levels of derivative and leveraged trading in cryptos last week – a lot of positions in Bitcoin futures were abruptly closed out as the price went into freefall.Under these circumstances, as the sell-off of riskier assets accelerated, it isn’t surprising that the market for crypto assets was hit much harder than that for conventional investments. The “mainstreaming” of crypto is a double-edged sword.

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Crypto investors are, of course, used to wild rides and appear to regard every crash in their value as an opportunity. Bitcoin, it should be said, is still up nearly 60 per cent from the start of this year.The experience of the past week, however, does underscore the uselessness of cryptocurrencies as alternatives to fiat currencies as media of exchange.

No-one would sensibly accept Bitcoin in exchange for real goods or services when the price can move 20 per cent in an hour. It is a medium for speculation, not exchange.LoadingNor does it work as a diversifier when it is needed to be one.While in calmer conditions, there appears little correlation between crypto assets and the other major asset classes, whenever there is turbulence and prices fall in the sharemarket they move in sync – but the movement is almost three times as great as that experienced in the sharemarket. headtopics.com

The overall market is still working its way through the implications of the outbreak of Omicron and the sudden shift in the Fed’s stance. US inflation numbers are due out this Friday and will provide some new data for the Fed and investors to absorb.Until a more settled view on the outlooks for the pandemic, economies and monetary policy settings emerges, investors are likely to remain risk-conscious and the markets volatile.

For crypto investors, that might mean experiencing more wild rides like the one that occurred late last week and built so explosively into the weekend. For traders that would provide opportunities, and for investors it would generate anxiety.

Read more: The Sydney Morning Herald »

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