Increasing Correlation Between Crypto and Stocks Raises New Risks

There is an increasing interconnection  between virtual assets and financial markets.

 Introduction:

The virtual asset market has become more interconnected with traditional financial markets, posing potential risks. The market value of cryptocurrencies has soared, reaching nearly $3 trillion in November 2023 from $620 billion in 2017. This popularity among retail and institutional investors has led to increased correlation between crypto assets and stocks, limiting the perceived diversification benefits and potentially creating contagion across financial markets, as per research by the International Monetary Fund (IMF).

Changing Dynamics:
Previously, cryptocurrencies like Bitcoin and Ether were considered to have little correlation with major stock indices, providing risk diversification and acting as a hedge against other asset classes. However, the correlation changed after the central bank crisis responses in early 2020. Bitcoin and US stocks surged together due to favorable global financial conditions and increased investor risk appetite.

Increased Correlation:
The correlation coefficient between Bitcoin and the S&P 500 was just 0.01 in 2017-2019. However, it rose to 0.36 in 2020-2021, indicating a stronger association between crypto assets and equities. This increased correlation is also evident in emerging market economies, which have been at the forefront of crypto adoption. For example, the correlation between returns on the MSCI emerging markets index and Bitcoin increased 17-fold in 2020-2021 compared to previous years.

Risky Asset Behavior:
The stronger correlations suggest that Bitcoin now behaves more like a risky asset. The correlation between crypto assets and stocks has exceeded the correlation observed between stocks and other assets like gold, investment grade bonds, and major currencies. This implies limited risk diversification benefits compared to initial perceptions.

Spillover Effects:
The heightened correlation between cryptocurrency and stock markets raises the potential for the transmission of investor sentiment between these two asset classes.. Analysis indicates significant spillovers of prices and volatility between Bitcoin and global equity markets in 2020-2021 compared to 2017-2019. During the pandemic, the volatility of Bitcoin accounted for approximately one-sixth of the volatility observed in the S&P 500. Additionally, it explained around one-tenth of the variation in S&P 500 returns. Spillovers in the reverse direction, from the S&P 500 to Bitcoin, are of similar magnitude.

Stablecoin Influence:
Stablecoins, a type of crypto asset designed to maintain value relative to specified assets, also exhibit similar behavior. During the pandemic, there was an increase in spillovers from the leading stablecoin, Tether, to global equity markets. However, these spillovers are still smaller in comparison to those of Bitcoin.

Systemic Concerns:
The increased correlation and spillovers between crypto and equity markets indicate a growing interconnectedness that can destabilize financial markets. The relative volatility and valuations of cryptocurrencies pose risks to financial stability, particularly in countries with widespread crypto adoption. The IMF emphasizes the need for a comprehensive, coordinated global regulatory framework to guide national regulation and supervision and mitigate the financial stability risks arising from the crypto ecosystem.

Conclusion:
As the correlation between crypto assets and stocks strengthens, it is essential to recognize the interconnectedness between these two asset classes and the potential risks they pose. Regulatory frameworks should be established to address the main uses of crypto assets and define requirements for regulated financial institutions. Additionally, filling data gaps caused by the anonymity of crypto assets and limited global standards is crucial for monitoring and understanding the risks associated with the rapidly evolving crypto ecosystem