Digital tokens becoming mainstream and their volatile nature could quickly spread shock among global financial markets.
The correlation between cryptocurrency assets and traditional assets such as stocks increased significantly and raised the risk of contagion across financial markets, says International Monetary Fund.
Cryptocurrency assets are no longer on the fringe of the financial system. Given their high volatility, their increased co-movement with stocks could soon pose risks to financial stability, especially in countries with widespread cryptocurrency adoption, the Washington-based fund said in a blog post on Tuesday.
Before the Covid-19 pandemic, cryptocurrency assets such as Bitcoin and Ether showed little correlation with major stock indexes, said Tobias Adrian, one of the blog’s writers and financial counsellor and director of the IMF’s monetary and capital markets department.
“They were thought to help diversify risk and act as a hedge against swings in other asset classes,” he said.
“But this changed after the extraordinary central bank crisis responses of early 2020. Cryptocurrency prices and US stocks both surged amid easy global financial conditions and greater investor risk appetite.”
The price of Bitcoin hit record highs in 2021 and coincided with Wall Street’s growing appetite for cryptocurrency.
It started last year trading at slightly under $30,000 and more than doubled by April with the stock market debut of cryptocurrency exchange Coinbase. October’s peak above $66,000 came after the launch of a Bitcoin futures exchange-traded fund on the New York Stock Exchange.
Tesla boss Elon Musk helped the market to rise – and fall – with controversial tweets about cryptocurrencies. The move by El Salvador in September to make Bitcoin legal tender also made an impression.
However, China’s regulatory action against the trading and mining of cryptocurrencies piled pressure on the digital tokens. Climate change activists also shone a spotlight on the huge amount of electricity used to power computers required to mine new Bitcoin tokens.
“Our analysis shows that spillovers between cryptocurrency and equity markets tend to increase in episodes of financial market volatility – such as in the March 2020 market turmoil – or during sharp swings in Bitcoin prices, as observed in early 2021,” said Tara Iyer, co-writer of the IMF blog and an economist in the fund’s global financial stability analysis division.
The correlation between cryptocurrency and equity markets “permits the transmission of shocks that can destabilise financial markets”, she said.
The interconnectedness also raises the possibility of transfer of investor sentiment between those two asset classes. Spillovers from Bitcoin returns and volatility in stock markets, and vice versa, have risen significantly from 2020 to 2021 compared with the period between 2017 and 2019, according to the IMF research.
“Bitcoin volatility explains about one sixth of S&P 500 volatility during the pandemic and about one tenth of the variation in S&P 500 returns. As such, a sharp decline in Bitcoin prices can increase investor risk aversion and lead to a fall in investment in stock markets,” the fund said.
The stronger association between cryptocurrency and equities is also apparent in emerging market economies, Mr Adrian said. For example, correlation between returns on the MSCI emerging markets index and Bitcoin was 0.34 in the period from 2020 to 2021, a 17-fold increase from the preceding years, he said.
“Stronger correlations suggest that Bitcoin has been acting as a risky asset,” Ms Iyer said.
“Its correlation with stocks has turned higher than that between stocks and other assets such as gold, investment-grade bonds and major currencies, pointing to limited risk diversification benefits in contrast to what was initially perceived.”
Stablecoins are displaying similar correlation with stocks. Spillovers from the dominant stablecoin, Tether, to global equity markets also increased during the pandemic, although they remain considerably smaller than those of Bitcoin, explaining about 4 per cent to 7 per cent of the variation in US equity returns and volatility, according to the IMF blog.
It is time to adopt a comprehensive, co-ordinated global regulatory framework to guide national regulation and mitigate the financial stability risks stemming from the cryptocurrency ecosystem, said Mahvash Qureshi, a co-author of the blog and division chief in the IMF’s monetary and capital markets department.
“Such a framework should encompass regulations tailored to the main uses of cryptocurrency assets and establish clear requirements on regulated financial institutions concerning their exposure to and engagement with these assets,” Mr Qureshi said.
“Furthermore, to monitor and understand the rapid developments in the crypto ecosystem and the risks they create, data gaps created by the anonymity of such assets and limited global standards must be swiftly filled.”
(Except for the headline, this story has not been edited by The Finance World staff and is published from a syndicated feed.)
