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Bitcoin fails latest diversification test

Dominant cryptocurrency down alongside US equities, while the crypto sector overall faces yet more doubt following ‘stablecoin’ collapse
Bitcoin fails latest diversification test

A calamitous week in cryptocurrency markets has once again cast doubt on the long-term viability of the bold new financial sector. A coin that was ostensibly pegged to the US dollar lost almost all its value and bitcoin slipped to a 12-month low even as investors search high and low for inflation hedges. 

 

But those in the sector point to the growing involvement of traditional financial institutions as one reason behind bitcoin’s price decline, and also a sign of the space’s increased maturity compared to a few years ago. 

The collapse of ‘stablecoin’ TerraUSD, started early last week. Designed to track the dollar, it broke from its $1 (80p) peg, hitting around 12¢ while its linked cryptocurrency, luna, plunged from around $80 in the first week of May to thousandths of a cent.  

Stablecoins are a crucial part of the crypto ecosystem and are used by traders in an effort to maintain the value of their assets without converting their holding back into a fiat currency such as the dollar.  

Despite Terra’s implosion and bitcoin now trading at $30,000, down by more than half since its all-time high in November, those in the sector claim crypto can still become a mainstream investment class. 

“It’s important to remember that it's still a nascent asset class and is considered a risk investment, so it’s not surprising to see a selloff in massive risk liquidations,” said Ryhaneh Sharif-Askary, managing director for investor relations at crypto investment firm Grayscale. 

For some, bitcoin’s current slump is even a sign of asset maturity. Last month, the 90-day correlation between bitcoin and the S&P 500 rose to 0.49, the highest since October 2020, indicating a moderately strong correlation to traditional stocks. 

A Morgan Stanley analyst said this was due to a shift in the crypto traders. “We think the increased involvement of institutions, which are sensitive to availability of capital and therefore interest rates, has contributed in part to the high correlation between bitcoin and equities,” said Sheena Shah last week. 

The way out of this correlation would be for bitcoin to become a widespread medium of payment, which “looks unlikely to happen soon”, Shah added. 

This closer correlation to the traditional market comes with some obvious drawbacks for crypto as an alternative investment space.  For instance, when the US Federal Reserve decided to raise its benchmark interest rate by half a percentage point to a range of 0.75 per cent to 1 per cent a fortnight ago, bitcoin fell 14 per cent in response. “Bitcoin is a global asset…it is therefore subject to the realities of monetary tightening, inflation liquidity provisions and central bank policies,” said James Check, a senior analyst at analytics firm Glassnode.  Check added that bitcoin’s “always open” market meant the cryptocurrency was a leading indicator for global sentiment, given trading can take place when specific stock markets are closed. 

Untethered

Stablecoins are needed for the crypto world to function. Most stablecoins are pegged to a fiat currency and backed at least in part by cash or cash-equivalents, such as market leader Tether (USDT).  

Although algorithmic stablecoins, like the Terra coin, make up a fraction of the stablecoin asset class, its collapse has reverberated around the market and impacted hard-backed stablecoins. 

Tether for instance, who hold more than $34.5bn in Treasury bills and over $4.2bn in cash and bank deposits, recently de-pegged to $0.9935, the largest deviation in over two years as spooked investors jumped ship. 

The mix of an unstable stablecoin and potentially vulnerable retail investors has attracted the attention of regulators. Last week, the European Commission was reported to be considering hard restrictions on stablecoins, deeming them an unfit alternative to fiat currencies such as the euro. This news comes as lawmakers in Europe are finalising a landmark law known as the Markets in Crypto Assets Regulation (MiCA) to develop a legal framework for crypto assets.  

Across the Atlantic, US regulators have long been in discussion on how to regulate stablecoins, with members of the Senate Banking Committee introducing a bill in April to help the government specify how different agencies should deal with companies issuing stablecoins backed by the dollar or other assets. 

In the aftermath of Terra’s collapse, Treasury Secretary Janet Yellen told lawmakers at the House of Financial Services Committee that “[stablecoins] present the same kind of risks” that are inherent with bank runs. 

Yet some say crypto selloff is just another step on the road to greater integration with the broader financial system. “Total outflows as a percentage under management were 5 per cent of assets under management in 2018, this time round it is 1 per cent,” said James Butterfill, the head of research at digital asset manager CoinShares. The massive expansion of the crypto space means that this kind of outflow is much bigger in size than the 2018 selloff, but indicates that investors are not dumping and running as much as has happened in the past.  

Butterfill said buying was already happening again. “In the last two weeks we have seen inflows as investors take advantage of the recent price weakness,” he said.

Bitcoin the new gold? Read our piece on the precious metal here.