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PORTFOLIO PERSPECTIVES | – 3 Min

Crypto’s contagious effect on equities

By CHI LO 09.11.2022

In this article:

    The increasing correlation between cryptocurrency trading and equity markets – especially in Asia – could be contagious. Large crypto losses for individual or institutional investors who hold both crypto and traditional financial assets and liabilities could drive them to rebalance their portfolios, causing financial market volatility or even defaults on traditional liabilities.

    Before the pandemic, the cryptocurrency world seemed isolated from financial markets. Bitcoin and other crypto instruments [1] showed little correlation with equity market performance. Cryptocurrencies were even regarded as helpful in diversifying risk and as a hedge against swings in other asset classes.

    However, since the Covid-19 crisis, the correlation between crypto and equity market movements has risen sharply, meaning that the financial sector may not be insulated from future crypto boom-bust cycles. Arguably, it also adds to the incentive for central banks to develop central bank digital currencies (CBDCs) as a means to regulate the crypto market and manage its risks.

    The rising correlation

    Research [2] shows that between 2017 and 2019, the correlation coefficient of Bitcoin’s daily market movement and that of the S&P 500 equity index was just 0.01. However, that jumped to 0.36 between 2020 and 2021. A similarly sharp increase was seen in the correlation between returns on the MSCI Emerging Markets index and Bitcoin rising to 0.34 in 2020–21 from only 0.02 in the preceding years.

    Crypto trading has soared since the pandemic, as millions of locked-down people jumped on the digital trading bandwagon. Low interest rates and easy financing conditions further boosted flows into the crypto market. Governments’ pandemic relief cash handouts also contributed.

    Crypto contagion

    However, the crypto market is volatile. The world’s crypto market capitalisation surged 20-fold to USD 3 trillion from June 2020 to December 2021, according to the International Monetary Fund. It then abruptly shrank to less than one trillion dollars in June 2022 when central banks began to tighten monetary policy to fight inflation.

    Greater crypto/equity market correlation raises the possibility of spill-overs from one market to the other. Contagion could spread when individual or institutional investors who hold both crypto and traditional financial assets and liabilities suffer large losses in volatile crypto markets. Were these investors to rebalance their portfolios, it could cause greater financial market volatility or even lead to defaults on traditional liabilities.

    Asia’s major crypto markets include India, Vietnam and Thailand, all of which have witnessed a sharp rise in crypto/equity correlation (see Exhibit 1). This growing interconnectedness between crypto and stock markets facilitates the transmission of shocks that could destabilise the financial system.

    Sensitive to this rising risk and seeking to manage it, some Asian central banks are imposing regulations on the crypto market and creating their own digital currencies.

    China went to the extreme of banning all Bitcoin trading, mining and transactions in 2021 and creating the world’s first CBDC, the ‘Digital Currency Electronic Payment’ (DCEP) with centralised control, in 2014. [3]

    Central banks digital currencies

    According to the Atlantic Council, [4] the number of countries exploring the CBDC idea has risen from 35 in 2020 to more than 105, representing over 95% of global GDP. The main motives are to improve financial access and inclusion and facilitate payment and settlement. [5]

    So far, most CBDC development is concentrated in the emerging markets, half of it in Asia. China is leading the efforts, with 23 cities now participating in the DCEP experiment.

    Crucially, the People’s Bank of China (PBoC) launched the Multiple CBDC Bridge (or mBridge) project in Hong Kong in 2021 with the Bank for International Settlements, the Hong Kong Monetary Authority, the Central Bank of Thailand (BOT) and the Central Bank of the United Arab Emirates.

    This project explores the potential of digital currencies and distributed ledger technology (DLT) for delivering real-time, cheaper and safer cross-border payments and settlements. It could challenge the USD-based SWIFT [6] system.

    Disrupting the crypto disruption

    Some countries are more cautious. The Monetary Authority of Singapore, for example, has been exploring CBDC applications for more than five years and sees no pressing need for a retail CBDC. Others, notably in Europe and the US, have concerns about CBDC, especially with regard to data security and privacy.

    While the advent of cryptocurrencies looks set to disrupt the global financial system, the evolution of CBDC will likely act as a regulatory constraint on their development. Arguably, China’s anti-crypto policy is disrupting the crypto disruption process.

    References

    [1] We have our doubts about cryptocurrencies such as Bitcoin as an asset, though they are investible. See What is the problem with cryptocurrency (bitcoin)?”  

    [2] Iyer, Tara (2022), “Cryptic Connections: Spillovers between Crypto and Equity Markets”, Global Financial Stability Notes, Monetary and Capital markets, IMF, January. Retrieved from https://www.imf.org/en/Publications/global-financial-stability-notes/Issues/2022/01/10/Cryptic-Connections-511776  

    [3]Chi Time: Crypto-Renminbi to Challenge the US Dollar”, May 2020, “Chi on China: The Crypto-Renminbi’s Disruption to the Market, Economic Growth and Policy”, August 2020, and “Chi on China: The Inherent Risks of Cryptocurrencies – When Bitcoin Meets CBDC”, May 2021.  

    [4] “Central Bank Digital Currency Tracker”, Atlantic Council. Retrieved from https://www.atlanticcouncil.org/cbdctracker/  

    [5]Chi on China: The Crypto-Renminbi’s Disruption to the Market, Economic Growth and Policy”, August 2020  

    [6] Society for Worldwide Interbank Financial Telecommunication 

    Disclaimer

    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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