Cryptography loses its hedging role

The big question on everyone’s lips in the cryptocurrency markets right now is: Where will this brutal sell-off end?

Moreover, many people wonder what happened to the supposed zero relationship between cryptocurrencies and traditional assets — the idea that bitcoin and other currencies provide a hedge against dips in stocks like stocks and bonds. They point out that we have recently seen the crypto and stock markets collapse in the face of the same macroeconomic headwinds. Are these markets interconnected in the end?

The shift to quality occurs in times of economic uncertainty, as investors rebalance their portfolios away from volatile (high-risk, high-return) assets such as stocks in favor of low-risk and low-risk assets, such as bonds or cash.

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Even before the recent turmoil, the correlation between bitcoin, the major cryptocurrency, was not zero, but rather low to medium.

Research shows that this relationship has now moved into a very positive correlation, from 0.5 to 0.8 in mathematical terms. In fact, today, when stock prices go down, Bitcoin goes down as well.

What caused this sudden change and what does it mean for investors? I think Bitcoin as an uncorrelated asset class is clearly a victim of its own success. Over the past 12-18 months, we have seen an increase in institutional capital being invested in digital assets.

A 2021 study from the digital assets arm of Fidelity indicated that 70% of surveyed institutional investors plan to buy or invest in digital assets in the future, and more than 90% of those interested in digital assets expect allocation in their institutions or client portfolios. within the next five years.

An investment opportunity originally led by innovative retail investors has become mainstream, and thus faces the same market volatility as other high-risk investments. This means that these institutional buyers are buying and selling cryptocurrencies because they are another high-risk investment.

As long as institutions continue to participate, there is a great chance that this relationship will remain – crypto will remain associated with risky assets. Not likely to be a hedge against stocks in times of economic uncertainty.

It is worth noting that there are thousands of different crypto tokens and they are not all the same. The majority of structured investment products — and the indices used by institutional investors — will be based on “premium” assets such as bitcoin and ether, the two largest cryptocurrency markets by capitalization.

In times of extreme volatility, it is wise to turn to more stable assets. Within the cryptocurrency ecosystem, an investor could – in principle – exchange a volatile token for a stablecoin, for example, allowing the owner to tie their capital to a real-world asset such as fiat currency, including US dollars, British pounds, and euros, or a precious metal. like gold.

But, if the intent is the journey to safety, why do you continue to use cryptocurrencies instead of turning your capital into cash, which is secured in a bank?

A good reason is that you are making your crypto holdings work for you in terms of earning a return by lending the stablecoin through a platform. These platforms can be centralized (managed by a core team) or decentralized – built and maintained by a community of core contributors – and can offer a higher return on the loan – around 10% per year for stablecoin – than a traditional bank.

While this is fine in theory, in practice a major problem has emerged in the recent market turmoil with the collapse of a stablecoin called UST – a stablecoin pegged to the US dollar, a token based on the original algorithm of the terra blockchain.

In addition, Celsius, a crypto-lending platform with over $20 billion in assets, has frozen stablecoin withdrawals from clients due to liquidity difficulties.

As with any investment in any other asset, it is essential to conduct your own due diligence to understand the risks involved.

Unfortunately, at this point, most of the industry is unregulated, and the protections we take for granted when purchasing financial services are generally not afforded in the crypto world.

This is changing, as governments and financial service regulators realize the adoption and importance of the promise that technology brings to society at large. In the UK, the Financial Conduct Authority is developing new guidelines and safeguards to protect consumers.

But in the meantime, investors are largely alone in the face of sharp price drops and pressures that are now threatening the financial stability of some individual crypto companies.

They also run the risk of market turmoil revealing more about the criminals operating in the cryptocurrency markets, as often happens in tough times in the financial world, when liquidity suddenly vanishes.

Investing in cryptocurrency can be done safely as long as you are reasonable and follow guidelines like those posted on Take Five – Avoid Fraud, backed by UK Finance, the industry body.

Investors should invest with caution. This new ecosystem is growing in real time with many new products and services distributed online for everyone to use at any time without restrictions.

Honestly, it is impossible to say at this point whether the cryptocurrency world will go to zero and a financial catastrophe will occur. It is also impossible to determine whether prices will bounce back from their current lows, as happened after the previous crypto sell-off.

As with any high-risk asset, investors should not invest more than they can afford to lose. And if they are cautious, they should keep cryptocurrencies as a small part of a diversified investment portfolio.

Regulators and policy makers rightly focus on protecting consumers from harm and ensuring financial stability.

But such shocks can lead to a reactionary policy that can have unintended consequences. As the UK government has said, fintech has a great future in Britain. Cryptocurrencies are an essential part of financial technology. Therefore, it is very important to recognize the advantages and risks of cryptocurrencies and adopt a proportionate and balanced approach to regulating the sector.

Ian Taylor is the CEO of the CryptoUK Trade Association

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