When the stock market sells off sharply — as it did on Monday during the Evergrande meltdown — bitcoin and other cryptoassets often sell off too.
This always surprises people. Skeptics come out of the woodwork and shake their heads, noting sarcastically: “I thought cryptoassets were supposed to be uncorrelated.”
I find this baffling.
If there is one thing everyone agrees on about crypto, it’s that it’s a risky investment. Why, then, are we surprised when crypto sells off during risk-off moments?
I know that crypto gets billed as an uncorrelated asset, and it is: Over any meaningful period of time, the correlation between crypto and the stock market is about 0.2, which is very low. But a general lack of correlation doesn’t guarantee crypto will zig when the market zags over the short term. It means it will offer uncorrelated returns over months and years, which it has, historically.
The people who expect crypto to precisely offset the market fail to understand what actually drives crypto performance. In reality, there are three main drivers of crypto returns. If you want to understand why different crypto assets move the way they do, you have to understand how these three main drivers interact.
Driver 1: Risk-On/Risk-Off Appetite
The first major driver of crypto returns is risk appetite. As mentioned, cryptoassets like bitcoin are risky investments. When investors get nervous, they sell risky assets. When they get bullish, they buy.
That’s true of all risky assets, and that’s what we saw on Monday, when crypto traded down in line with stocks. You see the same effect on other risky areas of the market, including in the “disruptive technology” ETFs offered by Cathie Wood and ARK Invest.
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Crypto responds to risk-on/risk-off dynamics.
Driver 2: Industry-Wide Factors
The second major driver of crypto returns is industry-wide factors. That means news and developments that impact the entire crypto industry, or certain sectors of the industry.
Regulation is a good example. Regulators in Washington and elsewhere today are debating issues like how to regulate stablecoins, crypto exchanges, and the DeFi space. Good news on the regulatory front would lift the price of the crypto market as a whole, while concerns about overreach could drive the market lower. You’re seeing that today as the market reacts to China’s ban on crypto trading.
Another example is education. I’ve been on the road for the past two weeks speaking to literally thousands of institutional investors and financial advisors about crypto at multiple conferences. This kind of education — multiplied by all the other people doing the same thing — has an industry-wide benefit and is a long-term driver of returns. Knowledge breeds confidence.
Driver #3: Asset-Specific Drivers
The third driver of returns is factors that impact individual cryptoassets and their use cases.
For example, the price of ether is up significantly this year due in part to booming interest in NFTs, or non-fungible tokens, which are tied to the Ethereum network. Bitcoin’s price is up less in part because it’s not exposed to the NFT boom.
By comparison, bitcoin’s price is more responsive to central bank activity and concerns about inflation than ether’s, since bitcoin’s primary use case is as digital gold.
Different cryptoassets and their related blockchains provide different services and are targeted at different markets. As they succeed or fail … and as those markets grow or ebb … the returns of the specific asset feel the impact.
What This Means for Investors
Understanding the interplay between these three factors is key to understanding how cryptoassets perform.In the early days of crypto, investor risk appetite was the only factor that mattered. Crypto was extremely speculative at the time and use cases were abstract. As a result, risk-off sell-offs (and risk-on bull runs) were extreme. Cryptoassets regularly moved 10% or more on individual days.
Today, industry and asset-specific drivers have come to predominate. There are days — like Monday — when risk factors can overwhelm the market, but on most days, crypto is driven by factors like regulation and institutional adoption. This is why crypto exhibits low correlations with stocks and other markets when measured over time, even if correlations can spike to 1 during risk-off moments.
Long term, as the markets mature, I expect asset-specific drivers to become the dominant or at least a larger driver of returns. You can already see this in markets, where assets like Solana are showing spectacular returns (up more than 9,000% year-to-date) as they are increasingly perceived by investors as an alternative to the overcrowded Ethereum blockchain. I expect the correlations between different cryptoassets to decrease as their distinct characteristics and use cases become more evident. There is no particular reason why bitcoin (which acts as digital gold) should be highly correlated with ethereum (which is the platform for DeFi, NFTs, and other applications) over the long term. It is today, because they are both buffeted by significant industry-wide forces and risk-appetite dynamics. But in a mature, steady state, they should have fairly distinct return patterns.
Meanwhile, don’t let short-term returns fool you: Cryptoassets trading down on risk-off days are just a reminder that it’s still early in crypto, and that crypto is a risky asset. This risk factor can overwhelm the industry and asset-specific drivers in the short term. But over the long term, crypto has demonstrated a low correlation with other assets, and that lack of correlation seems likely to persist over time.