What Would Happen to Crypto In a Global Market Meltdown?

A common thought experiment in the crypto community is to ponder how cryptocurrencies would fare in the event of another global financial meltdown.

It is not an idle question. There is a host of troubling developments in the global economy: the threat of a trade war, jitters in Italian debt markets, problems at Deutsche Bank and new emerging market crises in Turkey and Argentina.

Meanwhile, central banks, led by the U.S. Federal Reserve, are tightening or signaling tighter monetary policy. That’s putting a brake on the huge gains that low interest rates and quantitative easing had bestowed on global markets in the eight years since the end of the last crisis.

With this combination of risk factors already in play, there’s always a chance that some unforeseen trigger could set off another terrified rush for the exits among global investors.

What would the impact be on bitcoin and other cryptocurrencies? Would their reputation as independent assets see them benefit from safe-haven inflows? Or would the market-wide reduction in risk appetite spread wide enough that crypto assets get caught up in the selloff?

Opposing scenarios

Some crypto hodlers salivate at the idea of market panic.

They contend that, unlike the 2008-2009 collapse, when Satoshi Nakamoto’s newly launched cryptocurrency was essentially out of sight and unavailable to the hordes seeking a haven from the fiat world’s chaos, bitcoin is now widely recognized as a more versatile alternative to traditional flight-to-safety assets such as gold.

In a crisis, they say, bitcoin could shine – as might other cryptocurrencies designed as alternatives to fiat cash such as monero and zcash. Unaffected by future monetary policy responses, immune from draconian interventions such as the Cypriot bank deposit freeze of 2013, and easily acquired, they could prove their value as digital havens for the digital age in such a moment. Accordingly, the bulls’ argument goes, their prices would surge.

On the other hand, if there’s enough of a market-wide departure from risky investments, it’s hard not to see this sector being swept up in it.

Just as the most extreme gains in crypto prices in the latter part of 2017 were inextricably linked to the rapid “risk on” uptrend seen in stocks, commodities and emerging-market assets, so too a major selloff could easily infect these new markets.

Cryptocurrencies and tokens are perceived by most ordinary investors as high-risk assets – you buy them with money you can afford to lose when you’re feeling upbeat about market prospects. When the mood sours, this class of investment is typically the first to be retrenched as investors scramble to get cash.

At $300 billion, according to Coinmarketcap’s undoubtedly inflated estimates, the market cap of the overall crypto token market is more than three times its value of a year ago (even though it’s down more than half from its peak in early January).

But it’s less than 1 percent of the end-2017 market cap of $54.8 trillion for the S&P Global Broad Market Index, which includes most stocks from 48 countries. If risk-hungry investors are panicking and looking for things to dump – or for that matter if they’re looking for something safe to buy – it won’t take much of their funds to move the crypto markets, one way or another.

Low correlations

Backing the bitcoin bulls’ argument is the fact that correlations between cryptocurrency and mainstream risk assets – the degree to which prices move in tandem with each other – are quite low.

A 90-day correlation matrix compiled by analytics firm Sifr put bitcoin’s correlation with the S&P 500 index of U.S. equities at minus-0.14. That’s a statistically neutral position since 1 represents a perfect positive correlation while -1 is a perfectly negative relationship.

But they say that in a crisis “all correlations go to 1.” The panicked state of the crowd, with investors selling whatever they can offload to cover debts and margin calls, means that everything could go out with the flood.

Intellectually, too, that sort of wholesale downturn would comfortably stand as a logical counterpoint to the conditions seen last year when market valuations reached excessive levels. We cannot separate the flood of money that flew into crypto at the end of the year from the fact that eight years of quantitative easing had driven a “hunt for yield” in once-obscure markets as the return shrank on now pricey mainstream investments such as corporate bonds.

With bond funds paying little more than, say, 2 percent for years, bitcoin looked attractive to mainstream investors. When that artificially-stoked liquidity disappears, the reverse could happen.

Despite all of this, I do believe a global financial crisis could be an important testing moment for crypto assets.

Perhaps there’ll be a two-phase effect. In the immediate aftermath of the panic, there would be a selloff as every market is hit by the liquidity squeeze.

But after things settle, one can imagine that the narrative around bitcoin’s uncorrelated returns and its status as a hedge against government and banking risk would gain more attention.

Just like the mid-2013 surge in bitcoin that accompanied the Cypriot crisis’ lesson that “they can come for your bank account but not for your private keys,” so too a wider financial crunch could spur conversation around bitcoin’s immutable, decentralized qualities and help build the case for buying it.

The wider point here is that, whether it’s as an aligned element that rises and falls in sync with the broader marketplace or as a contrasting alternative to it, cryptocurrencies can’t be viewed in isolation from the rest of the world.

Image via Shutterstock

Michael J. Casey is the chairman of CoinDesk’s advisory board and a senior advisor for blockchain research at MIT’s Digital Currency Initiative.

The following article originally appeared in CoinDesk Weekly, a custom-curated newsletter delivered every Sunday exclusively to our subscribers.