IMF: ‘Increased correlation between bitcoin and equities creates new risks’

Last week, the International Monetary Fund (IMF) published another blog about bitcoin and crypto. This time, concerns were raised about the increased correlation between bitcoin and stocks, potentially causing financial instability. In 2020 we wrote that – according to asset manager Fidelity – there was little correlation between bitcoin and shares. In this article, we find out what is left of the 2020 paradigm.

In 2019, but also in 2020, various voices emerged from the traditional financial sector that bitcoin might be a good way to diversify a broadly diversified investment portfolio. One of the special properties of bitcoin is not only that it offers a hedge against inflation, but also the prospect of a higher return than other investments. However, this was not the main argument for the potential diversification benefit to be achieved. It was all about the so-called low correlation with other types of asset classes, such as stocks, bonds and gold.

Correlation?

What’s the meaning of this? According to the Van Dale, correlation indicates a mutual relationship or interdependence. In short, correlation simply means coherence. In the financial sector, for example, the correlation between different stocks is calculated in order to compile a balanced investment portfolio. Several asset managers, including Fidelity and VanEck, have calculated the correlation between bitcoin and other types of asset classes and concluded that it was very low.

The value of the correlation coefficient is always between -1 and +1. But what do the numbers in the table above mean? A correlation of 1 indicates a perfect positive correlation. In other words: the variables move together in the same direction. A correlation of -1 indicates a perfect negative correlation. In other words, the variables move in opposite directions. A correlation of 0 or close to 0 (uncorrelated) means that there is no relationship between the variables.

In the table above and chart below, we see that the correlation between bitcoin and the S&P 500, a stock index that includes the 500 largest companies in the United States, has historically been negative. In 2020, the correlation coefficient was 0.22, according to Morningstar. In 2021, the correlation between the S&P 500 and bitcoin appears to have increased again. At the end of 2021, the 100-day correlation coefficient stood at 0.33, according to Bloomberg. This was one of the highest values measured in 2021. However, the increased correlation remains low. So we don’t know exactly what it means yet. One of the risks is that a correction in the financial markets may have a greater impact on bitcoin than before.

Do you want to know more about the correlation between bitcoin and stocks? Then listen to episode #190 of Satoshi Radio from minute 39:35.

IMF blog

?ǣCrypto-assets like bitcoin have matured from an obscure asset class with few users to become an integral part of the digital asset revolution, raising concerns about financial stability.?ǥ

The IMF’s blog opens with the above quote. Subsequently, the blog focuses on the growth of the crypto and bitcoin market in itself. According to the IMF, the greater acceptance of bitcoin, among other things, has led to a significant increase in the correlation with equities. This has removed the diversification advantage of bitcoin in an investment portfolio and increased the “economic contagion risk” between the bitcoin market and traditional financial markets, which can lead to financial instability, according to new research from the IMF.

Further, the IMF’s new research examines the interconnectedness and potential spillover effects between crypto and bitcoin markets and traditional financial markets. The increased correlation between bitcoin and equities, according to the IMF, can be attributed to the extraordinary interventions of central banks in response to the corona crisis in early 2020.

Somewhat remarkable and perhaps also somewhat arbitrary seem the chosen periods for the comparison of the correlation between bitcoin and equities. The period of 2017-2019 is compared in the study with the period of 2020-21. Although the correlation has increased significantly in the period 2020-21, the period before 2017 is not considered, so that the result may be slightly higher.

The IMF’s research suggests that crypto assets such as bitcoin are no longer on the fringes of the financial system. However, this could cause financial instability given the increased correlation between bitcoin and equities and the high volatility and valuations of crypto and bitcoin, according to the IMF. The IMF therefore once again calls for harmonized regulations at a global level for, among other things, bitcoin that are comprehensive, consistent and coordinated. You can read more about this call from the IMF here.

It is perhaps still too early to talk about a real paradigm shift. Although the correlation between bitcoin and stocks seems to be increasing, we don’t know how this will develop in the future. What we do know is that ??? like everything related to correlations ??? it will change.

Why does the IMF want harmonized regulations at a global level for Bitcoin, among other things? Read more here.

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