Bitcoin and other crypto-assets have grown from an esoteric asset class with very few users to a crucial element of the technology platform revolution, sparking worries about financial stability.
According to an IMF study, cryptocurrencies’ rising co-movement might soon pose threats to financial stability due to their comparatively high volatility and values, especially in countries with substantial crypto usage. As a result, now is the moment to develop a comprehensive, coordinated international regulatory framework that guides national legislation and supervision, as well as alleviate the financial stability concerns posed by the crypto ecosystem.
This, That and The Other One
A framework like this should include laws targeted to the most common uses of crypto assets, as well as explicit requirements for regulated financial institutions’ exposure to and involvement with these assets. Furthermore, data gaps generated by the obscurity of such commodities and restricted worldwide standards must be quickly addressed in order to monitor and comprehend the rapid advancements in the crypto environment and the dangers they pose, according to the IMF. Crypto assets like Bitcoin and Ether have a minimal link with mainstream market indexes prior to the outbreak. They were considered to help spread risk and function as a buffer against asset class volatility. However, with the dramatic central bank crisis reactions of early 2020, this altered. Cryptocurrency prices and stock prices in the United States have both risen as a result of easy global financial markets and increased investor risk appetite.
In the year 2017–19, for example, Bitcoin returns didn’t budge in lockstep with the 500, the US stock market’s benchmark index. The daily correlation coefficient was only 0.01, but it increased to 0.36 in 2020–21 as the commodities moved more in lock-step, increasing or decreasing at the same time.
Mix of Everything
The rising and significant co-movement & spillovers between cryptocurrency and equities markets show a growing link between the two risky assets, allowing shocks that might destabilise financial markets to be transmitted. According to the IMF, “our study implies that digital currencies are no longer on the periphery of the financial system.” Despite considerable volatility, the market value of these innovative assets increased to roughly $3 trillion in November from $620 billion in 2017, owing to rising appeal among regular and institutional investors. The overall market value fell to almost $2 trillion last week, but it still represents a nearly four-fold gain since 2017.
According to recent IMF research, the connection of digital currencies with conventional holdings like equities has grown dramatically as usage has expanded, limiting their perceived risk diversification and raising the danger of contagion across capital markets. Increased crypto-stock connection enhances the risk of investor sentiment spillovers between asset classes. Indeed, according to our research, which looks at price and volatility spillovers between crypto and global equity markets, spillovers from Bitcoin returns and volatility to stock markets, and vice versa, have increased dramatically in 2020–21 compared to 2017–19.
Bitcoin volatility accounts for around one-sixth of 500 volatility and one-tenth of S&P 500 returns during the epidemic. As a result, a severe drop in Bitcoin prices may raise investor risk aversion, resulting in a drop in stock market investment.