Investors have a new option to add to their portfolios. Bitcoin has finally achieved the status of a new asset class, disrupting the way many traditional investors conceive of the financial markets as we know them.

In 2016 and 2017, Bitcoin’s parabolic price surge was mostly driven by retail investors. This year it seems like it’s the institutional interest that is taking over. While retail investors are cautious in heavily buying cryptocurrencies as the memories of losses that they suffered in 2018 and 2019 are still vivid, institutional investors employ sound risk management processes to protect themselves from drawdowns. On top of that, even low percentages of allocations from corporations are relevant in a market that is still relatively young and illiquid compared to equities, bonds, and commodities.

Now that more and more corporations publicly announced to be adding Bitcoin to their reserve treasuries, it will be tough to put the genie back into the bottle.

Why correlations matter

Retail investors base their investment judgments primarily on sentiment, price actions, and news. Institutional investors’ decision-making processes are more complex and done on advanced models, which often consider the correlations between the assets included in a portfolio. Risk-management is the key to the long-term survival of a professional investment entity. The best way to assess the risk starts by determining the relationship that statistically links different assets.

Portfolio managers reduce the overall risk by holding assets that are as “de-correlated” as possible from each other. When different assets don’t move in the same direction, it significantly trims the aggregate portfolio volatility because the profits from one asset statistically compensate losses from other assets.

That’s what happened for the first time in March 2020, during the Covid-related market crash. After years of low correlation with other traditional risky assets, Bitcoin sank together with stocks amid a suddenly increased correlation.

Data: Coinmetrics

New players in the game

It’s interesting to notice that the main driver of the crypto market crash was probably the reaction of short-term oriented investors and speculators. As we can see from the number of open leveraged positions on Bitfinex, short-sellers added their exposure at a record pace, while buyers had to close their trades due to sudden margin calls and liquidations. We can assume that at least part of these short-term traders also invest in stocks and equity derivatives and had to adjust their trading accordingly.

Between March and June, Bitcoin, Facebook, Google, and Apple’s price performances almost overlap perfectly (in relative terms).

This was historic as it was the first time Bitcoin and cryptocurrencies were affected by a broad macro event. As Bitcoin becomes a new asset class, there will always be a sharper overlap in market infrastructure and market participants with traditional markets.

This tweet from Peter Brandt from March 12th captures well how correlations work in times of panic selling.

On another level, though, something was brewing and is being reflected gradually in the strong V-shaped recovery that brought Bitcoin one step away from a new all-time high.

The Grayscale Bitcoin Trust has been attracting funds at increasingly high rates since March, holding now over 500,000 BTC. As a reminder, the fund targets institutional and accredited investors willing to pay a large premium to Bitcoin’s spot price to add to their portfolio a regulated vehicle that allows exposure to the crypto market.

The GBTC is by far the single largest investment pool in Bitcoin, but in parallel, other large private entities and corporations are piling up Bitcoin as a reserve asset. They are likely not as price-sensitive as the average crypto investor focused on short-term speculation. These corporations invested after a long due-diligence process and, being well aware of the risk involved, they likely adopted risk management tools to mitigate this risk, as it is a common practice for institutional investors.

Data from JP Morgan seems to certify Bitcoin’s new status as a new asset class among institutional investors. Since the second half of 2020, the capital influxes to Gold ETFs slowed down in parallel with the rise of holdings in the GBTC Trust – unlikely a coincidence.

A whole new game

Old and new market participants add a mix of perspectives to the market that reflects short-term volatility but also drive the macro trend, depending on whichever one is the prevailing force on the day.

As already noted, Bitcoin’s correlation with stocks has historically been very low. The same emerges when comparing it with Gold.

Data: Coinmetrics

There is a reason for that. Bitcoin plays according to its own rules.

Bitcoin is a new asset class like no other in the financial landscape. Bitcoin doesn’t hold any ties with the economic cycle. Bitcoin introduced metrics such as the halving and the hash rate that affect its value/price but are detached from any financial model ever developed.

To an extent, traditional currencies have the same characteristics from an investment point of view. News, data, and metrics affect currencies every day. There’s always a different reason for them to move up or down. These components usually balance one another, leading to relatively low volatility and correlation with other asset classes.

Investors tend to avoid assets surrounded by uncertainty and prefer those that are more predictable. Ironically, unexpected swings in monetary policies are the main causes of price shocks in currencies. Bitcoin has a mathematically planned monetary policy. What could be more predictable than this?

Tactical opportunities

Traditional currencies with the lowest volatility are among those assets that investors add more often to their portfolio for long-term investments. Yet, derivatives on the EUR/USD, the GBP/USD, or the YPY/USD are traded in huge volumes by traders every day around the clock.

Bitcoin is on track to join the most liquid forex trading pairs thanks to the derivatives infrastructure evolving at remarkable speed. The market is adapting to the needs of far more exigent participants. The days when whales on less transparent exchanges used to manipulate the prices may be about to end.

New, larger whales are entering the playground. The growing interest in Bitcoin from institutional investors is not only reflected in long-term portfolio allocations. Large investors from the traditional markets are gradually touching base with the crypto space.

In terms of Open Interest, the CME has grown in recent months to top the second-highest place. Bitcoin’s higher volatility is a great opportunity; traders of all backgrounds will be willing to exploit.

Data: Skew

It’s worth noticing that traders on the CME share their liquidity across derivatives on different asset classes, which will potentially enforce spikes in correlations between Bitcoin and traditional assets in case of margin calls during market corrections.

The piano player is warned, once again.

Bottom line

As Bitcoin becomes a new asset class, more investors will recognize its added value in a diversified portfolio. The low long-term correlation with any other existing asset represents an investment decision with a unique risk/reward form.

New investment vehicles will emerge and will make it easier for large institutions to accumulate Bitcoin. It feels like those corporations that already chose to include cryptocurrencies into their reserves are in a similar position to the retail early-adopters back in 2015.

At the same time, growing liquidity, an improved market structure, and more transparency will attract new speculators that so far only watched the parabolic Bitcoin price rise from the sidelines. This will catalyze a positive feedback loop that can only strengthen Bitcoin’s status as a new asset class. In turn, every market participant needs to incorporate into its models occasional periods of correlations with traditional assets.

If in March millennials bought the dip investing with their $1200 stimulus check, large corporations may be supporting the price during the next crashes to add to their reserve. It’s easy to understand how the magnitude of the involved dynamics is changing, and the implications for Bitcoin are significant.

Bitcoin, stocks, commodities, and forex will be increasingly interconnected, and investment platforms like Coinrule will allow a multi-asset exposure to add unprecedented value to their users.


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