September 13, 2023

Insights and analysis for the professional investor

Was this newsletter forwarded to you? Sign up here.

Supported By

Welcome to Crypto Long & Short!

This week, Todd Groth of CoinDesk Indices explores the relationship between interest rates and bitcoin.

Then, Max Freccia of Truvius also does some number-crunching to evaluate the benefits of expanding beyond the biggest cryptos.

As always, get the latest crypto news and data from CoinDeskMarkets.com.

– Nick Baker

From the Analyst

Crypto's Interest in Rates

It appears crypto investors have been enjoying time away from the trading desk during the late summer months.

With some exceptions (a flurry of excitement around potential bitcoin spot ETFs and trading enforcing upper and lower price support levels), they appear to be less focused on their holdings and more focused on other matters, including taking much-needed R&R.

Amid that relative calm, the U.S. Treasury has been busy at work in the fixed-income market borrowing more and more via bond issuance. This increase has been significant enough to prompt Fitch ratings to cut the U.S. debt rating from AAA, joining S&P's move to the same AA+ level more than a decade ago. Amped up issuance may also have pushed yields on 2- and 10-year Treasuries up in relation to inflation-linked TIPS.

Source: Federal Reserve Bank of St. Louis

Should this have nudged digital asset prices, too? How do interest rates impact crypto asset prices?

Changes in rates can indirectly affect the price of bitcoin (BTC), although the relationship between these markets is complex and influenced by various factors, including:

Opportunity cost: Bitcoin and other proof-of-work cryptocurrencies that don't provide holders what amounts to interest payments can become more alluring to investors when conventional interest rates are low. This allure and demand can push up their prices in a low-yield environment. And the opposite can happen in moments like now when conventional interest rates are relatively high. This effect of interest rates ("cost of cash") can be slightly offset with proof-of-stake digital assets like Ethereum's ether (ETH), which do offer a rate of interest from staking activities to secure the network. Crypto is intrinsically global, so rates of interest across the world need to be taken into consideration.
Risk sentiment: Changes in rates can influence overall market sentiment. When central banks raise them to cool down an overheating economy or combat inflation, it can signal a more restrictive monetary policy and a desire to slow economic growth, potentially damping risk appetite ("animal spirits") in financial markets. In such circumstances, investors may move away from riskier assets like growth stocks and digital assets, including bitcoin, toward safe haven assets that typically pay interest. While very much related to the opportunity cost of capital, sentiment is slightly distinct as it relates to the overall mood of the market.
Inflation expectations: Interest rates are often adjusted by central banks in response to inflation expectations. If central banks raise rates to combat rising inflation, it can erode the purchasing power of fiat currencies like the U.S. dollar. In such cases, some investors may turn to bitcoin as a store of value, viewing it as a hedge against inflation, which can drive up its price. However, if the inflation-fighting credibility of the central bank remains intact with inflation expectations well anchored, this can result in bitcoin prices falling due to the increase in interest rates (i.e. adding to the opportunity cost of not being in short term treasury bills).

Source: St. Louis Fed, CoinDesk Indices

To answer whether or not bitcoin has been impacting by the recent moves higher in interest rates, I ran a quick rolling regression analysis on the recent bitcoin price history against interest rates (both the 2-year US Treasury yield and the 10-year inflation adjusted real interest rate) and the EUR/USD spot exchange rate to correct for moves in the U.S. dollar. From the results (see figure above), it appears that current bitcoin prices reflect the move up in nominal and real interest rates.

— Todd Groth, CFA, head of research at CoinDesk Indices

A message from Messari

Come build with us and register for Mainnet 2023, the premiere crypto event of the year!

Hosted by Messari, Mainnet returns to Pier 36 NYC from Sept 20-22. Mainnet unites together the leading voices in crypto and will spotlight the true innovations propelling crypto forward, with programming focusing on regulation & policy, real-world finance & DeFi, operators & builders, AI's native currency, and a wide variety of other topics. This year, Mainnet will feature 100+ in-person speakers from across the crypto and TradFi landscapes, including Coinbase's Brian Armstrong, Circle's Jeremy Allaire, Ripple's Brad Garlinghouse, Stellar's Denelle Dixon, EY's Paul Brody, PayPal's Jose Fernandez da Ponte, Onyx by J.P. Morgan's Tyrone Lobban, and many more.

Institutional Outlook

What Correlations Tell Us About the Value of Multi-Asset Crypto Portfolios

The ongoing battle between the U.S. Securities and Exchange Commission and prospective issuers of bitcoin (BTC) spot ETFs is dominating current crypto headlines. An approved bitcoin ETF would increase access and signal a bullish new chapter for crypto. Investors who limit their exposure to the small concentration of mega-cap assets formed by bitcoin and ether, however, may not capture the full value proposition of digital assets in their portfolios. Broadening the digital asset investment universe beyond the largest single assets empowers crypto portfolios in the following ways:

Improving diversification

Both within crypto and in the context of an investor's broader asset allocation, increasing the breadth of digital asset holdings may lead to better diversification characteristics while also avoiding the risks of single-token concentration.

Investors should consider the following two questions regarding the portfolio-level benefits of allocating to digital assets:

Does crypto provide long-term diversification characteristics versus traditional assets?
If so, is bitcoin enough to capture this benefit fully (i.e., is it worth allocating to other tokens)?

Below we look at rolling correlations of the top 25 crypto assets to explore these questions:

Figure 1: Rolling 60-day correlations to U.S. 60/40 portfolio (left) and to bitcoin (right), Aug. 1, 2021 to Aug. 31, 2023. Source: Truvius.

The chart on the left shows rolling correlations of daily returns for the 25 largest crypto tokens to a U.S. 60/40 stock/bond portfolio. Over the trailing two-year period, digital assets maintained strong diversification characteristics to traditional portfolios with full-period correlations of less than 0.50 for each crypto asset. This relationship is also more attractive when comparing the correlation of the full set of tokens to that of bitcoin, improving from 0.46 for BTC alone to an average of 0.40 across all top 25 assets.

The chart on the right shows correlations of non-BTC crypto assets to bitcoin. The variation of the correlations, along with modest overall levels, leaves the stigma that "all crypto is the same" looking largely unfounded. Exposure to a variety of crypto sectors and fundamental blockchain use cases may help drive this token diversification.

Accessing a broader set of active management strategies

Active crypto managers focusing only on bitcoin are mostly limited to timing the market – a uniquely challenging undertaking in any asset class. Tried and true relative value investment strategies, or strategies that compare assets to one another, from traditional finance may provide longer-term solutions for those seeking uncorrelated alpha in the space.

Effectively implemented relative value strategies call for both asset breadth and sufficient differentiation among those assets. Figure 2 takes returns for the top 25 crypto assets except BTC, controls for exposure to systematic risk (roughly approximated by bitcoin), and shows the correlations between each token pair's residual returns (i.e., ETH vs. DOT, SOL vs. LTC, etc.):

Figure 2: Top 25 ex-BTC crypto token pair residual correlations, Aug. 1, 2021 to Aug. 31, 2023. Source: Truvius.

The goal of this chart is to see if the estimated idiosyncratic portion of each token's returns is differentiated enough from one another to drive meaningful relative value comparison and allow active managers to benefit from increased breadth of the investment universe. The average residual correlation among the crypto asset pairs shown above is 0.29. All else equal, this suggests that on average much of the residual variation among these token pairs (up to approximately 90%) is unique, indicating a substantial amount of differentiation for relative value strategies to exploit.

Conclusion

Multi-asset crypto portfolios encompass a wide variety of fundamental use cases of blockchain technology, offering more robust diversification characteristics versus single-token concentration and unlocking relative value active management opportunities within and across crypto sectors.

– Max Freccia, COO/CFO and co-founder at Truvius

Takeaways

From CoinDesk Deputy Editor-in-Chief Nick Baker, here is some news worth reading:

REAL STUFF: So much of the FTX saga concerns bewildering questions about what was actually real there. How much money did clients have? Where did it go? Etc. On the other hand, a bankruptcy restructuring is all about being super tangible for stuff, searching beneath the proverbial couch cushions to figure out how much stuff there really is and what's it worth. FTX's bankruptcy overseers released an illuminating report this week listing about $7 billion of assets, including cash, cryptocurrencies and real estate. That includes $1.16 billion of SOL, the token behind the Solana project that Sam Bankman-Fried supported. There have been worries in the aftermath that FTX is about to dump a bunch of crypto – to cash out – spooking some investors. There is not, however, actually evidence that's about the occur, raising the question of whether any swoon in prices will be short-lived.
DEMOCRAT'S DISLIKE: At a hearing this week, a key Senate Democrat, Ohio's Sherrod Brown, made clear he dislikes crypto. He also praised the Securities and Exchange Commission's application of current laws to crack down on the industry. "I'm glad the SEC is using its tools to crack down on abuse and enforce the law," Brown said. This has implications for any legislative movement to give the industry the clarity it yearns for since Brown runs the Senate Banking Committee, and could signal that crypto could remain a partisan issue in the U.S. presidential race (Democrats opposed and Republicans supportive).
ETHER TRUST: The Grayscale Bitcoin Trust (GBTC) has for a long time traded at a price way below the value of the BTC it holds, though that discount has narrowed as GBTC's odds of being converted into a more-appealing ETF have improved. But another Grayscale product, the Grayscale Ethereum Trust (ETHE), is seeing similar movement as companies apply to ilst ether ETFs. "The market is weighing higher odds that Grayscale will be able to convert its ETHE product into an ETF following the push from traditional finance giants into the space," said IntoTheBlock's Lucas Outumuro.

Want more? For the latest news affecting the crypto markets, listen to CoinDesk's Markets Daily podcast.

State of Crypto: Policy & Regulation

It is now more important than ever to set industry standards and align on practical short-term and long-term objectives through pointed conversations with the best legal minds and Washington D.C.'s most important decision makers.

Join us at State of Crypto: Policy and Regulation on October 24 in Washington D.C. for an unprecedented opportunity to evaluate, dissect and ultimately shape crypto regulatory frameworks that support a vibrant, secure and healthy future for the digital economy.