If by Bitcoin
Parsing the Narratives about Bitcoin
By: Verdad Research
If, when you say Bitcoin, you mean the currency of hackers and scammers, the environmental scourge that pollutes our air and water, the greedy monster that dethrones reason, promotes speculation and gambling, yea, literally takes the bread from the mouths of little children, then certainly we are against it.
But if, when you say Bitcoin, you mean the foundation for a new financial system that is impartial, equitable, and universally accessible, a model for property rights on the internet, a miraculous combination of game theory and cryptography that will bring to an end the rent-seeking behavior of financial middlemen, then certainly we are for it.
Noah “Soggy” Sweat, Jr. originally delivered the “If-by-whiskey” speech in 1952 on the subject of whether Mississippi should continue to prohibit or finally legalize alcoholic beverages. Today, the speech offers a humorous parallel to the world of Bitcoin, where it would seem that the value of the technology often seems contingent on the listener’s opinion. Depending on who you follow and listen to, Bitcoin is either a brilliant invention or an outright scam.
Fortunately, as quantitative investors, we can dispense with the controversy of narrative-based perspectives and consider Bitcoin as we would any other asset: does Bitcoin offer attractive returns and diversification for investors, and, if so, can these returns be forecast?
Before joining Verdad, I spent two years contemplating these questions as I attempted to build a Bloomberg-like data provider for crypto investors. The real-time and public nature of the blockchain offers investors a valuable trove of information to manage crypto risk, but is it worth managing? Relative to traditional asset classes, there’s certainly a high degree of risk. Figure 1 shows the volatility of Bitcoin relative to traditional asset classes.
Figure 1: Annualized Bitcoin Volatility, Aug 2010 – Present
Source: Thomson Reuters Datastream, Coinmetrics, Verdad analysis
Bitcoin is dramatically more volatile than traditional asset classes.
In terms of trading behavior, cryptocurrency’s correlation to traditional asset classes is low. But Bitcoin tends to do well when stocks are rallying, particularly the Bubble 500 stocks we’ve written about recently. And Bitcoin tends to do poorly when volatility spikes higher. Figure 2 shows the correlation of Bitcoin with the S&P 500, the Bubble 500, gold futures, the USD/Yen exchange rate, 10-year Treasurys, and volatility.
Figure 2: Asset Class Correlations, Bitcoin, July 2010 – Present
Source: Thomson Reuters Datastream, Coinmetrics, Verdad analysis
Bitcoin promoters tend to advertise cryptocurrency either as a competitor to fiat currencies or as a successor to gold as a long-term store of value. But Bitcoin doesn’t behave anything like gold or traditional currency pairs.
Bitcoin can most aptly be characterized as an equity-like risk asset. But even this perspective is static and doesn’t show the full picture. Figure 3 shows the one-year rolling correlation of Bitcoin with the S&P 500 and the Bubble 500 since July 2010.
Figure 3: Rolling 1Y correlation, S&P 500, Bubble 500, July 2010 – Present
Source: Thomson Reuters Datastream, Coinmetrics, Verdad analysis
Through 10 years of trading history, Bitcoin’s relationship with equities, its closest correlative neighbor, has changed wildly. Bitcoin’s monthly returns have oscillated between having a +73% and -46% relationship with the returns of the S&P 500. Since COVID, crypto’s returns have been significantly correlated with equities.
The drivers of return for Bitcoin are meaningfully different than other asset classes. It’s unclear what traditional macroeconomic drivers like growth and inflation have to do with this wildly volatile, speculative asset. But Bitcoin network data does appear to provide some strong indicators of what drives Bitcoin’s short-term volatility. Other researchers have found significance among subsets of variables similar to those shown below.
Figure 4: Bitcoin Regression Panel
Source: Coinmetrics, Verdad analysis
This regression, based on data from Coinmetrics, shows some of the supply and demand metrics that drive Bitcoin prices. Increasing prices and an increasing number of users predict rising prices, a dynamic that also characterizes Ponzi schemes and other bubbles. An increase in the amount of Bitcoin held by miners, who verify transactions and introduce new Bitcoin supply, also predicts an increase in prices. Notably, the relationship between Bitcoin’s price and the count of transactions should be troubling for advocates of Bitcoin’s use as a currency: the data suggest that, over short time horizons, the more Bitcoin is used, the less value it has!
With roughly 10 years of trading data, it’s difficult to arrive at any reliable conclusions. We know that Bitcoin is volatile. Our research shows it doesn’t trade like a currency or like gold. Our research shows that the primary driver of Bitcoin’s short-term volatility appears to be the supply-demand dynamics on the blockchain (What an insight! Supply and demand drive prices!). And our research shows that, in the short run, Bitcoin’s price is negatively related to actual transactions on the blockchain.
What does this suggest about Bitcoin as an asset class? The Bitcoin network contains several short-term feedback loops that induce volatility and drive its ephemeral behavior. Perhaps most concerning for Bitcoin investors today is the asset’s relationship with a quickly declining basket of high-flying equities: The Bubble 500. It’s unclear that Bitcoin return dynamics will stabilize in any reliable fashion, but in the meantime, like whiskey, we can bet that Bitcoin will continue to have its promotors and detractors.
This is our stance, and we shall not equivocate.