Crypto fuels stock market volatility: IMF

Bitcoin is moving more in line with stock prices than pre-pandemic, raising the risk that volatility in the $US2 trillion ($2.8 trillion) crypto assets sector transmits a shock to destabilise financial markets, the International Monetary Fund has warned.

Crypto assets such as bitcoin have historically been viewed as being uncorrelated to major equity markets and a way to diversify and act as a hedge against swings in other asset classes.

However, a new IMF analysis says that since central banks slashed interest rates to near zero to support economies during the pandemic, there has been increased co-movement and spillovers between crypto and equity markets.

The IMF blog post, Crypto Prices Move More in Sync With Stocks, Posing New Risks, said the market development had raised the risk of contagion and “ripple effects” across financial markets.

“The increased and sizeable co-movement and spillovers between crypto and equity markets indicate a growing interconnectedness between the two asset classes that permits the transmission of shocks that can destabilise financial markets,” noted the analysis led by IMF financial counsellor Tobias Adrian.

“Given their relatively high volatility and valuations, their increased co movement could soon pose risks to financial stability especially in countries with widespread crypto adoption.”

A sharp sell-off in crypto assets since November has caused the value of the digital assets to fall from almost $US3 trillion to about $US2 trillion, although their value is still about four times as high as 2017.

Global stock markets have also suffered falls in recent weeks, due to the spectre of central banks raising interest rates faster than anticipated and the rapidly spreading COVID-19 omicron variant.

In the zero interest rate environment, investors have piled into riskier assets such as crypto, stocks and junk bonds to chase returns.

More than 2 million Australians are estimated to have exposure to private digital currencies, and institutional investors including some superannuation funds are including crypto as a small part of their overall portfolio.

Commonwealth Bank of Australia will allow its customers to hold and use bitcoin and other cryptocurrencies via its 6.5 million-user banking app in a bid to appeal to young customers and keep pace with rivals such as Square and PayPal, which already allow users to trade and spend bitcoin.

The IMF analysis finds that spillovers between crypto and equity markets tend to increase in episodes of financial market volatility — such as in the March 2020 market turmoil — or during sharp swings in bitcoin prices, as occurred in early 2021.

Returns on bitcoin did not move in a particular direction with the US benchmark stock index, the S&P 500, between 2017 and 2019.

The 60-day correlation coefficient of their daily moves was just 0.01, but that measure jumped to 0.36 between 2020 and 2021, as the price of the assets moved more in lockstep, rising together or falling together more closely.

Bitcoin’s correlation with stocks was higher than that between equities and other assets such as gold, investment grade bonds, and major currencies, “pointing to limited risk diversification benefits in contrast to what was initially perceived”, the IMF said.

According to the IMF’s estimates, bitcoin volatility explains about one-sixth of S&P 500 volatility during the pandemic, and about one-tenth of the variation in S&P 500 returns.

“As such, a sharp decline in bitcoin prices can increase investor risk aversion and lead to a fall in investment in stock markets.

“Spillovers in the reverse direction—that is, from the S&P 500 to bitcoin—are on average of a similar magnitude, suggesting that sentiment in one market is transmitted to the other in a nontrivial way.”

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