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Bitcoin and cryptocurrencies already have the ability to unleash a domino effect and destabilize markets, according to the IMF

Cryptocurrencies have crossed the threshold. Its size and interconnection with financial markets has reached a point where its fluctuations can already have a more than notable impact on other assets or even trigger a domino effect. Now they are a real risk, especially in the wake of the covid pandemic. Since then, bitcoin or ethereum show a strong correlation with stocks, posing new risks to markets and financial stability, the International Monetary Fund warns.

The growth of crypto assets in recent years has been one of the most striking trends in the markets. Few would have bet back in 2009 (when bitcoin was born) that this market would reach a capitalization that was twice the GDP of Spain.

The capitalization of cryptocurrencies reached 3 trillion dollars in November 2021, compared to 620,000 million in 2017. Much of this growth is due to the entry and growing interest from retail investors and institutional alike, who seem not to fear the high volatility of these assets.

For years, central banks and other institutions have denied that this market could generate risks for stocks or bonds due to its poor connection and smaller size. Now the IMF finally recognizes that cryptocurrencies can create a domino effect in the markets: their falls and rises can infect stocks, cause greater volatility and even destabilize the financial system.

Cryptocurrencies are correlated with exchanges (they are risk assets)

Critical currencies have been one of the spearheads of this sparkling market spurred by the huge amount of stimulus launched by central banks and governments. As world stock markets recovered from the covid, with Wall Street from a record high to a record high, cryptocurrencies have also shot their yields to historic heights. Stocks and cryptocurrencies have been clearly correlated since the COVID pandemic broke out in Western countries in 2020.

Tobias Adrian, Tara Iyer and Mahvash S. Qureshi From, economists at the International Monetary Fund, highlight “the correlation of cryptocurrencies with other traditional assets such as stocks has increased significantly, limiting their use as a ‘diversifier’ and increases the risk of contagion in financial markets. ”

“Bitcoin and Ethereum showed little correlation with the main stock indices before the pandemic. They were thought to help diversify risk and act as a hedge against swings in other asset classes,” these experts explain. It was common to read and hear analysts who compared bitcoin to gold for its ability to diversify a portfolio and act as a hedge against inflation or corrections in other markets dominated by risk assets. The data that could support this hypothesis have evaporated with the last crisis.

Crypto assets have moved to the sound of central banking stimuli and fiscal policies that have flooded the markets with liquidity, lifting almost all the ships that float in this ocean of finance. With the focus on bitcoin, the major cryptocurrency has seen a roller coaster ride with steep rises since the pandemic broke out and central banks put all the meat on the grill.

It should be remembered that in mid-March 2020, with the covid causing the first havoc in the West, the cryptocurrency was around $ 5,000. From there, a stratospheric rally began that took it to touch $ 64,300 in April 2021, an all-time high that reached the day before Coinbase went public. The retail investment boom had too much to do with it.

The IMF recognizes that the beginning of this correlation between stocks and cryptos it stems from “the extraordinary responses to the crisis by central banks in early 2020. Cryptocurrency and American equity prices rose amid expansive global financial conditions and increased risk appetite from investors.”

As can be seen in the graph, bitcoin returns did not show a specific direction when compared to the S&P 500 between 2017-2019. The 60-day correlation coefficient of its daily movements was just 0.01, but that indicator shot up to 0.36 between 2020-2021, starting a new trend in which stocks and cryptocurrencies move in unison. Bitcoin has marked its all-time high on November 10, when it reached another all-time high at $ 68,925, with the American indices also touching all-time highs at that time.

“This strong correlation suggests that bitcoin has been acting as a risk asset. Its correlation with stocks is higher than that of stocks themselves with other assets such as investment grade bonds and major currencies, “argue the IMF economists.

Possible domino effect

This represents a significant risk for investors and markets, since the fall of large cryptocurrencies such as bitcoin or ethereum can trigger a domino effect. “The higher correlation between cryptocurrencies and stocks increases the likelihood that investor sentiment will rub off between those asset classes. Indeed, our analysis, which examines the spill-over effects of prices and volatility between cryptocurrencies and markets global stock markets, suggests that the spill-over effects of bitcoin returns and volatility on stock markets, and vice versa, have increased significantly in 2020-2021. “

Right now, according to IMF calculations, the strong volatility of bitcoin explains about a sixth of the volatility suffered by the S&P 500 during the pandemic and about a tenth of the variation in returns.

“As such, a sharp drop in bitcoin prices may increase risk aversion of investors and cause a fall in the stock markets … which suggests that sentiment in one market is transmitted to the other in a remarkable way, “warns the report of the International Monetary Fund.

Another close and illuminating example has been observed during the past week, when the Fed’s clear commitment to a faster-than-expected tightening of its monetary policy made risk assets tremble, including bitcoin and ethereum. The ‘queen’ cryptocurrency has lost $ 40,000 in recent days, while Wall Street also suffered significant losses. It is in these episodes of panic or euphoria when the feeling between some assets and others is most fed back.

The IMF findings reveal that this transmission between assets is more intense in turbulent times for the markets: “The spill-over effects between the cryptocurrency and securities markets tend to increase in episodes of financial market volatility, such as in the housing turmoil in March 2020 or during the strong swings in bitcoin prices, as observed in early 2021. “

Systemic concerns

Everything mentioned above reveals that “there is a growing interconnection between the two classes of assets that allows the transmission of shocks that can destabilize financial markets. Our analysis suggests that crypto assets are no longer on the fringes of the financial system. Given its volatility and relatively high valuations, its higher correlation could soon pose risks to financial stability, especially in countries with widespread crypto adoption, “warn IMF experts.

Both stable currencies (stablecoin) and some investment vehicles (bitcoin ETFs) have considerable positions in assets in the fixed income market (bonds, bills, promissory notes …) which in the event of a correction in the cryptocurrency market can be used as a way to offset losses through the sale of those assets, which could generate some selling pressure on said bonds and assets.

Therefore, from the International Monetary Fund they make a global call to all regulators to adopt a comprehensive global regulatory framework and coordinated to launch a supervisory framework and parameters to mitigate the increasing risks these assets pose to financial stability.

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