Best Practices of Crypto-Assets Portfolio Diversification
Co-Authors: Patrick Poirier, Michel Laporte
Since the initial papers on cryptographic electronic money systems, and the creation of Bitcoin of pseudonymous developer Satoshi Nakamoto in the midst of 2008, cryptocurrencies have seen a monumental rise in popularity from both institutional and retail investors alike seeking to capitalize on some of its rising value. While the digital asset market saw a steep decline after the first record highs in the early 2018, it’s been climbing steadily with Bitcoin (BTC) still leading the market capitalization share at around 60%.
Assets such as Bitcoin (BTC), Tether (USDT), and Ethereum (ETH) are, and will remain staples in any digital wallet for the foreseeable future, but the deployment of new exchanges, strategies, and the wider adoption of this kind of alternative asset is paving the way for even more emerging cryptocurrencies. With more than 8,000 different assets available on the market as of this writing, the debate on how the concept of diversification plays a role in risk management and hedging opportunities against other kinds of cryptocurrencies and more conventional markets is still a very active topic.
Stock Market & Crypto Correlation
As shown in the figure above, if we take a snapshot of the cryptocurrency market with some of the largest coins and tokens by market capitalization, there was a strong correlation across the board with only a few exceptions during the year 2020. A similar correlation profile is found if we were to take, for instance, 40 stocks from the information technology sector. While we can assume for stocks within a single sector to have a certain degree of correlation, this is also the case for the cryptocurrency market in general. In contrast, if we take a look at the third matrix it shows a well diversified portfolio inspired by the interviews of notable asset manager David R. Swensen from Yale University. The portfolio includes assets such as stocks, developed and emerging markets, real estate, treasury bonds, inflation protected assets, among other things.
Overall the difference between the first and second matrix compared to the third shows that conventional diversification techniques inside the cryptocurrency industry would not shield an investor against market risk. It would be necessary to identify non-crypto assets to include in a diversified portfolio.
The correlation inside the cryptocurrency markets is also not something new. When we compare Bitcoin (BTC) against other large coins and tokens, we observe that they kept a strong positive trend for the most part over the last 5 years. Although there are some exceptions occurring periodically where the correlation gravitates toward 0, or even diving into negative coefficients. This was in part attributed to uncertainty regarding regulations and lower trading volumes among certain assets. Since 2018, as the appreciation and market capitalization of large cryptocurrencies grew, so did their correlation among each other.
Despite the correlation, return on investments is stronger in cryptocurrency markets
As shown in the figure above, while some major market indices have made steady climbs over the past years, their performance has been eclipsed by assets such as Bitcoin (BTC). However this performance comes at the price of high volatility.
Volatility has long been a motivation for some investors, while deterring others. It has often been associated with higher returns and as we can see from the last figure, this remains the case for Bitcoin (BTC). From the last figure we can see a 7 day rolling standard deviation from price changes that captures the effect of swings. To the defense of cryptocurrencies, this volatility can be attributed to the maturity of the market and the unrelated purposes coins and tokens tackle. Despite the chart above and its growth, Bitcoin (BTC) remains one of the most stable assets in the crypto market.
Stablecoins and Currency Markets
In 2014, a new type of asset entered the fray under the concept of stablecoins. As their name suggests, stablecoins attempt to tackle the issue of price volatility and fluctuation inherent to current cryptocurrency markets, their solution? To back their holdings against more traditional assets such as fiat currencies, exchange-traded commodities, and even other cryptocurrencies. The first of its kind to spearhead this movement was called RealCoin, later renamed Tether (USDT), pegging its price to the USD.
With stablecoins came the opportunity to provide digital currency exchanges a medium of exchange without involving fiat currencies, which could on occasions result in regulatory issues. This new type of coin brought about the best of both worlds- the fast and efficient settlement of transactions associated with cryptocurrencies, and the more price stable characteristics of an established fiat economy. Some major stablecoins in circulation today include Tether (USDT), True USD (TUSD), Paxos Standard (PAX), and USD Coin (USDC), among others.
While some of the first attempts at developing a stablecoin had some controversy attached, it has nonetheless become a popular vehicle as a medium of exchange between platforms, even with companies such as Walmart and Facebook looking into the introduction of their own stablecoins. One key characteristic of this type of asset is its low correlation with other cryptocurrencies due to its very unique profile. Taking as example the last matrix figure, in contrast to the 0.83 correlation coefficient between Bitcoin (BTC) and Ethereum (ETH) during the year 2020, most of the stablecoins share no price correlation between both each other, and the aforementioned assets.
We can take as example Tether (USDT), with its impressive 21bn USD market capitalization, had a correlation coefficient of 0.18 with Bitcoin (BTC). The reason behind this behavior is attributed to a stablecoin’s collateral security often fluctuating outside of the cryptocurrency economy. Hence, they have become an attractive means of diversifying wallets, often allowing for the ease of movement between a more volatile asset, and another. Just like Gold is often used as a refuge asset in times of turmoil, stablecoins can be used for the same purpose, however the vast majority of them are pegged against USD. This last statement should inspire fear since more than 35% of the USD supply was printed in 2020 to fight the COVID-19 pandemic. As such, it is difficult to predict if USD will maintain the stability it once had.
Other notable options
Another interesting development was the expansion of smart contract platforms. While not a type of asset on its own, after the success of the Ethereum (ETH) network, these platforms started emerging to handle different needs and shortcomings of the original projects. Some of these even have coins of their own.
Some examples include the Cardano (ADA) network with its internal currency called ‘Ada’, the ‘ATOM’ with the Cosmos network, or ‘XRP’ with the Ripple (XRP) network. This results in giving these internal coins a similar profile not only among themselves as seen with the performance of the Ethereum against other networks, but also with the more popular Bitcoin (BTC). Without the latter, some of the major coins of this category sported a mean correlation coefficient of 0.60 during the year 2020, showing a positive relationship. Notice that Polkadot (DOT) is only partially correlated to Bitcoin (BTC) with a coefficient of 0.31 during this time period.
Despite their clear correlation, they offer different solutions depending on the risk profile of the investor. For more passive strategies, the smart contract networks or platforms often return dividends, or interests on coins or token staked. Some examples of these include VeChain (VET) and NEO (NEO), among others. These can provide simple solutions to volatility tolerance.
Commodities are not correlated to currencies or crypto-assets
As seen from the figure above, we can also see that after taking a varied basket of commodities and currencies, those markets fluctuate outside of the cryptocurrency market environment. There is clear correlation between some metal commodities, being the case with gold and silver, which are seen as hedging options against traditional markets, but this relationship does not affect assets such as Bitcoin (BTC), or cryptocurrency markets in general.
Given the very absence of correlation between certain commodities, fiat currencies, stock market, and crypto-assets, one can predict a rise of commodity-pegged stablecoins as a necessary instrument to unshackle crypto-assets from USD predominance.
To make this point more apparent, we can see that even with an 8 month rolling correlation between Bitcoin (BTC) and this same basket of commodities and currencies, that the relationship remained intact through the last 5 years, with crude oil reaching both the highest and lowest coefficients of 0.24 and -0.21 respectively in 2015.
Bitcoin is not the new Gold
It seems clear that both the traditional markets and the cryptocurrency ecosystem exist as independent economies but in times of market panic, they show a stronger relationship. This was seen during both during the earlier adoption period of this alternative investment option, and the early sightings of the 2020 pandemic during April and March, where the renowned fear-gauge reached its all-time record high, all the while major indices took a sharp downturn, hitting record bottoms. The cryptocurrency market made a rapid recovery but the correlation between both markets in time of extreme sentiment was seen in plain sight as shown in the last figure. As such, Bitcoin (BTC) is not the new Gold, it is not a refuge asset in time of financial crisis. Gold and other such commodities still have no equivalent except for stablecoins pegged on gold such as PAX Gold (PAXG).
Different assets serve different purpose
Cryptocurrencies have become an accredited alternative investment vehicle to diversify a more traditional portfolio, but it is difficult to put the pieces together on how to, in turn, diversify a cryptocurrency portfolio. At the moment, coins and tokens that show either a null or small correlation are few, and often used as a utility mechanism for various purposes such as to facilitate transactions between different exchanges, which is the case for stablecoins. At present, the movement of Bitcoin (BTC), and other large coins and tokens share a similar story. This opinion also takes into account the wild price volatility of smaller more recent assets that are often shrouded in uncertainty.
More complex and creative solutions to current needs in the form of coins, tokens, and smart contract platforms need to emerge before a real opportunity and means of diversification present itself. Even today, new regulations threaten the integrity of the popular privacy coin, while in contrast, some governments are starting to adopt smart contract platforms to modernize and scale their infrastructure. It is difficult to predict the nuances of the cryptocurrency market as it is still a new one and it will have to mature before the dust settles. Most of the portfolios that have performed well over time, have gone against traditional strategies and gambled for a few good performers, betting on a few winning horses instead of a varied basket of assets. So until a more widespread adoption of cryptocurrencies happens, hold onto that small basket of eggs tight!
Cryptium, a commodity-pegged high-yield, low volatility crypto-asset
The facts described above led our investment fund Dragon’s Vault, to pursue the development of our own crypto-assets designed entirely to solve some of these issues to become a reliable utility to manage business operational cash flows of our investment portfolio. Cryptium, is a high-yield, low volatility, business focused crypto-annuity pegged against Gold for now. However, we aim to peg Cryptium to a basket of commodities in the near future as one becomes available. Especially one composed of milk, orange juice, rice, and other basic necessities of life. This would enable Cryptium to be uncorrelated to the stock markets, other crypto currencies, and fiat currencies.
Existing stablecoins would not benefit the companies we invest in, since by definition they are stable without high return potential. Cryptium on the other hand is built to allow high growth, but utilize elastic supply and collateral mechanisms to prevent loss of value for the risk-averse investors that want to rely on Cryptium to convert a portion of their business cash flow to crypto-assets without the high volatility risk.
Conclusion
A diversified portfolio of only crypto-currencies is not currently achievable given that most crypto-assets are highly correlated to one another. However, despite the high correlation, the value appreciation of crypto-assets far outpace conventionally investments such as the stock market. With that said, new crypto-assets, such as Cryptium, are being designed entirely to be uncorrelated to other crypto while still benefiting from high growth potential without high volatility. There will be a time in the near future where investors will be able to properly diversify their portfolio to protect against risk, but for the moment, investors need to invest in a mix of commodities, real estate, etc. to properly shield themselves against a potential heavy correction from the crypto-industry.
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