Not so Cryptic Take on Crypto
Addressing Volatility, Risk, and Central Bank Digital Currencies
Multiple traditional asset institutions have released reports on cryptocurrency, with mixed views, discussing digital assets as an investment. Large institutions are taking notice of crypto and researching the asset class, but there are a few overarching themes that we’d like to approach.
FalconX has been deeply involved in building tools for institutional asset managers, and our mission is to support our clients with not only technology and products, but insight into a nascent asset class that many are exploring for the first time. We will publish a series of articles expounding on misconceptions, institutionalization, and technological advancements that we encounter every day.
A quick summary:
- Bitcoin’s volatility is often viewed in a negative light, but has acted as a catalyst in attracting participants to crypto.
- Central bank digital currencies are not incompatible to bitcoin, but synonymous with stablecoins like USDC that already exist, and have a different use case than bitcoin.
Bitcoin is too volatile
While Bitcoin may seem like a volatile financial asset, the volatility in cryptocurrency markets cannot be equally compared to those in traditional markets. Here’s why.
5x more time
First, the US stock market is open 32.5 hours per week compared to bitcoin’s 24/7 nature of 168 hours per week. That equates to bitcoin being “open” almost five times more often. If we also consider that 60% of the US trading volume is during the first and last hour of the trading day, there is a considerable concentration of activity focused on a much shorter time and a multitude of market participants paying attention.
Bitcoin experiences a concentration effect of volume in a pattern that follows the sun, spiking when morning time rolls around for Asia (12:00 UTC), around US market open (14:00 UTC), and US market close (20:00 UTC). As shown on the chart below from Skew, this leads to periods where trading volume is light, magnifying the effect market participants have on price impact.
Volatility pattern similar to emerging tech
Cryptocurrency and blockchain technology are concepts that challenge legacy industries, just as Amazon forever changed brick and mortar retail (not to get sidetracked, but I love this video). As the world’s fourth-largest company with a market capitalization of $1.58 trillion, Amazon’s volatility tracks closer to that of the S&P 500 than a risky startup. In late 2001 during the internet bubble, Amazon experienced a drawdown of over 93%, and its six-month rolling volatility hovered around 100% during its first five years as a publicly traded stock. When comparing bitcoin and Amazon’s volatility over their first years in existence, they follow strikingly similar characteristics.
Bitcoin volatility is a feature, not a bug
Bitcoin’s elevated volatility has also fueled a technological boom. Traders crave opportunity, and bitcoin has planted the seed to a new financial infrastructure. New products like 100x levered contracts and perpetual futures were conceived for cryptocurrencies. Free, direct APIs to hit exchanges, and swap contracts have existed, but never have been accessible. Bitcoin has fueled a generational adoption of taking risk and the stomach acid that comes with it. The gamification of trading has intensified this risk-taking in traditional assets, but when diving down the rabbit hole into crypto, there is an astonishing amount of technological development taking place that will upend the traditional financial infrastructure.
For the more institutional-minded, rarely has an asset presented itself with an asymmetric risk profile like bitcoin. Modern Portfolio Theory suggests that risk is calculated, fit within a balance of high-risk and low-risk investments to optimize a return stream. Bitcoin’s Sortino ratio exacerbates that of the highest performing stocks over the last ten years. Risk is not a bad thing, especially when the compensation is outsized. The chart below highlights bitcoin’s premium in reward received for downside risk taken in comparison to the best-performing stocks over the last decade.
Central Banks will replace bitcoin
The word replace holds much weight here because, ultimately, it depends on your view of bitcoin itself. Is it a replacement of the US dollar as the world currency? Or is it a store of value, a new version of gold, and viewed as an inflationary hedge?
As noted in Bank of America’s report, several central banks are working on developing central bank digital currencies (CBDCs). Furthermore, the report quotes ECB Executive Board member, Fabio Panetta, who wrote:
“A digital euro would combine the efficiency of a digital payment instrument with the safety of central bank money. It would complement cash, not replace it.”
Stablecoins, like USDC, are already doing this. 1 USDC is always equal to 1 dollar; for every USDC circulating globally, there is one US dollar held in treasury. Furthermore, Grant Thornton LLP audits the treasury and shares the results publicly. There is currently $10 billion of USDC in circulation, and $534 billion has been transacted on the network. A far cry from the $1.2 trillion US Dollars in circulation, but the experiment works. USDC can be created and redeemed, enabling the circulating supply of the digital form to match supply and demand for holding the asset in its digital form.
So how does bitcoin fit in here? Bitcoin is too slow, cannot process transactions fast enough, and is too volatile — these are the major argumentative points against bitcoin becoming a global currency. Bitcoin is currently averaging 3.4 transactions per second (TPS), with a maximum of 7 TPS; this is hardly competition with Visa processing 1,500–2,000 TPS and having the capacity for up to 65,000 TPS. Future technological upgrades to bitcoin like the lightning network, or an alternative, may be able to eventually compete given the rate of advancement in the space.
The BofA report notes:
“Global central banks pulled out all the stops in 2020 to counter the COVID-19 crash, delivering 190 rate cuts and $8tn in stimulus, equal to $1.4bn spent every hour. In our view, the big investment trends of the 2020s are bigger government, smaller world, US dollar debasement, fiscal excess and more accommodative central banks.”
How does one protect their purchasing power in this kind of environment? Gold? Since the end of 2019, the United States M1 money supply (the amount of circulating currency) is up 232%, but gold has only appreciated by 4.5%, hardly a perfect hedge. Bitcoin is up 621% over the same time period, and was created out of the Great Recession as an alternative to fiat currency during the first significant stimulus effort and, thus far, has performed admirably well during this money printing regime we are in. It remains to be seen how this will hold up over time, but it’s two for two on inflation hedging during an economic crisis.
What’s next?
We’re excited that large financial institutions are taking notice of cryptocurrency. After all, many of us at FalconX came from traditional finance, and all went through our own journey that started with dismissal, but intrigue led to discovery. Peeling back the first layers of news headlines and statistics often touted, we found out that it wasn’t just a currency or internet money, but a fundamental shift in how trading, investing, and banking was going to be upended by an idea started by cyberpunks, outcasts, and anonymous founders. Cryptocurrency investing is not for everyone, but the world is approaching a divergence where dismissal without understanding is going to be the basis for enduring a generational shift or being left behind. Our next article in this series will focus on energy consumption and the concentration of large holders.
David Martin is an experienced finance and fintech professional, starting his traditional finance career focused on trading, quant modeling, and managing portfolio risk. Since 2017, David has centered on his passion for financial technology, founding AlphaStream Analytics, a hedge fund risk management platform, and was the CIO at Blockforce Capital — a quantitative, multi-strategy hedge fund focused on managing volatility in crypto assets. Prior to joining FalconX, David was charged with building front office tools at Ridgeline. He recently joined FalconX as a member of the product team focused on the institutionalization of crypto as an asset class.
This document is not investment advice and FalconX is not an investment advisor. This information is for informational purposes only. The information contained herein is the opinion of the author and does not necessarily reflect the opinion of FalconX.
