May 11, 2021
Can Ethereum Provide Institutions with A Source of Diversification?
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If anyone has been following Ethereum over the past few weeks, you’ve noticed some insane price action, especially compared to Bitcoin. Over the last week ETH has gone up nearly 18%, compared to BTC which has had some ups and downs but is down 3%. This divergence in recent performance is especially fascinating when placed in the context of the trend we’ve been seeing over the past 6 months. In the fall, when this bull market took off, ETH generally moved in a fairly consistent pattern relative to BTC — Bitcoin would go up and Ethereum would follow with an even stronger move upwards a day or two later. When Bitcoin dipped, Ethereum would follow, again more aggressively. The pattern appeared consistent and predictable — like clockwork. For many institutional investors Ethereum was considered the more risky exposure which they would dip their toes in only after they got comfortable with Bitcoin — ETH offered a higher risk, higher reward profile for those who could stomach the volatility. Especially for those new to crypto, Bitcoin offered plenty of risk on its own (in particular compared to the traditional assets) and there was little appetite to venture further out the crypto risk curve.
But what’s been fascinating about the 3–4 weeks of ETH performance is that it is beginning to show signs of carving out its own path in providing an uncorrelated source of crypto return relative to Bitcoin, holding the potential of providing diversification and helping to reduce risk rather than increase it from a total portfolio perspective.
Now the sample size is small, but three events over the past month got my attention. The first is when BTC crashed after the hype and pump around the Coinbase IPO. BTC reached an all time high of nearly $65K in mid-April only to come crashing down below 50K ten days later. There are a few explanations for the crash, the most common being that the Coinbase IPO generated a Bitcoin mania and was fueled by excessive leverage, which led to a rapid downward spiral when futures positions were liquidated on the initial dip. During this same period, ETH modestly rose leading up to the Coinbase IPO but experienced a much more moderate correction: While Bitcoin sunk for ten consecutive days (which for many investors new to crypto was their first taste of what a normal market correction feels like), ETH was basically flat. For those that held a balanced BTC-ETH portfolio, that diversification was comforting, somewhat mitigating the roller coaster ride of investing in such a volatile asset class.
What’s even more interesting is what happened last week, on May 4th, when Treasury Secretary Janet Yellen alluded to the potential need to raise rates to keep the economy from overheating. Now, raising rates isn’t even Secretary Yellen’s current job, but given her current role and experience as former Fed Chair, her words still matter to markets, and the far end of the risk curve sold off in response to her remarks — spooking both tech stocks and crypto. Ethereum fell, but Bitcoin fell by more, and Ethereum was able to recover and continue on its upward trajectory more quickly than Bitcoin. This pattern was displayed yet again today, when tech and crypto sold off, and while ETH took a hit, it was able to recover quicker than BTC and the broader crypto market.
There are a few possible explanations for Ethereum’s performance and resilience at this particular moment in time, including but not exclusive to: 1) The NFT and DeFi boom, much of which depends on Ethereum’s infrastructure and requires the purchase of ETH to participate in. 2) The ongoing Ethereum Improvement Proposals (EIP) including the recent Berlin fork and the upcoming London Fork which are part of Ethereum’s transition from a Proof of Work to Proof of Stake protocol designed to make ETH more scalable and sustainable. 3) The European Investment Bank’s recent issuance of their first ever digital bond through Ethereum 4) Institutional money starting to look at Ethereum as something to invest in parallel to Bitcoin rather than investing in ETH in sequence after they get comfortable with BTC. With a market cap less than half the size of Bitcoin, a big purchase of ETH leads to an even bigger market impact.
Some of the phenomena currently driving ETH’s price may be short term in nature and there are a lot of open questions remaining to be answered including how long this DeFi boom will last and will the EIPs translate into real and working improvements for Ethereum? While time will tell, the question of whether ETH can provide reliable diversification to an institutional investor’s BTC allocation is one worth investigating. While some coming from traditional finance view ETH more as a levered exposure to BTC (if they even heard of ETH to begin with) perhaps it is more appropriate to see ETH as something entirely different. And because it’s different, and different forces are driving ETH’s performance, it is worth asking whether ETH can provide a source of diversification and rather than increasing risk, allocating ETH alongside BTC can actually reduce the volatility of an investors crypto portfolio.
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