Crypto is more affected by US monetary policy than even US stocks.
Why & what it means for your portfolio:
Estimates show crypto prices have become more sensitive to US monetary contraction than stocks over past cycle, i.e. when Fed tightens it hurts crypto (a lot) more than equities.
’Tis ironical given prevailing narrative of crypto as a “hedge” against volatilities in tradFi mkts & inflation (more on this in a min).
Why is crypto having outsized response to Fed policy? 3 main reasons:
1. Massive inflow of institutional investors since 2020
Institutional money grew from nothing to 70% of crypto txn volume in past cycle.
Two important effects this has on mkt:
1) Institutional money has more access to leverage & is more sensitive to interest rate / funding cost changes, leading to larger reactions of crypto prices to macro environment change.
2) Institutional money is heavily invested in tradFi, leading to larger spillover from equity mkt to crypto when the former is affected by macro. This is evidenced by increasing correlation btw stocks & crypto since 2020.
2. Massive increase in leverage
There was little on-chain liquidity b/f 2020. Advent of DeFi changed that. TVL & leverage went vertical in 2021 thanks to growth of DeFi money mkts, liquidity pools & complex yield products.
Institutional money were channeled to DeFi lending through CeFi products & exchanges. Hard to gauge how much institutions were involved in DeFi lending & yield farming directly & indirectly. Possibly not far from institutional portion of overall crypto txns, i.e. > 50%.
Fast growth of crypto derivatives on centralized exchanges also fueled demand for leverage, which was met by new inflows into crypto by predominantly, again, institutional players.
After several CeFi entities (e.g. Celsius, Voyager) blew up this yr, DeFi maximalists argued if lend/borrow were all done in DeFi it’d be *safer* for the system, as loans would be over-collateralized & programmably liquidated.
That’s wishful thinking.
Yes DeFi may be less exposed to certain risks— e.g. duration mismatch, counter-party default— compared to CeFi platforms.
But it magnifies other risks. E.g. programmability & composability make rehypothecation (i.e. collateral reuse) super easy, which leads to more interconnected protocols & encourages higher overall leverage.
Different systems have their own strength & weakness. But at end of day leverage is leverage. The large leverage buildup in a system, the more dramatic ensuing deleveraging would be.
Rather than eliminating systemic risks, programmability & composability likely make leverage cycle more acute— w/ steeper but shorter peaks & troughs compared to tradFi systems.
Changes in DXY index has bigger effect on crypto than on equities or commodities.
USD is single biggest fiat currency in crypto mkt: tokens are mostly priced in dollar, USD stablecoins account for 95% of stablecoin mkt, & lend/borrow are largely executed in USD stablecoins.
But crypto is world-wide & most users are outside US. When USD appreciates, tokens become de facto more expensive for non-US investors whose purchasing power is based in other fiats—> reducing inflow into crypto mkt mechanically.
Plus USD stablecoin borrowing becomes more expensive when USD appreciates—> weakening reflexivity in crypto mkt that’s fueled by leverage.
Current Fed tightening has led to one of the fastest dollar appreciation stretches in past 20 yrs. You can deduce the rest.
4. Compounding effect of different factors
Note that factors mentioned above do not work in isolation but instead interacting w/ each other to compound the impact.
E.g., entry of institutional players increases demand & access of leverage in crypto. Higher system leverage increases impact of spillover from equity mkt & of dollar appreciation.
Result is Fed policy & macro environment having even larger effect on crypto than on tradFi mkts.
Implications for individual investors:
Exponential growth in crypto mkt over past couple yrs has led to sea changes in mkt structure & mkt participant profiles. Certain crypto narratives that may have got you interested in this mkt at beginning are no longer true.
How should you react?
A few thoughts:
1. Large cap tokens are no longer a “hedge” against overall mkt risk
A popular selling point for crypto used to be that it’s an asset class offering superior return profile uncorrelated w/ rest of your portfolio in stocks, bonds, real estate.
But lack of correlation w/ tradFi wasn’t b/c of some censorship resistance magic or decentralized mythical quality of crypto. Instead it was due to boring reasons:
1) mkt cap was too small for institutions to enter
2) investor base was mostly retail
3) system leverage was small
4) dominant investor demographic—e.g. libertarian young male— had little overlap w/ tradFi investors
As crypto adoption grows across different strands of society, these factors no longer hold, esp for large cap tokens like BTC & ETH. I don’t see the trend to reverse as digital assets go even more mainstream, i.e. the days of “crypto exceptionalism” were not coming back.
This is not to say don’t buy BTC or ETH, but rather these are now judged (and priced) by same criteria as your typical high growth tech stock, i.e. according to size & growth of their platform economy. They may have a special space in your heart, but not in the mkt.
2. Smaller cap tokens & emerging crypto sectors still offer prospects for uncorrelated returns
Metaverse is still virgin territory & tokenization revolution barely starting.
Same factors that led to uncorrelated return profile in large-cap tokens’ early days still apply to other tokens w/ high growth potential & serving distinct digital economies. Look for opportunities that fit the factors we already discussed—
1) small mkt cap
2) retail investor base
3) adoptor demographic not overlapping w/ existing crypto investors
4) potential for new network-effect economy
3) & 4) are key for possibly outsized returns uncorrelated w/ broader mkt.
This is one of the reasons why I’m optimistic abt utility tokens from web 2.5 companies. They can bring in a different demographic to crypto via their existing user base, while leveraging tokenization to create new network economy.
If you think abt these fan tokens for a sec, they actually checked box for all 4 factors mentioned above:
1) small mkt cap: ✅ largest one has mkt cap < $55 mil
2) retail investor base: ✅ token buyers are sports fans of individual clubs
3) non-overlapping investor demographic: ✅ buyers are introduced to the token by football clubs. Most aren’t existing crypto natives
4) network-effect potential: ✅ sports & sponsorship are huge biz, def possibility to create network economy w/ tokenization
Not saying you should def go buy those tokens (will share some thoughts on fan/social tokens in separate post). But an example of factors to look for to find uncorrelated returns in crypto today.
3. The need to shift investment mentality from religion to reason
For longest time crypto had a cultish culture of us vs them, w/ rampant tribalism & supporters of different ecosystems shooting frequent playground insults at non-believers & at each other.
Tuning out opposing views & faithfully DCAing (dollar cost averaging) into XYZ tokens regardless of price volatility was lauded as heroic & wise behaviors.
Religion is needed to uphold support for a project when real adoption is low & you can’t get hold of much measurable data to substantiate faith otherwise. But that’s changing fast.
As real network economies begin to emerge on blockchain platforms, protocols start to have “fundamentals” to track. Tools like DeFi Llama & Artemis are offering better real time analytics of protocol health & growth. Token pricing will increasingly reflect those metrics.
Growing dominance of institutional investors accelerates this change from religion to reason. Institutions aren’t used to basing portfolio decisions on faith, but instead on tangible metrics like companies’ sales & earnings growth, cashflow, balance sheet health.
This perspective can & will be extended more & more to crypto due to more substantiated fundamentals & better data. And where institutions go, retails will follow.
As individual investor you care abt companies’ sales & earnings growth not b/c they’re necessarily important to you, but b/c you know institutions use those metrics to decide where to put their money. Same will be true for crypto & increasingly so.
As result crypto investments will be more & more data & metrics driven just like in tradFi equities. Whether that necessitates any behavioral change on your part is something for you to think abt.