The rising popularity of Bitcoin is posing a threat to financial markets and ASX investors should be alive to this risk as well.
That’s according to an analysis undertaken by the International Monetary Fund (IMF). The study found a high correlation between cryptocurrencies and major share indices.
The connection between Bitcoin and shares
“Crypto assets are no longer on the fringe of the financial system,” said the IMF in its blog post.
“Amid greater adoption, the correlation of crypto assets with traditional holdings like stocks has increased significantly, which limits their perceived risk diversification benefits and raises the risk of contagion across financial markets.”
The market value of cryptos surged to around US$3 trillion in November last year from $620 million in 2017.
Why Bitcoin is more correlated now
The connection between the digital asset class and shares didn’t quite exist till the outbreak of the COVID-19 pandemic in early 2020.
Pre-COVID, cryptos and shares moved independently. But the flood of money unleashed by central banks around the world changed that, according to the IMF.
Why ASX investors should care is because of the potential spill-over effects. For instance, if the price of Bitcoin crashes, it could trigger a sharp sell-off in global shares.
How cryptos can cause a share market crash
This isn’t as farfetched as you might think. The IMF calculated that around one-sixth of the volatility on the S&P 500 (INDEXSP: .INX) is caused by the volatility of Bitcoin.
“As such, a sharp decline in Bitcoin prices can increase investor risk aversion and lead to a fall in investment in stock markets,” added the IMF.
“Spillovers in the reverse direction—that is, from the S&P 500 to Bitcoin—are on average of a similar magnitude, suggesting that sentiment in one market is transmitted to the other in a nontrivial way.”
No safe haven for Bitcoin investors
The other follow-on effect for ASX investors to note is that Bitcoin doesn’t make a good safe haven asset. There has been plenty of talk about how Bitcoin could replace gold.
But gold has a much weaker correlation to shares. History has repeatedly shown that gold outperforms during a financial crisis, such as the GFC. As it turns out, Bitcoin could actually be a source of a financial crisis.
Another point to note is that it may only be a matter of time before global regulations are imposed on cryptos.
If the IMF’s analysis is right, it is unlikely that governments would allow cryptos to trade without the same rules that apply to other assets in the financial system.
What’s also interesting is that the IMF article doesn’t talk about what happens when central banks withdraw stimulus.
If the sharp increase in loose monetary conditions drove an increase in correlation between crypto and shares, the question remains of whether the reverse will happen when monetary conditions tighten, as they surely will.