Crypto: all systems go?

02 February 2024

Nikola Vasiljevic, Ph.D., Head of Quantitative Strategy, Zurich, Switzerland; Lukas Gehrig, Quantitative Strategist, Zurich, Switzerland

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Bloomberg unless otherwise stated, and are accurate at the time of publishing.

Key points

  • After a surge in leading cryptocurrency valuations last year and a long-anticipated regulatory approval of “spot bitcoin” ETFs in January, could crypto’s moment finally have arrived?
  • The US ruling on spot bitcoin ETFs potentially opens the doors to a flood of institutional money being ploughed into the asset class
  • However, as our analysis shows, there is a scary side to crypto – with drawdowns of as much as 80%-90% and sluggish three-year recoveries witnessed since 2014, which dwarfs any dips seen in global equities
  • For all the early promise, cryptocurrencies remain a risky option and have little role to play as a long-term portfolio diversifier. However, this could change if crypto assets develop their capabilities as currencies and sharpen their profile as investable assets

The “crypto winter” is over, given the stellar performance of the largest cryptocurrencies in 2023. Furthermore, US regulators added to the positive sentiment in January with the long-anticipated approval of “spot bitcoin” exchange-traded funds (ETFs). Although investors could already gain exposure to the main cryptocurrency and trade in it via some platforms (such as brokerage houses, mutual funds and peer-to-peer payment apps), the approval of spot bitcoin ETFs promises to expand the market and acceptance of crypto.

Those unable to hold bitcoin, can now use liquid ETF wrappers instead. The regulator requires that sponsors of these products meet some criteria to ensure that certain protection mechanisms, such as full, fair, and truthful disclosure about the products, are in place for investors.  

Since the ETFs will be listed and traded on registered national securities exchanges, investors will benefit from monitoring and other control measures to address any conflict of interest, and to prevent fraud and manipulation. Indeed, the existing rules and standards of conduct that will apply to the trading of these products are expected to provide additional protection against certain risks. 

However, do the regulatory actions increase the attractions of holding cryptocurrencies in well-diversified portfolios? 

No endorsement by regulators in sight

Over the last five years over 20 exchange-rule filings for spot bitcoin ETFs have been rejected. For this reason, some financial markets now believe that the regulatory tide has shifted in favour of crypto acceptance. Ultimately, this could lead to much higher institutional investment in crypto.  

However, the Securities and Exchange Commission’s official release on 10 January made it clear1 that the ETF approval does not endorse bitcoin. The regulator stressed that crypto investments remain highly speculative and volatile, and often allow illicit activities. 

Taming Wild West tendencies 

Since their inception, crypto markets have vacillated between incredible booms and busts. Among the most memorable events, were the fall of the largest crypto exchange in 2014, via the hack of Tokyo-based Mt Gox, the COVID-19 market crash in 2020 and the collapse of several stablecoins, as well as the demise of crypto exchange FTX in 2022. 

Fortunately, the above failures did not spill over to the traditional financial system. However, keeping in mind that the ambition of a large part of the crypto community is to decentralise finance, potential systemic risk should not be underestimated.  

Not a currency in the traditional sense

The term cryptocurrency gives the impression that the asset functions as a currency, and while many shops allow cryptocurrencies as a means of payment, they should not be considered as such.  

Currencies generally fulfil three functions: a means of payment, a store of value and a unit of account. While at a push crypto might act as a means of payment, it is not a desirable store of value or unit of account, based on the high levels of volatility often experienced. 

This lack of the basic functions of money makes the likes of bitcoin more of a crypto-asset than a cryptocurrency. Similarly, precious metals and highly liquid government bonds can satisfy some functions of money some of the time, but not all of them all of the time. 

Is it a digital gold?

Given the similarities, crypto has been flagged as a potential inflation hedge, akin to precious metals. There are some similarities between them, such as scarcity and transactability. However, overall, it seems hard to draw a parallel between the two assets.  

The maximum drawdown for main cryptocurrencies since 2014 has been around 80-90%, and the recovery time was as long as three years. Over the same period, global equities’ biggest drawdowns were up to 35%, with far shorter recovery times.

Finding a role for crypto 

In judging whether allocations for crypto-assets might be appropriate in a multi-asset portfolio, the first port of call is an analysis of their correlation to global equities and bonds. This suggests that crypto-assets sit within the ‘risk-on’ basket, exhibiting medium correlations to equities that are exacerbated during market drawdowns (see chart). As a result, the asset class does not seem to qualify as a portfolio diversifier in its own right, but competes with equity-like assets for a role in a diversified portfolio.

Crypto-equity correlations exacerbated in drawdowns 

Rising six-month rolling correlations to equities during drawdowns, in a 60% equities/40% bonds allocated portfolio, suggest that cryptocurrencies are not portfolio diversifiers

Crypto-equity correlations exacerbated in drawdowns

Source: Bloomberg, Barclays Private Bank, January 2024

A speculative position, but not a new portfolio staple

If crypto is not used to help diversify a portfolio, it might be employed as a small, speculative position to add additional spice. While potential rewards could be large, correlated speculative spice does not generally have a role to play in a well-diversified portfolio, due to its undesired features during portfolio drawdowns.

To visualise this point, what might the marginal contribution to the historical drawdowns of a global equity-bond portfolio be, when making small allocations to a basket of large cryptocurrencies? While manageable at a one percent allocation to cryptocurrencies, the added maximum drawdown increases quickly as the allocation to crypto grows (see chart). As suggested by the correlation analysis above: this analysis shows no diversifying qualities for including the asset in a diversified portfolio.

To conclude, cryptocurrencies and long-term portfolios that seek to grow capital and minimise losses during drawdowns do not go well together, at this point in time. This could change if crypto assets develop their capabilities as currencies and sharpen their profile as investable assets.

Allocation to cryptocurrencies exacerbates drawdowns

The addition of small allocations to large-cap cryptocurrencies exacerbates the drawdowns of a global equity-bonds portfolio, while not providing notable diversification benefits during drawdowns 

Crypto-equity correlations exacerbated in drawdowns

Source: Bloomberg, Barclays Private Bank, January 2024


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