Crypto Long & Short: What Trends in Volatility Could Mean for Bitcoin

By this stage, pretty much everyone knows that bitcoin’s volatility is well above that of equity markets. This is still true, even after the ructions of March.

What is less well-known is the balance of power when it comes to volatility is shifting. Market data indicates bitcoin markets are becoming less volatile, and equity markets more so. This seems to be unrelated to the crash in markets earlier this year.

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Of course, it’s possible this trend turns again. On the other hand, it could point to a broadening interest in bitcoin as an investment asset, as well as a new role for the cryptocurrency in portfolios.

Let’s look at the details.

It’s all relative

First, bitcoin’s volatility is currently below its 2019 average. Not so for the equity markets.

(Note: We calculate volatility by annualizing 30-day standard deviations. This smooths variations while still reflecting short-term trends and, as of mid-April, removes the effects of the March crash.)

Over the past month, BTC volatility has continued trending down, while S&P volatility has levelled off.

This could be a short-term anomaly. Or it could mean the “standard” expected S&P 500 volatility is now at higher levels than before, while bitcoin’s is lower.

The VIX index, which measures expected S&P 500 volatility using options prices, is currently almost three times higher than at the beginning of the year.

Second, this shift is supported by activity in traditional market volatility instruments. Earlier this month, the Wall Street Journal reported on data from Cboe Global Markets data that showed more than a trillion dollars’ worth of derivatives tied to the VIX has traded this year, more than four times the figure a decade ago. It also cited figures from industry tracker Hedge Fund Research that points to a record $19.4 billion of assets in hedge funds that trade volatility.

And earlier this week, the iPath Series B S&P 500 VIX Short-Term Futures exchange-traded notes (VXX) – the largest volatility ETN by far – had its second-largest daily inflow ever.

It doesn’t matter any more

When Fidelity Digital Assets released its survey earlier this month, in which institutional investors were asked about the barriers to investment in crypto assets, volatility was top of the list.

With the narrowing of the differential, that barrier could disappear or at least significantly diminish. It’s not just that bitcoin’s volatility seems to be trending down – if volatility overall is more acceptable, bitcoin’s swings could be seen as less of a negative.

Indeed, many of today’s crypto investors see the heightened volatility as an advantage. Where else are you going to get high potential returns?

What’s more, the strong growth in crypto derivatives gives professional investors more tools with which to hedge the volatility. The breadth of instruments available to crypto investors of all types is steadily widening, and the volume of open interest in bitcoin options heading into Friday’s expiry was more than six times its level at the beginning of the year.

In crypto as in traditional markets, options are not just used for hedging, they are also used to trade volatility, a further sign of the growing interest in the strategy.

Or does it?

Stepping back, it is curious something that used to be a performance metric is now an investment philosophy. Volatility has moved from the realm of statistics to the realm of strategy.

But now there’s an even bigger shift under way.

Volatility has traditionally been equated with risk. This makes sense – the greater the swings, the greater the chance you lose a lot.

But volatility is not the same as risk, it’s a historical performance metric. True, expected volatility derived from options pricing looks forward, but that measurement is based on data points that don’t claim to actually know what future volatility will be, let alone future risk. Especially in these uncertain times, where bad news lurks around every corner and capital flows can swell across oceans in nanoseconds, we may know what the volatility was yesterday and what is expected tomorrow, but we do not know what the actual risk is.

The more we attempt to quantify risk and to harness it for portfolio improvement, the more we lose touch with what it really means. And the more we actively seek it, the more it could spread throughout the system, introducing a systemic weakness that could hurt many.

The cryptocurrency world has long embraced risk. Ferocious creativity and the potential for staggering loss have been part of the DNA of the industry since the beginning. In other words, long-term crypto investors are used to this, and anyone who comes into the sector hopefully does so with his or her eyes open.

In regulated traditional markets, however, volatility is still a relatively misunderstood phenomenon, especially in these untethered markets. It may be creeping into the general vocabulary, and may even become a more entrenched aspect of portfolio construction. But most of those handling it do not have the experience of more-seasoned traders.

Yet, volatility is not a bad thing. In this low-yield environment, it can produce necessary returns unavailable in low-volatility alternatives. Managed with skill, it can provide the outperformance many fund managers need. And with the right tools, it can form a part of even conservative investment strategies.

Changing roles

This could influence the role crypto assets have in broad portfolios. One of the prevailing narratives of recent times has been bitcoin’s role as a hedge against market risk. If things go badly in the economy and the stock market, the reasoning goes, bitcoin will benefit from being seen as an alternative to a wobbly fiat system.

Yet, so far this year we have seen that narrative falter when faced with general turmoil and uncertainty.

Perhaps a new narrative is emerging. Bitcoin is volatile, yes, but so are a lot of other more mainstream investments that populate even conservative portfolios. And the volatility differential seems to be narrowing; this might continue. If so, bitcoin could become less a market hedge and more a volatility diversifier. As more investors embrace volatility, they will hopefully do so with a variety of tools.

You’ll have heard the saying: “They can pull the carpet out from under your feet, or you can learn to dance on a moving carpet.”

Anyone know what's going on yet?

The relentless and alarming climb in the number of COVID-19 cases in the U.S. and elsewhere seems to have spooked the markets a bit this week … but just a bit. The threat of walking back the tentative reopening enjoyed in some areas is denting confidence in the consumption recovery that the market was bewilderingly assuming was just around the corner. On the other hand, there’s a lot of fresh money apparently waiting in the wings, and it has to go somewhere.

As we’re pulling out our alphabets to get a handle on what’s ahead, what do you think: a V, a W, a swoosh or a flipped square root sign? I personally favor the ampersand. It feels less linear.

True to recent form, bitcoin acted like a risk-on asset this week, reflecting broader market skittishness by almost twice breaking its monthly lows. Meanwhile, correlation with the S&P 500 is, well, not exactly stable.

Chain Links

As the chess pieces move around the board of financial regulation and prosecution, various possible scenarios are playing out. One is especially intriguing: If current chairman of the SEC, Jay Clayton, is confirmed to become the new U.S. Attorney for the Southern District of New York, President Trump will likely appoint one of the remaining SEC commissioners as acting chair until Clayton’s successor is confirmed. This could well be Hester Peirce, known for her pro-innovation stance on crypto oversight and for her public dissent on the dismissal of a recent bitcoin exchange-traded fund proposal. TAKEAWAY: This is all in the realm of speculation, but it could end up being a significant turning point in crypto regulation.

The European Union is preparing a new regulatory regime that could include stricter requirements for crypto assets, including stablecoins. TAKEAWAY: Greater regulation is resisted by many in the crypto industry as it can stifle innovation. Most investors would welcome it, however, as it brings greater clarity and acceptance. And, let’s face it, it’s inevitable as cryptocurrencies grow in popularity. The increased attention from the regulators of one of the world’s principal economic blocs is a strong sign that crypto assets are being taken seriously at the highest levels.

The New York Department of Financial Services (NYDFS) will consider issuing conditional licenses under which startups would be allowed to partner with existing licensed entities to begin operations in the Empire State, and it has signed a Memorandum of Understanding with the State University of New York allowing fledgling prospective licensees to experiment with use cases under the school’s supervision. TAKEAWAY: This is a significant change for the BitLicense regime, long criticized for being too onerous and restrictive. More importantly, this shift could usher in a new season of innovative crypto services in one of the world’s largest financial centers.

Commodity markets veteran Chris Hehmeyer, CEO of Hehmeyer Trading + Investments, is rebranding his firm to reflect its growing involvement in the crypto markets. TAKEAWAY: This is significant: Hehmeyer Trading has been a fixture of the commodities trading scene since 2007, and the pivot of such a legacy name into crypto markets sends a signal to other traders that this is where the “new” markets are. Hehmeyer has been trading crypto assets for a couple of years now, and has spoken publicly about them on several occasions, but this marks a deeper commitment to the evolution of the industry.

According to sources, PayPal plans to roll out cryptocurrency buying and selling to its 325 million users, possibly within the next three months. TAKEAWAY: The numbers alone point to how big the impact could be. PayPal’s user base is almost as large as the entire population of the United States. What is even more intriguing are the possible reasons for PayPal’s strategy shift. Could it be the significant revenue competitor Square is earning on its crypto platform?

LibertyX plans to enable cash purchases of bitcoin at 20,000 locations, including at 7-Eleven, CVS and Rite Aid stores. And Australians can now purchase bitcoin at post offices. TAKEAWAY: This significant jump in the number of onramps does not necessarily mean that retail investors will start buying bitcoin in droves; it does, however, make it a lot easier for those that want to try it out with small amounts. Going even further, just seeing the purchase points at highly frequented and trusted retail sites is likely to entrench the public’s awareness of bitcoin, and acceptance of its legitimacy.

Cryptocurrency exchange Bitstamp shared some charts framing bitcoin’s role as a store of value. TAKEAWAY: Is bitcoin a store of value? There’s data for and there’s data against. The most compelling data against is bitcoin’s lack of correlation with gold. Is that the right metric to look at?

Coin Metrics looked into whether Coinbase’s announcements of possible listings has an impact on the asset prices. The outcome? Less than you would expect. TAKEAWAY: I have questioned this practice before. Surely an announcement of a potential listing, something that might increase liquidity of an asset (and therefore, in theory, its value), can be construed as price manipulation? Coin Metrics showed the price movements after announcements of potential listings is largely influenced by the market mood at the time.

Kaiko took a close look at bitcoin options market metrics, concluding that the options market has recently showed clear signs of maturity in terms of costs and trading behavior. TAKEAWAY: The recent growth in open interest and trading volumes in bitcoin options has attracted attention from market participants, who see it as a symptom of greater crypto market maturity overall. It is also a sign of deeper professional involvement, as heavy options volumes are a sign of deep pockets and high stakes. Also, more options products are coming to market, which should continue to enhance investor demand as the array of potential use cases and configurations broadens.

The net flow of bitcoins into miner addresses dropped on Tuesday into sharply negative territory, according to crypto data source Glassnode, reaching the lowest level since June 2019. Another metric shows that nearly all of the net outflow was to exchanges, which some are interpreting a bearish signal, given the accumulating sell pressure. TAKEAWAY: On the other hand, miners usually only sell when they believe the market can handle the orders. Furthermore, miners traditionally use OTC traders to move large blocks, so there may be something else going on here. And, as the chart shows, strong net outflows don’t always presage price dips. But, given that volumes are relatively low compared to previous weeks, this is worth keeping an eye on.

Barça Fan Tokens, listed as $BAR, went on sale on Monday, and reached its cap of $1.3 million within two hours. TAKEAWAY: This is more significant than it may seem. I’ve written before about how soccer club tokens can be a gateway into asset innovation for a mainstream audience – this news shows that where there is genuine interest, the underlying technology will not be a barrier. I doubt very much that the buyers were mainly crypto enthusiasts.

Also worth reading:

• Where the NY Fed ‘Bitcoin Is Not New’ Blog Goes Wrong – Nic Carter, CoinDesk
• Why CoinDesk Respects Pseudonymity: A Stand Against Doxxing – Marc Hochstein, CoinDesk
• The Future of Inflation Is the Biggest Question in Finance – John Ainger, Bloomberg
• Is our money about to spout memories? – Claire Long and Izabella Kaminska, FT Alphaville

Podcast episodes worth listening to:

• Bull vs. Bear: Who Has the Economy Right? – Nathaniel Whittemore, The Breakdown
• How Monopolies Sow the Seeds of Their Own Destruction, Feat. Tuur Demeester – Nathaniel Whittemore, The Breakdown
• The Bank for International Settlements tackles Central Bank Digital Currencies – Chris Brummer, Fintech Beat
• Anatoly, Maya and Ryan: Experts Discuss The Parallels Between Crypto and Wireless Networks – Tom Shaughnessy, Chain Reaction