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Bitcoin’s stealth rally

Bitcoin’s outperformance in March has been driven by a combination of positive fundamental and technical factors

April 4, 2023

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Key takeaways

  • At the moment, bitcoin returns appear to be relatively uncorrelated to traditional assets like stocks or bonds, reinforcing its status as an alternative to the points of failure witnessed in the financial system.
  • Overall, we’re constructive on the market outlook over the next few weeks due to positive seasonals and the macro environment, but stablecoin dominance has already declined from 14.5% to 11.2%.

Written by

  • David Duong, CFA, Head of Institutional Research

Summary

If a month ago someone had predicted that US$229B would be wiped off the value of US regional banks (threatening financial institutions on both sides of the Atlantic), our best guess would likely not have been bitcoin prices up by 18.5% and the total crypto market cap up 10.7% to $1.15T. The performance of US stocks (proxied by the S&P 500) was comparatively flat in March, dragging the correlation between stock and bitcoin returns from 58% at the start of the year to 25% (i.e. relatively uncorrelated) based on a 65-day rolling window.

While the resilience of cryptocurrency returns has been impressive, it belies the impact that banking failures have had on the onramps (offramps) into (out of) the digital asset ecosystem. The loss of Silvergate Exchange Network (SEN) and Signet have, for example, constrained market liquidity and widened price differentials across onshore and offshore exchanges that have been difficult to arbitrage away. On the upside, there are banks in the US (as well as the UAE and Switzerland) that already seem poised to fill the gaps left by Silvergate and Signature.

One peculiarity about crypto’s recovery in March is that bitcoin outperformed other digital assets, including ether. We believe the “flight to bitcoin” partly reflects (1) investor concerns regarding the regulatory status of non-bitcoin cryptocurrencies, (2) fundamental arguments that favor digital assets as an alternative to the existing financial system, (3) the approaching end of the Fed’s tightening cycle, and (4) relatively supportive technical factors.

Let bitcoin be bitcoin

From a performance perspective, March has mainly been a bitcoin story.

Bitcoin has been outperforming its digital asset peers since mid February, but the move accelerated in early March, coinciding with the onset of the US banking turmoil. In a previous report (“Bank mismanagement”, published March 17), we discussed the asset-liability mismatches at Silicon Valley Bank (SVB) that led the US government to take decisive action or otherwise risk a potential system-wide bank run among regional banks. In the weeks following that rescue, the gap between bitcoin and the top ten crypto assets by market capitalization (excluding stablecoins and ether) has widened considerably (see chart 1). Bitcoin accumulation is evident in the remarkably strong buy ratios of 50-70% last month compared to only 35-50% for ETH, while bitcoin dominance as a percent of the total crypto market cap surged from 43.9% at the end of February to 47.8% at the end of March.

Chart 1. BTC outperformance accelerated in March (Index 1 Jan 2023 = 100)

Screenshot 2023-04-03 at 8.59.16 PM

On a risk-adjusted basis, bitcoin is outperforming many traditional risk assets too, including US stocks and G10 currencies. For example, bitcoin appreciation is 1.87 standard deviations above the 65-day rolling average compared to only 0.01 standard deviations for the S&P 500 (indicating relatively flat performance) or even a 1.34 sigma for the tech heavy Nasdaq 100. Moreover, the data suggests bitcoin’s daily returns currently look relatively uncorrelated to the S&P 500’s with a correlation coefficient of 25% over a 65-day window compared to 58% at the start of 2023 (or 70% in May 2022). In fact, our correlation matrix (table 1) shows that BTC/USD returns currently share very little relationship with anything other than ETH/USD returns, although its correlation to gold has been on the rise this year from 16% in early January to 26% now.

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Fundamental resilience

Such trends support fundamental arguments that bitcoin still functions as a relatively uncorrelated asset that exists as an alternative and solution to the points of failure witnessed in the existing financial system. In fact, we believe bitcoin has recently been operating as a hedge for some market participants against the vulnerabilities of fractional reserve banking and the potential risks of a more serious credit crunch. Indeed, we have seen bank depositors continuing to migrate their excess (uninsured) deposits from mid-tier regional banks like First Republic and PacWest to larger institutions, creating further centralization pressures. Consequently, we think the risk of shocks may not yet have fully abated.

Additionally, the crisis has made banks more hesitant to make new loans or accumulate debt for fear of exacerbating their asset-liability mismatches, while the rotation into money market funds (currently $5.2T) has reduced bank reserves. The latter suggests that the Fed’s reverse repo tool (RRP) is draining more than just the excess liquidity in the system. All of this suggests financial conditions are implicitly tightening, while both business and consumer sentiment deteriorates.

That leaves the Federal Reserve much closer to the end of its monetary tightening cycle, which could be another reason why bitcoin has been strengthening as of late. Bitcoin tends to perform better when market participants anticipate looser monetary policy (as reflected by a pronounced drop in forward rates). Many also see the Fed’s Bank Term Funding Program (BTFP) as a form of monetary expansion – even if the majority of those newly created dollars will never enter the real economy – against which bitcoin could offer some protection.

Chart 2. Value in money market funds has climbed to $5.2T

Screenshot 2023-04-03 at 9.02.22 PM

Another reason for bitcoin’s outperformance may be the increased regulatory uncertainty surrounding the status of non-bitcoin cryptocurrencies in recent weeks. The most prominent example of this was in a lawsuit filed by New York Attorney General Letitia James on March 9 against crypto exchange KuCoin (for failing to register its platform in NYS). The lawsuit alleges that ETH (as well other cryptocurrencies including LUNA and UST) are potentially securities under New York’s Martin Act.

This coincides with more forceful language from SEC Chair Gary Gensler in a NY Magazine interview published February 23 that he believes “everything other than bitcoin” are securities because “there’s a group in the middle and the public is anticipating profits based on that group.” He is scheduled to appear before a House Financial Services committee on April 18 to provide further details about his regulatory approach. On the other hand, CFTC Chair Rostim Benham said in a Senate Agriculture Committee hearing on March 8 that ETH and stablecoins are commodities.

Technicals and on-chain data

Note that technicals have factored into bitcoin’s relative outperformance as well. For example, in February, we discussed the constraints on available bitcoin supply with tokens locked up in government custody or cold storage wallets. This contributed to a deceleration in bitcoin’s velocity from an average of 3.24 in October and November 2022 to 1.36 by December and January. (Velocity declines when more bitcoin are taken out of circulation rather than used for transactions on the network.) As of March, bitcoin velocity has only risen marginally to 1.49, while the number of transactions per active address on the network jumped by an impressive 16.2% last month. See table 1.

Comparatively, the transaction count per capita only increased 7.8% on Ethereum, although the smaller increment may have also had to do with the anticipated airdrop of ARB tokens (on March 23), representing optimistic rollup Arbitrum. This led to relatively flat transaction fees on Ethereum relative to the average over the last 12 months and no change in the total value locked between February and March. (That said, ETH supply continues to contract at a 0.30% annualized pace.) In juxtaposition to that, the transaction fees earned by bitcoin miners in March were almost 2.5 standard deviations above the fees earned over the entire preceding 12 months – bolstered by a more developed trading environment for Ordinals (NFTs or “digital artifacts”).

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Bitcoin’s price action was also driven by a massive option expiry on March 31 that accounted for 37.5% of the total open interest. There had been significant upside call buying from lower spot levels leaving dealers short gamma. The significant gamma hedging requirements likely perpetuated the squeeze higher as spot prices trended up. Moreover, the move was likely exacerbated by thin liquidity, driven not only by the effects of the US regional banking turmoil (which has affected all cryptocurrencies broadly) but also specifically by Binance’s termination of its bitcoin zero-fee trading program as of March 22.

Outlook

Overall, we’re sanguine about the market outlook over the next few weeks as April tends to be a seasonally performance-friendly month for risk assets. Typically, this is when people deploy cash from tax refunds in the US and Canada, while around this time, we also see an increase in multinational corporate USD remittances to other countries (for those companies who need to meet their own tax obligations). That puts pressure on the USD which tends to benefit crypto assets.

However, seasonal trends are not always reliable as observed last year, when the Fed’s hiking cycle and quantitative tightening were just getting underway. That should matter less over the next three months as the Fed is getting closer to the end of its cycle, although the situation is fluid. The latest evidence of this was the surprise OPEC+ announcement on production cuts, which may introduce upside inflationary pressures. Also, the US debt ceiling standoff in June could also be a precursor to more market volatility, particularly if the US experiences any economic slowdown - the likelihood of which has been raised by the stresses in the banking system.

One idiosyncratic factor for crypto is that the number of fiat onramps into the ecosystem are limited at the moment, while a lot of stablecoins have already been converted into BTC and other digital assets in March. Stablecoin dominance has fallen from 14.5% on March 9 (prior to the banking turmoil) to 11.2% as of month-end.

Chart 3. Stablecoin dominance of total crypto market cap has fallen

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