The note adds that “in absolute terms, spillovers from bitcoin to global equity markets are significant, explaining about 14 to 18 per cent of the variation in equity price volatility and 8 to 10 per cent of the variation in equity returns”.
The note points out that crypto has now moved from the fringes to the mainstream as an asset class, and increasingly sits alongside traditional assets such as stocks and bonds in the investment portfolios of both retail and institutional investors. And this has led to an increased integration between crypto and equity markets.
“Movements in bitcoin prices are associated with a non-trivial share of the variation in US equity prices,” the note says. “Specifically, the volatility in bitcoin prices explains about one-sixth of the volatility in US equity indices, while bitcoin returns explain about one-tenth of the variation in US equity returns.”
More bread is on the way
This suggests that investors everywhere will feel the bitter effects from carnage in crypto markets, which has wiped out trillions of dollars of value as confidence crumbles and liquidity disappears.
Already, global financial conditions have tightened dramatically, as the US Federal Reserve grapples with the highest inflation in four decades, which has pushed the US share market deep into bear market territory.
But investors now worry that global share markets could feel even more pain if investors dump shares to make up for their deepening crypto losses.
The total crypto market value has now slumped to about $US800 billion from a peak of $US3.2 trillion last November, as prices of digital currencies such as bitcoin and ether have plunged.
Hundreds of thousands of shell-shocked retail traders have had their crypto investments liquidated after they failed to meet margin calls to top up their security on loans they took out to buy digital currencies.
More worrying still are the enormous contagion risks that are now becoming apparent within the crypto industry, as the turmoil in the sector has prompted some crypto lenders to suspend or limit redemptions.
A week ago Celsius Network, one of the largest lenders in the crypto world with close to $US12 billion in deposits, announced that it would no longer allow customers to withdraw cash from their accounts because of extreme market conditions.
Other crypto platforms are taking similar steps. Crypto savings app Finblox imposed a limit on withdrawals and stopped paying interest because of uncertainty over the future of the crypto hedge fund Three Arrows Capital, which was backing the company.
Hong Kong-based Babel Finance, another crypto lender, suspended withdrawals on Friday because of what it described as “unusual liquidity pressures”.
Crypto lenders have flourished in the past few years by offering eye-watering yields that dwarfed the interest rates available from regulated banks. Celsius, for instance, paid customers annual percentage yields of up to 18.6 per cent on crypto deposits.
Typically, crypto lenders on-lend these deposits to other crypto investors, providing capital for them to make bets on crypto. They also frequently invested customer deposits in high-yield, high-risk decentralized finance, or DeFi, investments.
But last month’s $US60 billion implosion of what was supposedly a blue-chip cryptocurrency, TerraUSD, caused investors to worry. TerraUSD was a stablecoin, which was designed to maintain its value of $US1 per coin.
Instead of being backed by cash or US bonds, however, TerraUSD’s supposed stability rested on algorithms that linked its value to a sister cryptocurrency called Luna.
After witnessing the downfall of TerraUSD and Luna, investors increasingly wanted their money back from crypto lenders.
But this created a problem for Celsius which had placed some of the deposits in relatively illiquid investments that had fallen in value. It also faced pressure to increase the collateral for loans it had taken out, which created extra liquidity stains.
If clients continued to withdraw deposits, Celsius would have had little choice but to dump its investments at a substantial loss, triggering fresh declines in crypto prices and causing losses to cascade across the industry.
All the same, the move by crypto lenders to impose controls on withdrawals has fueled a fresh bout of nervousness in the crypto world.
Crypto lenders, of course, aren’t the only players suffering as the liquidity tide recedes.
Last week, the high-profile crypto hedge fund Three Arrows failed to meet a margin call from lenders to top up security for loans after its highly leveraged bets on crypto turned sour.
As a result, lenders, including two of the biggest crypto financial services groups – BlockFi and Genesis – sold the assets Three Arrows had pledged as collateral for their loans.
According to the Wall Street JournalThree Arrows has hired legal and financial advisers to help work out a solution for investors and lenders, which could involve asset sales or a rescue by another firm.
‘Not the first to get hit’
In an interview with the Wall Street JournalKyle Davies, the co-founder of the hedge fund, said that Three Arrows was able to sustain the losses on its $US200 million investment in Luna, but the sharp declines in prices of bitcoin, ether and other cryptocurrencies had created more problems.
Davies added that Three Arrows was still trying to quantify its losses and value its illiquid assets, which include venture capital investments in dozens of private crypto-related companies and startups.
“We were not the first to get hit … This has been all part of the same contagion that has affected many other firms,” he said.
As if to prove his point, the contagion effects from the problems at Three Arrows have already been felt by the crypto savings app, Finblox, which is one of the crypto platforms that has capped withdrawals.
Investors are just beginning to understand the magnitude of the contagion risks within the crypto industry, let alone how much of the crypto pain will spill over into the equity market.