A new paper from the International Monetary Fund this week highlights that cryptocurrency and equity markets are more interconnected than ever, and urges monitoring and regulation of crypto asset markets to reduce risks of financial instability.
Cryptocurrencies have surged in popularity during the pandemic, with the market capitalization surging from $620 billion in 2017 to more than $3 trillion in November. No longer on the fringe of the global financial system, the mainstream adoption of crypto has ramifications for financial stability, the IMF paper argues.
Prior to the onset of Covid-19 pandemic, it was rare for Bitcoin and Ether to correlate with stock markets. The IMF said that crypto gave investors a hedge for their investments and a viable diversification strategy. “But this changed after the extraordinary central bank crisis responses of early 2020,” the IMF said, pointing out that crypto and stocks began skyrocketing — and falling — in lockstep with one another.
“Spillovers from Bitcoin to global equity markets are significant, explaining about 14-18 percent of the variation in equity price volatility and 8-10 percent of the variation in equity returns,” the IMF paper said.
Indeed, there has been a 3,600% growth of the correlation coefficient between Bitcoin and the S&P 500 index, indicating that during the pandemic, stocks and crypto have increasingly grown and dipped together.
This raises alarm bells for the IMF, which says that the co-movement between crypto and equity markets increases the risk of shocks that can destabilize financial markets. Particularly in countries with high crypto adoption, the international financial body urged the creation of a coordinated global regulatory framework that might reduce risks from the crypto ecosystem.
This interconnectedness between crypto and stocks “limits their perceived risk diversification benefits and raises the risk of contagion across financial markets,” the IMF said.
