Coinbase Chief Economist: The Origin and End of This Bull Market

Key points

How should we evaluate the recent highs and lows in cryptocurrency prices? From a market efficiency perspective, cryptocurrency prices reflect the market's assessment of the future prospects of digital assets. This perspective can help us understand the historical trends in cryptocurrency prices and their correlation with the overall financial market:

• The cryptocurrency market has had tremendous returns over the past 5 years, driven in part by adoption by both institutional and retail investors, as well as by the foundations laid for web3.

• While the cryptocurrency market was initially uncorrelated with the financial markets, correlations have risen dramatically since 2020. As a result, the market expects crypto assets to become increasingly intertwined with the rest of the financial system.

• Today, the risk profile of the cryptocurrency market is similar to that of oil prices and tech stocks.

• The recent decline in the cryptocurrency market can be attributed to a deterioration in macro factors for ⅔ and a weakening outlook for cryptocurrencies for ⅓.

introduce

In the past eight months, the total market value of cryptocurrencies has fallen by more than two-thirds from a peak of $2.9 trillion to its current level of less than $100 million. This is not uncommon in the cryptocurrency market. Since 2010, the total market value of cryptocurrencies has experienced nine quarterly declines of more than 20% (a typical measure of bear market conditions).

Whenever cryptocurrency prices plummet, media and expert commentary usually takes two forms:

1. The “cryptocurrency is dead” cry reappears, where cryptocurrencies are portrayed as a giant Ponzi scheme, driven by FOMO (Fear of Missing Out), while falling prices are accompanied by FUD (Fear\Uncertainty\Doubt).

2. Hold a "HODL" attitude, as cryptocurrency is seen as a breakthrough technology. The bull and bear markets of cryptocurrency are a feature of disruptive innovation, not a flaw, just like national banks in the early 18th century, railroads in the mid-19th century, and the Internet and artificial intelligence in the late 20th century. We should hold and ride out the volatility, as cryptocurrency prices will resume rising in the near future.

However, neither of these scenarios can explain the historical trends we have seen in cryptocurrencies, nor the correlation we see with the overall stock market today. But there is a third way to explain the changes in prices, namely "market efficiency", where prices are a reflection of the market's assessment of the future prospects of digital assets.

Market efficiency

Studying crypto markets based on an understanding of market efficiency can help us interpret the data. For example:

• From June 2017 to June 2022, the cryptocurrency market cap has increased by 860%, indicating that the future of cryptocurrencies is much brighter today than it was then. Adoption by both institutional and retail investors, as well as the foundation of web3 (such as DeFi, NFT, DID, DAO, etc.) are partly responsible for these exceptional returns.

• Since 2020, the correlation between stock and crypto asset prices has risen significantly: while Bitcoin's returns were on average uncorrelated with stock market performance in the first decade of its existence, this correlation has increased rapidly since the start of the COVID-19 pandemic. This suggests that the market expects crypto assets to become increasingly intertwined with the rest of the financial system, exposing them to the same macroeconomic forces that drive the world economy.

• In particular, crypto assets today have similar risk characteristics to oil commodity prices and tech stocks. Beta is a classic measure of the systemic risk of financial assets. A beta of zero means that the asset is uncorrelated with the market. A beta of 1 means that the asset moves with the market. A beta of 2 means that when the stock market rises or falls by 1%, the asset increases or decreases by 2%. Our data simulations show that the beta coefficients of Bitcoin and Ethereum have jumped from 0 in 2019, to 1 in 2020-2021, to 2 today. Their risk profiles are now very similar to more traditional assets, tech stocks.

• As the Federal Reserve and other central banks around the world have recently begun to raise interest rates, long-term assets such as cryptocurrencies and technology stocks have become severely discounted and their value has rapidly declined. It may be useful to consider how much of the current decline is due to deteriorating macroeconomic conditions rather than a deteriorating outlook specifically for cryptocurrencies, especially considering that the cryptocurrency market capitalization has fallen by more than 57% so far in 2022. It is worth noting that over the same period, the S&P 500 has fallen by 19%, and if macroeconomic conditions were the only reason for the decline, we would expect a crypto asset with a beta of 2 to fall by about 38%. Therefore, we can roughly estimate that two-thirds of the recent decline in cryptocurrency prices can be attributed to macro factors and one-third can be attributed to a weakening outlook for cryptocurrencies alone. This is similar to what happened during the dot-com recession of 2000-2001, when the S&P 500 fell by 29% and the Nasdaq Composite (which is mostly composed of technology stocks), with a beta of 1.25, fell by 70% from peak to bottom.

The future of the cryptocurrency market

From the perspective of market efficiency, there is actually not much mention of "where cryptocurrency prices will go in the future." The most important theoretical support for the market efficiency hypothesis is that any tradable asset, from stocks to bonds, commodities, and even cryptocurrencies, incorporates the market's expectations of the future value of the asset into its price. For example, if the market expects Tesla to sell a lot of cars in the future, today's stock price will be high to reflect this expectation. If Tesla meets this expectation in the future, its stock price will not rise because it has already incorporated this event into today's price.

Then, similarly, prices will only change if expectations about the future prospects of an asset change. Therefore, according to the market efficiency theory of the cryptocurrency market, only changes in the prospects of the cryptocurrency industry relative to what was already expected will bring about changes in prices.

Compiled by GaryMa Wu Talks about Blockchain