Cryptocurrency is maturing and becoming safer

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Cryptocurrency is maturing and becoming safer

You don’t see the words ‘crypto’ and ‘safe’ together often. So, if you’re looking for safety, your best shot is usually the Treasuries market. However, there are a few beliefs about the crypto market that don’t correspond to reality.

Things have been changing so quickly during the pandemic that we can no longer afford to disregard new trends. Over the last two years, bitcoin has been rising in popularity and it may be time for investors to find some room for it in their portfolios.

To help understand how risky bitcoin is, I collected some data on returns for stocks, oil, gold and bitcoin. Overall, bitcoin comes with a lot of risk. But is the risk worth taking, when it comes to returns?

Volatility looks bad…

If we compare the volatility of bitcoin, US stocks, emerging markets, European stocks, oil and gold, there’s no doubt that bitcoin is a clear winner.

However, it is also the riskiest, in comparison with other asset classes. For example, at the beginning of this year, the volatility measured by standard deviation of past monthly returns was 22.2% for bitcoin and between 4.3% and 5.0% for stocks. Thus, on a normal month, we must be prepared for four to five times more volatility from bitcoin than from a group of stocks.

If looking at maximum and minimum returns for the last four years, there are quite a few ‘scary’ numbers. At times, bitcoin dropped 50% in a single month. However, stocks also faced declines of over 20% at some points.

An even worse picture would emerge if looking at daily or intraday returns. Crypto assets sometimes experience very large intraday volatility. This market is made up of inexperienced traders that are quite often seduced into taking high levels of leverage. At the same time, there are some big traders in the market that have been able to manipulate prices their way, leading to sudden liquidation of open interest.

An example of this was the big drop experienced in bitcoin and other alternative coins overnight on December 3-4. I would put this down to the market being in the early stages of its development. It’s difficult to value the traded tokens, which turns sentiment into the main price driver. At the same time, there’s a lack of legal framework and institutional investors are still few. Both could help reduce volatility and eliminate any overnight attempts at price manipulation. However, the market is improving and seems to be here for the foreseeable future. Investors just have to find a way of getting a piece of the market while managing the risks effectively.

In my list, only oil appears with a level of risk that compares with that of bitcoin, a situation that doesn’t occur often. Oil turned riskier than bitcoin between June and October of 2020, when the pandemic was at its height. For the rest of the period, oil is riskier than other asset classes but still not as risky as crypto. Gold is by far the safest asset on the list.

While at times stocks appear safer than gold, the latter is characterised by a flat risk profile. In other words, gold shows no ‘fat tails’, meaning there is no skewness or kurtosis, and the risk of a ‘black swan’, which is pretty common for stocks, is less for gold. As an example, back in April/May 2020, the volatility measure for gold was standing still around 3.9%, while it suddenly rose to 17.9% for US stocks. Investors looking for lower-risk assets may be willing to increase gold holdings, carefully moderate stock holdings and eventually avoid bitcoin and oil completely.

Despite the picture above, regarding bitcoin, there are two points to make about the numbers. First, while bitcoin appears riskier than the other assets, its riskiness has been decreasing over time, at least on a monthly basis. This seems to be the opposite of what’s happening with oil.

I believe this is related to major shifts in markets. For instance, bitcoin is being adopted by institutional investors. Recently, big players like Michael Saylor’s MicroStrategy and Jack Dorsey’s Square purchased very large amounts of bitcoin. Also, the first US bitcoin ETF started trading in October. The increased presence of institutional traders in the market helps crypto prices converge faster with fundamentals and to avoid much of the bumpy ride observed in the past. Oil, however, seems to be going in the opposite direction: the gradual replacement of oil by cleaner energies will add volatility to this market over time.

My second point is about other measures that help assess risk, in particular skewness and kurtosis. Similar to the case for gold, bitcoin also shows less skewness and kurtosis. There’s risk, but no fat tails. Black swans are expected to happen less often than they do with stocks.

But risk-adjusted returns look good

Much has been said already about risk. But, if risk is the issue, there’s a very good way of managing it. You just have to cut back on your holdings. This is a game between risk and return, where you can exchange one for another. All you have to do is to find the right balance between them. This is where risk-adjusted returns are much better for giving an idea about the positioning of asset classes than we get from just looking at volatility. If we use the Sharpe ratio, which is a ratio of returns to standard deviation, we come to a measure of returns by unit of risk. This gives a better idea of how much we’re getting for the risk we incur. If we apply this to the asset classes depicted above, our idea about bitcoin is reversed.

On a risk-adjusted basis, bitcoin has outperformed US stocks for long periods. When we extend the analysis to European and emerging markets stocks, the outperformance is even more evident. Currently, the calculated Sharpe ratio points to 0.40 for bitcoin, 0.23 for US stocks, 0.19 for gold and 0.03 for oil.

While these numbers depend on several assumptions and may vary with period and calculation method, it appears that bitcoin ranks very well on a risk-adjusted basis. This means that it has been offering investors a great reward for the risks taken. My current volatility readings point to 23.6% for bitcoin and 4.7% for US stocks. An investor targeting a level of volatility of no more than that experienced by US stocks, can just hold one fifth in bitcoin of what they would hold in US stocks.

Final comments

With all of the above in mind, I agree with the recent comments from well-known investor Mike Novogratz, when he claims that:

On a risk-adjusted basis, BTC is an easier bet today than it has ever been. It’s being de-risked daily.”

Overall risk for bitcoin has been declining over time, due to the increase in its adoption, and on an adjusted basis it looks even better. Investors are getting a return on the risk incurred, which isn’t the case with oil and even with European stocks, both having experienced a ‘lost’ decade.

Even more interesting is, as Bill Miller puts it:

One of the things that’s interesting about bitcoin, is that it gets less risky the higher it goes, and that’s the opposite of what happens with most stocks.”

When stock prices rise, valuations become less attractive, as investors are paying more for expected profits. Crypto assets don’t deliver any profits to investors and prices just reflect wide adoption. In that sense, higher prices reflect wider adoption, and a wider adoption is a path towards lower risk.

Crypto assets aren’t an alternative to stocks. It is still early days for these assets. The legal framework is lacking, which creates opportunities for some price manipulation. If you go down the list into alternative crypto tokens like cardano, ethereum, miota and many others, things become even more complicated, as risk rises and market caps are too low to offer the stability of big US stocks.

But as the world becomes digitised, more and more of the crypto tokens will see their usage increase and with it, their value and stability. Bitcoin and a few other cryptocurrencies may offer diversification at a time when globalisation makes it ever more difficult to find uncorrelated assets. q


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