What is Your Crypto Really Worth?
How the 'Crypto Flood' Could Spell Doom for Crypto Investors & HODLers
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Several articles over the past year proclaimed that investors should invest in cryptocurrencies to diversify the risks of their domestic investment portfolios. For example, on June 2, 2022, NASDAQ quant wizards deemed Bitcoin and Ethereum to be useful diversifiers for U.S. portfolios since both have shown little correlation with the S&P 500. Crypto investors who “Hold On [to crypto] for Dear Life”, known as HODLers, rejoiced.
Examining the correlation of, say, BTC with the U.S. S&P 500 index, for example, we note that during crypto winter, the correlation of BTC with the S&P 500 did indeed go down. However, a closer examination shows that this only happened because BTC tanked and the S&P 500 stayed relatively stable over time. An asset continuously falling in value is hardly a candidate for a successful buy-and-hold portfolio diversification or HODLing.
While correlation is a useful metric traditionally used in simple portfolio allocation, our book Big Data Science in Finance (Aldridge and Avellaneda, 2021) shows that sophisticated investors have long moved away from correlation-based portfolios due to their historically poor performance. Instead, seasoned investors now deploy eigenvalue-based techniques discussed in detail in the Big Data Science in Finance book.
What happened to the investors who followed NASDAQ’s advice and bought Bitcoin or Ethereum in June 2022? As Figure 1 panel a) shows, the price of Bitcoin (BTC/USD) dropped steeply toward the New Year, but has since rebounded to the levels of the prior year. The rebound was at least partly driven by the fears of the U.S. banking collapse following the failures of Silicon Valley Bank and the First Republic Bank. The seemingly rosy BTC/USD price rebound made some analysts tout the “intrinsic” value of Bitcoin and Ethereum in a bid to reignite the currencies’ unlimited rally.
According to our research at AbleBlox and a forthcoming paper by Irene Aldridge, however, the situation looks a lot bleaker when liquidity provision of BTC/USD and other cryptocurrencies is considered. Specifically, AbleBlox estimates liquidity reserves of various crypto assets. Most exchanges studied by AbleBlox show the US denominated assets receding and the liquidity concentrating in the crypto currency. Figure 1, panel b) shows the color-coded evolution of the Automated Market Making (AMM) function of Bitfinex, a crypto exchange, corresponding to the color-coded dates in BTC price shown in Figure 1, panel a). The panel b) is organized as follows: the axes represent the estimated quantities of USD and BTC available for AMM at the dealer level, in this case, Bitfinex. As we move along the x-axis away from the origin, the dealer becomes more flush with USD. As we go up along the y-axis, the dealer accumulates BTC in its liquidity pool. The dealers’ liquidity pools are often structured as alternative investment vehicles where investors deposit some of their assets in either BTC or USD specifically to provide liquidity on the venue. The investors then reap a reward in the form of transaction fees that can be as large as 2%.
The location of the curves is also meaningful. When the liquidity in the pool increases, the curve moves away from the origin and flattens out. When the liquidity decreases, the curve shifts towards the origin and becomes more convex.
As the Figures show, over the past year alone, the liquidity of BTC/USD market making function on Bitfinex has 1) decreased, and 2) moved sharply into BTC and away from USD, even as the BTC price increased from January 2023 to today. In the process, the exchanges and other trading venues are flooded with cryptocurrencies. This phenomenon may be aptly termed “crypto flood” following the “crypto winter”. We can empirically show a similar pattern of crypto flooding on most other crypto exchanges and across the full spectrum of crypto currencies.
What’s wrong with that, one may ask? Well, one observation is that the similar pattern of crypto flooding immediately preceded the doom of Bittrex that filed for bankruptcy on May 10, 2023. Will other exchanges necessarily meet Bittrex’ fate? This is not 100% certain. However, when your business is an exchange between two currencies, but you only have one currency in your coffers, the business becomes very difficult to run.
The other natural conclusion is that the shortage of the US-denominated liquidity indicates increasingly higher demand for the USD-denominated assets and eventually drives down the crypto prices. It is likely that a fair share of the liquidity in the trading pools today is provided by BTC HODLers who switched from pure HODLing to liquidity provision pools in order to harvest the trading transaction costs. If the majority of trading is one-directional, however, how long will the BTC HOLDers hold out in the liquidity pools in the absence of transaction revenues remains to be seen.
While the Spring 2023 U.S. banking crises did stimulate legitimate concerns for the U.S. dollar and demand for crypto, the crisis appears to be largely resolved. Instead, the resurgence of prices of BTC in the face of shrinking demand for BTC as seen in the BTC liquidity profile shows that the current rebound in the BTC price is potentially a result of an artificial “propping”, not a free market outcome. This is consistent with several recent reports that the holdings of BTC and other crypto currencies have become much more concentrated across crypto wallets, with many crypto market participants turning to USD or USD-based stablecoins.
Does this mean that all the crypto exchanges are at a brink of imminent failure? The answer to this question is a complicated “maybe” that depends on many factors, some more obvious than others. For example, depending on the convexity of an exchange’s AMM function, some exchanges may be able to with the crypto flood better than others. Similarly, cash reserves and cost structures will allow some exchanges to survive longer than others.
As we know from the failures of FTX and, most recently, Bittrex, collapse of crypto exchanges further undermines public confidence in the crypto space and the value of crypto overall. That, in turn, further drives down investor appetite for crypto assets, with or without positive correlations present. Perhaps the crypto industry is waiting for a white knight: an entity to come and bail out the crypto exchanges. The U.S. government and its digital dollar initiative may turn out to be just that. Until then, the crypto exchanges appear to be stuck in a perpetual crypto-accumulating and dollar-divesting phase, spelling doom for the industry as a whole. The crypto valuations for the investors and HODLers, in particular, are not rosy, but still remain to be seen.
Irene Aldridge is a quant researcher, consultant, speaker, educator and entrepreneur. She is a co-author of Big Data Science in Finance (with Marco Avellaneda, Wiley, 2021), Real-Time Risk: What Investors Should Know About Fintech, High-Frequency Trading and Flash Crashes” (with Steve Krawciw, Wiley, 2017), and the author of High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems” (Wiley, 2013), several other books and many research articles. Irene is CEO of AbleMarkets (a real-time AI-based financial research company) and AbleBlox (a blockchain firm). She can be reached at firstname.lastname@example.org
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