Coinbase Chief Economist: The Origins and Reasons for the End of This Bull Market

Author: Cesare Fracassi, Coinbase

Compiled by: GaryMa, Wu Says Blockchain

Key Overview

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

Over the past five years, the cryptocurrency market has seen enormous returns, partly due to the adoption by institutional and retail investors, as well as the foundation laid for web3.

While the cryptocurrency market was initially uncorrelated with the financial market, the correlation has surged since 2020. As a result, the market expects cryptocurrency assets to become increasingly intertwined with other parts 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 ⅔ macroeconomic factors worsening and ⅓ a weakening of the cryptocurrency outlook.

Introduction

In the past eight months, the total market capitalization of cryptocurrencies has fallen from a peak of $2.9 trillion to currently less than $100 billion, a decline of over two-thirds. This is not uncommon in the cryptocurrency market. Since 2010, the total market capitalization of cryptocurrencies has experienced nine quarterly declines of over 20% (a typical measure of bear market conditions).

Each time the price of cryptocurrencies crashes, media and expert commentary typically takes one of two forms:

1. The refrain of "cryptocurrency is dead" resurfaces, depicting cryptocurrencies as a massive Ponzi scheme driven by FOMO (Fear of Missing Out), while accompanied by FUD (Fear, Uncertainty, Doubt) during price declines.

2. A steadfast "HODL" attitude emerges, viewing cryptocurrencies as a groundbreaking technology. The bull and bear cycles of cryptocurrencies are seen as characteristics of disruptive innovation rather than flaws, akin to national banks in the early 18th century, railroads in the mid-19th century, and the internet and artificial intelligence at the end of the 20th century. We should hold on and weather the volatility, as cryptocurrency prices will recover in the near future.

However, neither of these scenarios explains the historical trends we observe in cryptocurrencies, nor the correlation with the overall stock market we see today. There is a third way to explain price changes, which is "market efficiency," where prices reflect the market's assessment of the future prospects of digital assets.

Market Efficiency

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

From June 2017 to June 2022, the market capitalization of cryptocurrencies increased by 860%, indicating that the outlook for cryptocurrencies today is much clearer than it was back then. The adoption by institutional and retail investors, as well as the foundation laid for web3 (such as DeFi, NFTs, DID, DAOs, etc.), are part of the reasons for these exceptional returns.

Since 2020, the correlation between stock and cryptocurrency asset prices has significantly increased: while in its first ten years, Bitcoin's returns were generally uncorrelated with stock market performance, this correlation has rapidly increased since the onset of the COVID-19 pandemic. This indicates that the market expects cryptocurrency assets to become increasingly intertwined with other parts of the financial system, thus exposed to the same macroeconomic forces driving the global economy.

In particular, today's cryptocurrency assets exhibit similar risk characteristics to oil commodity prices and tech stocks. The β value is a typical measure of the systemic risk of financial assets. A β value of zero means the asset is uncorrelated with the market. A β value of 1 means the asset moves with the market. A β value of 2 means that when the stock market rises or falls by 1%, the asset increases or decreases by 2%. Our data simulation shows that the β coefficients for Bitcoin and Ethereum have jumped from 0 in 2019, to 1 in 2020-2021, and now to 2. Their current risk profile is very similar to that of more traditional assets, like tech stocks.

As the Federal Reserve and other central banks around the world have recently begun to raise interest rates, long-term assets like cryptocurrencies and tech stocks have become severely discounted, with their values rapidly declining. It may be useful to consider how much of the current decline is due to worsening macroeconomic conditions rather than a specific deterioration in the outlook for cryptocurrencies, especially given that so far in 2022, the market capitalization of cryptocurrencies has fallen by over 57%.

Notably, during the same period, the S&P 500 index has declined by 19%. If the worsening macroeconomic conditions were the sole reason for the decline, we would expect cryptocurrency assets with a β value of 2 to decline 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 of the outlook specifically for cryptocurrencies. This is similar to what occurred during the internet downturn of 2000-2001, when the S&P 500 index fell by 29%, and the NASDAQ Composite Index (primarily composed of tech stocks), with a β value of 1.25, fell 70% from peak to trough.

The Future of the Cryptocurrency Market

From the perspective of market efficiency, there is actually little mention of "the future direction of cryptocurrency prices." The most important theoretical support for the efficient market hypothesis is that any tradable asset, from stocks to bonds, commodities, and even cryptocurrencies, will incorporate the market's expectations of the asset's future value 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 that expectation. If Tesla meets that expectation in the future, its stock price will not rise because that event has already been factored into today's price.

Thus, similarly, prices will only change when expectations about the future prospects of the asset change. Therefore, according to the theory of market efficiency in the cryptocurrency market, only changes in the outlook for the cryptocurrency industry relative to what has already been anticipated will lead to price changes.