Uniswap Labs' latest research: What factors determine the price trend of Bitcoin?

Original Title: 《What Drives Crypto Asset Prices?》

Authors: Austin Adams, Markus Ibert, Gordon Liao

Compiled by: Fu Ruhe, Odaily Planet Daily

Researchers from Uniswap Labs, Copenhagen Business School, and Circle co-authored the paper "What Drives Crypto Asset Prices?" which analyzes Bitcoin's historical price trends and the impact of three institutional shocks through a VAR (Vector Auto-Regressive) model, revealing Bitcoin's market performance and showing its dual characteristics as a store of value and a speculative asset. Given the technical content of the paper, Odaily Planet Daily has organized a simplified version for readers' reference.

Key Conclusions:

• Traditional monetary policy and risk premium shocks have a significant impact on crypto asset prices.
• In the sharp decline of Bitcoin in 2022, over two-thirds of the reasons were attributed to tightening monetary policy.
• Since 2023, the main driver of cryptocurrency returns has been the compression of cryptocurrency risk premiums, rather than volatility in traditional markets.
• Stablecoins are viewed as safe assets within the crypto ecosystem; by observing the fluctuations in stablecoin market capitalization, we can further categorize cryptocurrency demand shocks into crypto adoption shocks and crypto risk premium shocks.
• In 2023 and beyond, the compressed cryptocurrency risk premium explains Bitcoin's positive returns, especially around the launch of the Blackrock Bitcoin ETF.
• Positive traditional risk premium shocks lead to declines in Bitcoin prices, and prices of traditional assets (such as U.S. Treasuries and stocks) also fall.
• Positive contractionary monetary policy shocks lead to declines in Bitcoin prices, rising bond yields, and falling stock prices.

For economists, policymakers, and investors, understanding the drivers of cryptocurrency prices and their relationship with traditional financial markets is an important and challenging task. As cryptocurrencies gain popularity in the mainstream world, their potential impact on the broader financial system is also increasing. However, the factors influencing cryptocurrency price movements and the interconnections between cryptocurrencies and traditional asset classes are not yet fully understood.

This paper aims to reveal the drivers of crypto assets through the lens of the Vector Auto-Regressive (VAR) model. It illustrates the usefulness of our approach in decomposing Bitcoin returns into three structural shocks: traditional monetary policy shocks, traditional risk premium shocks, and cryptocurrency-specific demand shocks.

The figures show the cumulative decomposition from 2019 to 2024 (Figure A) and year by year (Figure B). The model indicates that traditional shocks significantly affect the returns of the new asset class. For example, monetary policy shocks contributed to a 50% increase in Bitcoin in 2020, but caused a 50% decline in 2022. In other words, the model suggests that if the Federal Reserve had not unexpectedly tightened its monetary policy stance during 2022, Bitcoin's return would have been over 50% higher.

The model even indicates that in 2022, monetary policy was more influential in driving cryptocurrency returns than cryptocurrency-specific demand shocks. During our sample period, traditional risk premium shocks (the "safe haven" shock) generally contributed positively to the returns of crypto assets, indicating a decline in traditional risk premiums, except for a brief period during the COVID-19 sell-off in March 2020. Finally, while traditional shocks may have a significant low-frequency impact on cryptocurrency prices, most daily fluctuations in Bitcoin prices cannot be explained by traditional shocks.

We adopt intuitive and theory-guided sign restrictions. Specifically, we posit that positive conventional risk premium shocks (i.e., safe haven shocks) lead to declines in Bitcoin prices, lower U.S. Treasury yields, and falling stock prices. Conversely, we believe that positive (contractionary) monetary policy shocks lead to declines in Bitcoin prices, rising U.S. Treasury yields, and falling stock prices, which is conducted through the classic discount rate channel. Finally, we emphasize that specific cryptocurrency demand shocks elevate Bitcoin prices, but their impact on traditional assets remains uncertain (while managing the impact of cryptocurrency shocks on traditional assets through quantity restrictions).

Intuitively, the VAR model attributes daily cryptocurrency returns to different shocks based on the co-movement of assets. For instance, if interest rates drop significantly and both stock prices and Bitcoin rise on the same day, the model would be influenced by an expansionary (negative) monetary policy shock. On the other hand, if the stock market rebounds, interest rates fall, and Bitcoin rises, the model would attribute Bitcoin's positive returns to a reduction in traditional risk premiums. By aggregating Bitcoin return rates with specific patterns in the U.S. Treasury and stock markets (adjusted for their return rates), the model estimates the cumulative impact of each risk factor on Bitcoin prices over time. We further analyze cryptocurrency-specific shocks and related asset returns by studying the contributions of cryptocurrency growth and cryptocurrency risk premiums. To achieve this, we extend the model by combining fluctuations in stablecoin market capitalization with the three previously mentioned assets.

In the broader digital asset ecosystem, stablecoins are considered a safe asset, and changes in their total market capitalization relative to the volatile returns of cryptocurrencies help distinguish shocks primarily driven by risk premiums or adoption rates.

The core assumption in this extended model is that positive cryptocurrency adoption shocks will increase stablecoin market capitalization and Bitcoin prices, while positive cryptocurrency risk premium shocks (crypto safe haven) will lower Bitcoin prices but increase stablecoin market capitalization.

The model shows that we found a significant compression of cryptocurrency risk premiums starting in 2023, which explains a major portion of Bitcoin's positive returns, especially around the launch of the Bitcoin spot ETF. The four shocks studied in our extended model summarize the internal dynamics of the crypto market and its interactions with broader financial variables.

Cryptocurrency adoption shocks refer to changes in the intrinsic value and adoption rates of cryptocurrencies, reflecting shifts in innovation, regulatory changes, or changes in adoption sentiment. On the other hand, cryptocurrency risk premium shocks represent changes in the risk compensation that investors require for holding crypto assets, which may be influenced by factors such as market liquidity and volatility. Similarly, traditional risk premium shocks are also included to explain changes in the risk compensation required for holding traditional financial assets, which may indirectly affect cryptocurrency prices through changes in investor risk preferences and portfolio rebalancing.

Finally, monetary policy shocks are considered to capture the impact of broader economic growth dynamics on the crypto market, acknowledging the interconnections between cryptocurrencies and broader financial markets. While the impact of traditional monetary policy and risk premium shocks on Bitcoin returns occurs less frequently, most changes in daily Bitcoin returns are attributed to cryptocurrency risk premium shocks. This echoes research on stocks, indicating that risk premiums play a significant role in explaining returns.