The note adds that “in absolute terms, the spillovers from bitcoin to global stock markets are significant, explaining about 14 to 18 percent of the variation in stock price volatility and 8 to 10 percent of the variation in stock returns.”
The note points out that crypto has now moved from the fringe to the mainstream as an asset class, increasingly sitting alongside traditional assets such as stocks and bonds in the investment portfolios of both retail and institutional investors. And this has led to greater integration between crypto and stock markets.
“Movements in bitcoin prices are associated with a nontrivial portion of variation in US stock prices,” the note says. In particular, volatility in bitcoin prices explains about one-sixth of the volatility in US stock indices, while bitcoin returns explain about one-tenth of the variation in US stock returns.
More pain is on the way
This suggests that investors everywhere will feel the bitter effects of massacres in crypto markets, which have wiped out trillions of dollars of value as confidence crumbles and liquidity disappears.
Global financial conditions have already deteriorated dramatically as the US Federal Reserve grapples with its highest inflation rate in four decades, pushing the US stock market deep into bear market territory.
But investors now worry that global stock markets could feel even more pain if investors dump stocks to make up for their mounting crypto losses.
The total crypto market value has now fallen to about $800 billion from a peak of $3.2 trillion in November last year, while the prices of digital currencies such as bitcoin and ether have fallen.
Hundreds of thousands of shocked retailers have had their crypto investments liquidated after failing to make margin calls to top up their collateral on loans they took out to buy digital currencies.
Even more concerning are the massive contagion risks that are now becoming apparent within the crypto industry, as the industry turmoil has prompted some cryptocurrency lenders to suspend or limit redemptions.
A week ago, Celsius Network, one of the largest lenders in the crypto world with nearly $12 billion in deposits, announced that it would no longer allow customers to withdraw funds from their accounts due to extreme market conditions.
Other crypto platforms are taking similar steps. Crypto savings app Finblox imposed a cap on withdrawals and stopped paying interest due to uncertainty over the future of crypto hedge fund Three Arrows Capital, which backed the company.
Hong Kong-based Babel Finance, another cryptocurrency lender, suspended withdrawals on Friday due to what it described as “unusual liquidity pressures”.
Crypto lenders have thrived in recent years offering eye-watering yields that eclipsed the available interest rates from regulated banks. For example, Celsius paid customers annual percentage returns of up to 18.6 percent on crypto deposits.
Typically, cryptocurrency lenders lend these deposits to other crypto investors, allowing them to provide capital to bet on crypto. They also often invested customer deposits in high-yield, high-risk decentralized financial or DeFi investments.
But last month’s $60 billion implosion of what was supposedly a blue-chip cryptocurrency, TerraUSD, worried investors. TerraUSD was a stablecoin designed to maintain the value of $US1 per coin.
However, instead of being backed by cash or US bonds, TerraUSD’s supposed stability rested on algorithms that linked its value to a sister cryptocurrency called Luna.
After witnessing the demise of TerraUSD and Luna, investors increasingly wanted their money back from cryptocurrency lenders.
But this created a problem for Celsius, which had placed some of its deposits in relatively illiquid investments that had fallen in value. It was also under pressure to increase collateral for loans, which created additional liquidity spots.
If customers continued to take deposits, Celsius would have had little choice but to dump its investments at a significant loss, leading to further declines in crypto prices and industry-wide losses.
Nevertheless, the move by cryptocurrency lenders to impose controls on withdrawals has fueled a new nervousness in the crypto world.
Crypto lenders are, of course, not the only players to suffer as the liquidity tide recedes.
Last week, the high-profile crypto hedge fund Three Arrows failed to meet a margin call from lenders to top up loan security after its heavily borrowed bets on crypto turned sour.
As a result, lenders, including two of the largest crypto-financial services groups — BlockFi and Genesis — sold the assets Three Arrows had promised as collateral for their loans.
According to the Wall Street JournalThree Arrows has hired legal and financial advisors to help craft a solution for investors and lenders, which could lead to a sale of assets or a rescue by another company.
‘Not the first to be hit’
In an interview with the Wall Street JournalKyle Davies, the co-founder of the hedge fund, said Three Arrows could bear the losses on its $200 million investment in Luna, but the sharp falls in the price of bitcoin, ether and other cryptocurrencies had caused more problems.
Davies added that Three Arrows was still trying to quantify its losses and value its illiquid assets, including venture capital investments in dozens of private crypto-related companies and startups.
“We weren’t the first to be hit… This is all part of the same contagion that has hit many other companies,” he said.
As if to prove his point, the contagion effects of the problems at Three Arrows have already been felt by the crypto savings app Finblox, one of the crypto platforms that has restricted withdrawals.
Investors are just beginning to understand the magnitude of the contagion risks within the crypto industry, let alone how much of the crypto pain will spill over into the stock market.
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