Crypto Came After Tumbling

The sharp decline of the crypto market has put cryptocurrencies in the news again. People wonder if this is the end of the crypto boom. The answer is no’. Cryptocurrency is not really a currency. It is an asset that allows people to keep their money out of the formal financial system and make it accessible so that it can be used anywhere in the world. In today’s world, such assets will be in great demand until some other asset innovation allows owners to achieve this objective in a more efficient manner.

price rises and falls

Crypto assets like bitcoin have been subject to wide fluctuations in their prices since their inception. The current recession is not the first of its kind. There have been similar ups and downs in the past. The unprecedented rise in the price of bitcoin in recent years dwarfs its price volatility in the past. The popularity of Bitcoin is evident from the price difference with Ethereum and Litecoin. Most of the volatility in the price of bitcoins is caused by changes in the demand side as the supply of the asset moves very slowly given the huge cost of mining additional bitcoins at this stage.

The rise in the price of crypto assets started at the beginning of the pandemic as people with more money parked them in crypto assets. This was understandable given the lack of investment opportunities due to the uncertainty arising out of the lockdown. As the spread of COVID-19 slows, people may want to pull their money out of crypto assets and into more attractive real investment opportunities arising from a recovering economy. This led to the final fall in prices. The withdrawal by Celsius caused panic among investors especially as the company is considered to be one of the largest crypto lenders.

Despite the effects of these specific events, we must acknowledge that crypto assets are only one asset in an individual’s portfolio. Therefore, changes in the general availability of profitable business opportunities and fluctuations in the prices of other assets will certainly affect the price of crypto assets. Recently, there have been changes in the price of an important class of assets: government bonds issued by the governments of developed countries. Many central banks across the developed world are raising their policy interest rates to combat rising inflation. For example, the federal funds rate was hovering around zero for most of the pandemic. The Federal Reserve recently extended this, leading to a continued increase in the federal funds rate as well as the three-month Treasury bill secondary market rate.

secured assets

Debt raised by the governments of developed countries, particularly the US, but also the UK and Germany, is an important class of assets as they are considered secure assets around the world. In an influential paper published in 2017, Ricardo Caballero and Emmanuel Farhi defined a secured asset as a simple debt instrument that is expected to preserve its value during adverse systemic events. As the central banks of these countries raise their policy interest rates, the rate of return is expected to rise as well, prompting large institutional investors to buy more of these. Accordingly, these investors will exit some of the existing investments and use the newly realized liquidity to buy these safe assets.

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U.S. government bonds make up a substantial portion of secured asset portfolios, as do the portfolios of many central banks, including those of India. Across the world, there has been an increase in the demand for safe haven assets as many developing countries have developed rapidly and amassed huge foreign exchange reserves. These countries then sought USD-denominated assets to preserve the value of their portfolios. Events like the pandemic only further fueled the demand for safe assets. Unfortunately, the supply of safe assets has not been in line with this demand as the developed countries producing these assets have grown at a much slower rate. Given that there is generally a paucity of safe assets, it is likely that demand and prices for crypto assets will change frequently as institutions look for alternatives with slight fluctuations in the rate of return on safe assets. For example, Celsius reportedly could not raise additional liquidity due to tightening of interest rates, which led to the suspension of its operations.

Overall, investors should understand the nature of crypto assets and their demand and should not ignore the interconnectedness of financial markets on a global scale. Since crypto assets are digital assets that can be mined and transacted from anywhere in the world, the rate of return of crypto assets is more sensitive to changes in global liquidity conditions than to local conditions.

Parag Vaknis is Dean, International Affairs and Associate Professor of Economics, Dr. BR Ambedkar University Delhi