Thought experiment: Will COVID-19 make or break crypto?
In this article, we put forward a provocative thought experiment: will COVID-19 make or break crypto? We look at various paths the financial system might take over the medium term as a result of COVID-19’s impact. While not attempting to predict the future, we put forward our view on how crypto might fare under each scenario, and look forward to the debate.
The global, record-breaking response to stop COVID-19. Was it enough?
Once the scope and scale of COVID-19’s impact became clear, most western governments swiftly took extraordinary and unprecedented measures to mitigate the impact of the economic shutdown. The US Federal Reserve cut rates to near zero, announced a USD 2 trillion economic stabilisation package (with possibly more to come), cut the banks’ reserve requirement to zero, and announced “unlimited” Quantitative Easing (QE). Other countries announced similar measures, including the extraordinary step taken by the Bank of England to directly finance government spending.
Many already considered the global economy to be vulnerable before the current crisis, pointing to below trend growth since the 2008 global financial crisis, increasingly overextended valuations and high levels of indebtedness in both the private and public sectors. Under this pressure, global financial markets crashed, despite the extraordinary measures taken. Wall Street had its worst performance since 1987, and the magnitude of the drop in several asset markets in March set new records. Even gold, the investor’s favourite safe haven, fell almost 15%.
This global deleveraging also impacted Bitcoin and other cryptocurrencies, with the market briefly losing about half of its total capitalisation – although it recovered around half its losses within a week while the S&P 500 continued to fall.
Equity and credit markets have recovered from the lows for the time being, and the markets will continue to react to liquidity, in particular to the QE and large-scale asset purchases driven by central banks. Nevertheless, a lot of bad economic data is ahead of us, and with it the risk of a prolonged bear market. Investors, in addition to selling off risk assets and having increased sensitivity to counterparty risk, are also asking fundamental questions about the stability of the global financial system.
Before we start - are crypto and traditional assets correlated?
Let’s first address the claim that bitcoin is a highly correlated risk asset.
High correlation amongst all assets during a sharp risk off is a consequence of large-scale institutional deleveraging and should not be taken as a sign of change in the nature of these assets. Gold and silver also fell initially in March, just as they did in the early stages of the 2008 financial crisis. Indeed, the gold price sustained a downtrend between March and November 2008, before embarking on a sharp 3-year rally.
On a closer look, the hourly correlation between Bitcoin and the S&P 500 (which has stayed very close to 0% historically) only rose to ~30 percent. This is normally considered the lower level of ‘moderate’ correlation or the higher bounds of ‘low’ correlation.
We should also clearly distinguish between “uncorrelated” and “negatively correlated”. Bitcoin is normally characterised as being highly “uncorrelated” with other financial assets, i.e. around 0%, and driven by factors specific to the crypto market. Bitcoin has historically not been a negatively correlated asset, i.e. the asset investors rush to buy when traditional markets fall, or vice versa.
It is interesting to note that despite institutional deleveraging driving all asset prices down initially, including Bitcoin and gold, retail has been steadily accumulating both these assets. Online gold exchanges selling physical gold saw record buying volumes, gold ETFs saw huge inflows, and digital asset exchanges and brokers reported record volumes of buy orders from retail investors.
Short term market moves aside, we expect that Bitcoin (and cryptocurrencies in general) may prove to be a macro hedge over the medium term, for reasons that we will elaborate on below.
Thought experiment scenario 1: system collapse
The global financial system was already vulnerable before COVID-19. The current economic shock is the trigger - not the underlying cause - of a broad, systemic financial crisis. And it’s just starting.
The situation Some argue that the fiat based global financial system has been gradually building up to an increasingly unsustainable bubble since the abandonment of the gold standard (starting around the 1930s). Since then, the dollar has lost 95% of its purchasing power and global government debt has ballooned to now approximately USD 60 trillion. The US M1 money supply has grown from approximately USD 50 billion in 1971 to USD 4 trillion, and M3 from USD 600 billion to USD 15.5 trillion.
The increase in government indebtedness has been particularly dramatic since the 2008 global financial crisis. In 2005, global government debt was just over USD 26 trillion in 2005, and in 2007 the public debt of western countries was 70.9% of GDP. Today, it’s 103.8%. If ballooning welfare states and uneconomic spending is not kept in check, the economy may not be able to service and repay its debts. And with COVID-19-related fiscal and monetary stimuli now being rolled-out across the world, the credit risk on government debt is becoming significant, and fiat currencies are increasingly at risk of a dramatic devaluation.
Meanwhile, monetary policy has kept interest rates artificially low and caused a large portion of non-financial private debt (which has increased from around 50% to 150-300% of GDP in most developed economies) to be invested in uneconomic projects. Statistical measures that understate true inflation further compound the problem.
The economic challenges caused by COVID-19 can kickstart a severe crisis where shortages of essential goods lead to sharp price increases, falling tax revenues coincide with rising welfare costs, and supply chain payment flows are disrupted.
Many have been questioning if the fiat currency system is fundamentally flawed – or at least unstable as long as it is subjected to political influence. The COVID-19 crisis may be the trigger, causing accelerating inflation, and potentially hyperinflation, leading to a simultaneous loss of confidence in specific fiat currencies domestically, and even to the dollar losing its status as reserve currency.
Under such a scenario we can expect that business and personal transactions will increasingly avoid fiat currencies, and instead use barter, commodities (gold, silver), and cryptocurrencies – i.e. assets that are global, permissionless, scarce, divisible and counterfeit resistant.
Crypto’s response: As both barter and commodities have physical limitations, cryptocurrencies may rapidly step in to become the primary means of transacting globally. At the very least, some global economic activity would likely migrate to cryptocurrencies, which would be increasingly sought as a store of value.
As the digital asset market is still very small (<USD 250 billion market capitalisation), even a small shift towards cryptocurrencies in the global economy would result in a spectacular rally in the value of these assets.
Thought experiment scenario 2: Confidence regained
At great cost, the unlimited commitment of the US and global governments succeeds in restoring confidence in the stability of the global financial system.
The unlimited commitment of the US government, and most Western governments, to reviving their economies at any cost may succeed in restoring confidence, especially if the COVID-19 crisis surprises to the upside. Some recent studies on the progress of the pandemic suggest that the situation may end up being less dire and shorter lived than current expectations.
But as we have seen the markets shrug off the extraordinary, unprecedented, bottomless stimuli of central banks, if confidence is regained, this may have a thin veneer, prompting more and more participants in the global economy to want a plan B. Cryptocurrencies represent such a plan B and we expect that they would be increasingly favoured, both as a means of transacting and as a store of value.
On any further cracks in the global financial system, there would likely be a rush to using cryptocurrencies – after all, Western governments have put all their chips on the table now, pledging unlimited liquidity. If this proves insufficient in future, there would truly be nowhere left to go.
Although in this case there would be no need for cryptocurrencies to fill a void, we still view this scenario as bullish for cryptocurrencies.
In the short term, just as they participated in the ‘risk off’, it is significantly likely that investors would knee jerk participate in the ‘risk on’ as well.
Ultimately cryptocurrencies are expected to decouple from global risk assets again, but remain medium term supported by the fact that the fragility of the global financial system will have not been addressed. The 2008 financial crisis has already exposed this fragility, and the current crisis even more so. Meanwhile, cryptocurrencies have proven to be antifragile – each shock making them stronger.
Thought experiment scenario 3: System redesigned
Governments in the developed world seek a fundamental redesign of the financial system, such as a return to some version of the gold standard.
Although this may appear an unlikely scenario as it requires abandoning much of the welfare state and entrenched policies of wealth redistribution, it is seen by some as the best option available to governments.
However, reimplementing the gold standard carries serious political risks. The transition may have high social costs, with the possibility of the beneficiaries of entrenched welfare policies putting up fierce, even violent, resistance. The risk of this kind of instability would again favour cryptocurrencies as an alternative, similar to scenarios 1 and 2 above.
This path would also favour cryptocurrencies for a number of reasons: Bitcoin shares many characteristics with gold, and is arguably superior in not diverting from productive use the significant labour and other resources required to excavate, refine and store gold. As such cryptocurrencies may over time become a complement to (and even eventual replacement for) gold.
Conclusion: A bullish case for crypto?
The conclusion from the above analysis is that the macro backdrop is undoubtedly bullish for cryptocurrencies in the medium term. This, however, does not mean that a bullish scenario for the market is assured but rather that the risks to the cryptocurrency market lie elsewhere.
The technology is still at an early stage, with many technological challenges yet to be solved, the market structure is still immature, and liquidity is limited. Cryptocurrencies are still at a nascent stage of their journey, with the risk and volatility that entails. And if the crisis results in a shift towards authoritarian rule, some governments may be actively hostile to a decentralised system that is harder to control, thereby slowing the adoption of cryptocurrencies.
We hope that you enjoyed this food for thought. Which scenario do you think is most likely? Do you agree with our assumptions on how cryptocurrencies would fare under these scenarios?
Please let us know by emailing us at email@example.com. We look forward to hearing from and starting a dialogue with you.
The Sygnum team
 Economist Intelligence Unit
 International Monetary Fund