How can we explain the rise in crypto asset prices since the start of the pandemic? (Note)

Usefulness of the article: This article looks back at the exceptional rise in the price of cryptoassets since the start of the pandemic and analyzes the various factors behind it.

Summary:

• The COVID-19 crisis has renewed interest in cryptoassets as safe-haven assets or portfolio diversifiers, particularly among institutional investors.
• PayPal’s acceptance of Bitcoin marked a turning point in interest in cryptoassets, and Bitcoin in particular.
• Cryptoassets have been used to protect against uncertainty: the overreaction of financial markets, accommodative monetary policies, and the loss of value of the currencies of certain economies, particularly emerging ones.
• Cryptoassets have also been used to make significant profits (speculative motives).
• They are also subject to price manipulation, in a context where they escape traditional regulations.
• Their use has also been accentuated by the new working conditions brought about by the health crisis.

Blockchain was invented in 2009 by one or more computer programmers using the pseudonym Satoshi Nakamoto following the publication of a white paper. According to its creators, this invention was intended to provide « a purely peer-to-peer version of electronic cash, which would make transactions possible without the need for a financial institution » (Nakamoto, 2008).

According to Satoshi Nakamoto’s line of thinking, the presence of a trusted intermediary would be due to a (conscious) ignorance of a security flaw. He therefore set about establishing a completely decentralized, time-stamped, and tamper-proof protocol (see the appendix for details of some of the technical specificities of blockchain that may also impact the price of cryptoassets).

The first application of blockchain is bitcoin. Due to its use during geopolitical or economic events (the Cypriot crisis, the Greek crisis, the Venezuelan crisis, etc.) and its sharp price fluctuations (€0 in January 2009, €7,026 on March 12, 2020, and €46,374 on March 16, 2021), will contribute to the development of new cryptoassets on the market (8,815 in March 2021, source: https://coinmarketcap.com/fr/). However, it remains one of the most popular assets despite the cost of entry, which can be very high when dealing directly with the blockchain (costs of storing your digital key, costs of creating a wallet, etc.).

Today, bitcoin is the crypto asset with the highest capitalization (more than $1 trillion, or 61% of the market). From March 2020 to March 2021, the price of bitcoin rose by more than 500%, pulling other cryptocurrencies such as ether (+742%), cardano (+2,342%), polkadot (+705.47%) and ripple (+115.6%) in its wake[1].

How can we explain the explosion in the value of crypto assets since the start of the pandemic?

1. A macroeconomic and socioeconomic environment favorable to cryptoassets

In 2020, crypto assets experienced their first real financial crisis. Numerous studies (Brière et al., 2015; Dyhrberg, 2016; Bouri et al., 2017; Bouri et al., 2020) have shown that, when they first appeared, cryptoassets were excellent safe-haven assets because they were negatively correlated with traditional financial assets.

Today, with their introduction into the portfolios of several institutional organizations and their growing use in the real economy( possibilities for using cryptoassets on traditional payment platforms via PayPal), this negative correlation is tending to fade and become positive during certain periods (at the start of the COVID-19 crisis, for example). However, this did not prevent investors from holding them in their portfolios during the crisis (see Chart 1).

Chart 1:Number of active addresses on the Bitcoin blockchain

Source: Glassnode

With the health crisis, cryptoasset prices rose, reacting in particular to the monetary policies of various countries (interest rate cuts, asset repurchases) according to several scenarios:

• The first concerns the type of investors generally referred to in the literature on cryptoassets. An investor, wanting to protect themselves from the devaluation of their currency, buys cryptoassets that are not controlled by central authorities and therefore a cryptoasset that is not primarily a « stablecoin^«  because it is backed by a traditional currency (risk of transferring the devaluation of the traditional currency to the stablecoin).

• The second scenario concerns investors who, due to their appetite for risk, will use the liquidity injected into the economy to invest in cryptoassets (which are generally very volatile) in the hope of achieving high returns (speculation motive).

However, long before the expansionary monetary policies implemented in the wake of the Covid-19 crisis, several countries were already recording significant transactions on the cryptoasset market. In 2016, 14% of global cryptoasset trading was recorded in Latin America, compared with 38% in Asia-Pacific, where the vast majority of mining pools were located due to low electricity costs. The populations involved wanted to protect themselves from the sharp devaluation of their national currencies, such as Colombia, Venezuela, Argentina, Chile, Brazil, and Mexico, which traded significant volumes of bitcoin and dash to minimize the effects of inflation on their currencies and their devaluation against the dollar. Venezuela was the country with the highest amount of cryptoasset trading in 2019, with a value of over $7 million. In addition, the Central Bank of Kenya announced that it was considering buying Bitcoin to protect itself from the depreciation of its currency against the dollar (a depreciation that would be exacerbated by the IMF, according to the Governor of the Central Bank of Kenya).

2. Scarcity

Cryptoassets, like all traditional assets, are subject to the law of supply and demand. The supply of bitcoin, for example, is fixed at 21 million units. Some analysts refer to a « deflationary process, » which is based on three combined factors: the limit on the number of bitcoins available in the long term, the reduction over time in the number of bitcoins available after transaction validation (halving), and the hoarding of bitcoins. These factors combined are expected to cause the price to rise over time. Some crypto-optimists (Willy Woo, for example) believe that the price of bitcoin will reach a value of over $200,000 in 2021, while JP Morgan remains much more modest, forecasting a value of $146,000, which will take several years to reach.

During the evolution of Bitcoin, this scarcity effect has been clearly observed following the « halving » that has taken place every four years. By halving the miners’ remuneration (and therefore the number of new Bitcoins issued), the price of Bitcoin immediately jumps. Bitcoin thus stands out from other cryptoassets, most of which have no limit on their issuance, which may also explain its popularity.

3. The involvement of institutional investors

2020 was an exceptional year for crypto assets, with a change in their perception by institutional players. Institutional players, who were once very skeptical about holding crypto assets, have revised their positions.

JPMorgan, which had previously described crypto assets as purely speculative products, changed its mind in June 2020 by welcoming the Coinbase and Gemini exchange platforms. In addition, it will launch its own stablecoin, JPM Coin, in October. JP Morgan will finally advise its clients to invest 1% of their portfolio in crypto assets.

Also in June 2020, Grayscale announced that it had purchased 18,910 bitcoins and planned to buy more. Grayscale is an institutional investor that offers secure access and diversified exposure to crypto assets. In 2021, Grayscale will diversify its funds by adding 23 new crypto assets, which could also impact prices given the large sums generally injected by Grayscale.

The enthusiasm of institutional investors for crypto assets is confirmed by a Fidelity study of 800 institutional investors. 82% of them say they are open to cryptocurrencies. This will be followed in 2020 by increasing investment in crypto assets, particularly bitcoin, by institutional investors:

• PayPal announced that in 2021, its 346 million users will be able to use cryptocurrencies at the 26 million merchants in its network.

• Square purchases 4,700 bitcoins worth $50 million.

• MicroStrategy purchased 20,000 bitcoins in August 2020.

• Investment funds Ruffer Investment and SkyBridge Capital also announced the purchase of several hundred million dollars worth of bitcoins.

• The US authorities have granted a growing number of authorizations to platforms, notably those operated by the New York Stock Exchange (NYSE) and supported by Nasdaq, to launch bitcoin-based derivatives.

• S&P Dow Jones plans to launch cryptoasset indices in 2021.

One of the major players in the rise in crypto asset prices is Tesla. After announcing the purchase of $1.5 billion worth of bitcoin, Tesla whetted investors’ appetite for bitcoin. The price of bitcoin immediately jumped 17%, exceeding $48,000 in February 2021. Some players are talking about price manipulation because Elon Musk has been tweeting constantly to encourage the purchase of crypto assets, namely bitcoin and dogecoin.

4. Fraud and price manipulation

Finally, interest in cryptocurrencies is also attracting growing interest from hackers. During this health crisis, phishing and hacking attempts have also increased.

Hackers generally used crypto assets as rewards or ransom. From 2019 to 2020, funds received from hacking increased by 311% (see Chart 2), equivalent to approximately $350 million (see Chart 3). No other category of crypto-based crime increased as dramatically in 2020. The new work-from-home arrangements promoted by the health crisis have opened up many vulnerabilities for many organizations. According to Chainalysis, these figures are low compared to reality because not all payment addresses have been recorded in their database.

Figure 2: Percentage of crypto assets received by crime category

Source: Chainalysis

Graph 3: Total annual value of cryptoassets received by hackers

Source: Chainalysis

Before the health crisis, a scandal had erupted on cryptoasset exchange platforms. Analysis of cryptoasset volume movements on the Bitfinex, Bittrex, and Poloniex platforms suggested that Tether was being used to manipulate the price of Bitcoin and other cryptoassets (Griffin and Shams, 2020). A sharp increase in the number of tether tokens put into circulation at the beginning of each month was observed. These tether tokens were transferred across the three platforms and gradually converted mainly into bitcoin, which led to an increase in the price of bitcoin. At the end of the month, Tether had to justify the number of tether tokens put into circulation during the month and sold bitcoin equal to the value of the tether tokens printed, causing the price of bitcoin to fall at the end of the month. The company’s executives were questioned and admitted in 2019 that they had not always backed the tether tokens in circulation with US dollars[15].

Crypto asset price manipulation can also be carried out via tweets or discussion groups, which generally take place on Telegram or Discord. Most cryptoassets are characterized by a shallow market (in 2018, for example, 2.5% of bitcoin network users held 96% of the bitcoins in circulation), which is fertile ground for pump and dump raids. It has been observed that there are several groups of people who chat via Telegram or Discord and plan raids on often little-known cryptoassets. These groups buy huge quantities of cryptoassets over a short period of time, attracting naive investors (who only notice the sharp increase in the price of the asset) and then sell them within seconds. There is a hierarchy within these raid groups. Those at the top of the pyramid are informed a few minutes or seconds in advance of which cryptoasset will be attacked and sell it first to maximize their profits (Hamrick et al., 2021).

Thus, this significant increase in the value of cryptoassets, particularly Bitcoin, is considered by some to be a bubble that is struggling to burst, but a bubble nonetheless( Michael Bollinger, 2021).

Conclusion

Cryptoassets are attracting growing interest from investors. This interest is clearly due to public confidence, which is reinforced by the involvement of institutional investors. This confidence should not obscure the fact that cryptoassets remain highly volatile and their markets are still immature.

For the moment, the only guarantee given to investors is that the price of cryptoassets has never fallen below the cost of validating transactions (the cost of computer equipment and electricity), with this validation cost increasing with the popularity of assets based on a public blockchain such as Bitcoin.

The involvement of institutional investors should help reduce price manipulation of cryptoassets and have a significant impact on their value. However, there is still doubt that this surge in the price of cryptoassets is a bubble and that a price correction is likely to occur soon.

APPENDIX

Before the Covid crisis, several factors specific to cryptoassets were attracting investor interest. These factors also have an impact on their value.

1. Transparency and pseudonymity

One of the qualities that a financial intermediary must have, according to Satoshi Nakamoto, is transparency(the opacity of financial intermediaries’ actions being at the root of the 2008 financial crisis).

This transparency is demonstrated by the availability of all transactions recorded by the intermediary, as well as the amount of funds held by each user.

However, this transparency must go hand in hand with the protection of users’ identities. When the blockchain was created, bitcoin transactions were completely anonymous thanks to the use of software such as TOR. This feature explains why bitcoin was initially attractive to organized crime and terrorism. Bitcoin was widely used on the Silk Road website, which provided several illegal services, including the sale of weapons and drugs.

To prevent this type of transaction, regulators that authorize Bitcoin exchanges in their territory (in their currency) will prohibit the use of such anonymity software. Pseudonymity therefore prevails on the blockchain in general. This pseudonymity takes the form of an alphanumeric code (this code designates the user’s wallet).

As a result, users can exchange large amounts securely without revealing their identity on the blockchain.

2. Security

Data recorded on the blockchain cannot be modified or deleted. The recording of a block following mining activity is permanent: the data cannot be falsified. This feature of the blockchain is very important because it provides proof of existence, which is one of the most important foundations of trust between agents. A blockchain whose data integrity is compromised is doomed to failure because participants will withdraw from it. Furthermore, for some, the use of blockchain is motivated by a lack of trust in financial intermediaries, particularly in their ability to store data correctly and not manipulate index prices (spoofing and short selling).

3. Decentralization and deterritorialization

By removing a central entity responsible for establishing trust between agents and validating transactions, the (public) blockchain empowers its participants through mining. This significantly reduces costs, as there is no longer a central entity seeking profit by charging commissions to its customers. However, this implies direct costs for the individuals involved in this mining activity (Ciaian et al., 2015).

In recent years, this promise of ever-lower transaction costs (in the order of a few euro cents in 2011, then €10 from 2015 to early 2020) has been increasingly broken: when investors turn to « pools « ^[22] of miners who have a certain monopoly on the market, the latter can set fairly high transaction costs (between €20 and €30)^[23]. Miners also validate transactions based on the fees that an investor can pay when the network is saturated (usually following a halving⁾. To have their transaction validated, investors must pay higher fees than those currently observed on the market. Miners therefore accentuate investor appetite and the shallow nature of the cryptoasset market.

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