August 9, 2023

Insights and analysis for the professional investor

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Welcome to Crypto Long & Short!

This week, CoinDesk Indices' Todd Groth takes a break from summer to explain that, yes, things are slow at the moment in crypto markets — though that can always change.

Then, Gregory Mall of SEBA Bank delves into the history of investing (John Bogle, Harry Markowitz and William Sharpe make appearances) and what it means for crypto.

As always, get the latest crypto news and data from CoinDeskMarkets.com.

– Nick Baker

From the Analyst

Yeah, Bitcoin's Summer Lull Is a Wild Month for U.S. Treasuries

Welcome to the summer market lull.

Like the doldrums that wrap around the equator, late summer markets tend to be a quiet period partitioning the fresh optimism of a new year from the looming deadlines and targets brought forth by the passing of another calendar year. And, similar to sailors in the doldrums (or intertropical convergence zone for all you atmospheric weather buffs reading), these periods of calm have a tendency to gnaw away at impatient traders trying to play catch-up from gains missed earlier in the year.

Over the past month of super-low market volatility, the U.S. equity market has been slowly moving higher, while we seem to be sliding backward in the crypto market. Realized volatility across markets has ticked meaningfully lower (see Figure 1), with bitcoin (BTC) seeing annualized realized volatility of about 20%, in line with exchange-traded funds tracking 20-year Treasuries (which counts as a wild period for U.S. debt!) and West Texas Intermediate crude oil. Ether's (ETH) realized volume is at about 25%, similar to the equity volatility last year.

Figure 1: Rolling 22-day realized volatility; Source: CoinDesk Indices (CDI), Yahoo Finance

Checking in on correlations across digital assets and traditional markets (see Figure 2 below), we can see that over the past three months (upper right-hand side triangle of the matrix) BTC and ETH have generally decorrelated from equities, foreign exchange and commodities, when compared with the February-to-April period (lower left-hand side of matrix). The strongest correlation to traditional finance is now to fixed-income markets. As mentioned in previous "Crypto Long & Short" newsletters, it's generally a good sign when digital assets move to the beat of their own drum, although at the moment the market pulse appears to be faint.

Figure 2: Upper right triangle: May 1 - Aug. 4; lower left triangle: Feb. 1 - April 30; Source: CDI Research, Yahoo! Finance

Even the CoinDesk Bitcoin and Ether Trend indicators, the telltales of trending market conditions, are now at neutral and slightly negative trend values respectively (see Figure 3 below) as we wait for the financial market winds to pick back up.

Figure 3: CoinDesk Trend Indicators, Aug. 7, 2023. Source: coindeskmarkets.com

From an analysis of daily returns across asset classes, and comparing volatility of each month versus a five-year average volatility of the same period, we can confirm that both July and August have been particularly benign months for financial markets over the past five years (see Figure 4 below). We can also see that both BTC and ETH have different and distinct monthly seasonality volatility patterns from equity and fixed-income markets, as indicated by S&P 500 and U.S. Treasuries ETFs, although July and August lulls are shared across markets.

Figure 4: Monthly vs. past five-year average volatility, daily returns; Source: CDI

What drives the market calm during the later months of summer? While there is no definitive answer, there are a number of reasons why financial markets are often less volatile during August:

Summer Holidays: Many traders and investors take vacations during August, leading to reduced trading activity, which can result in decreased volatility. (And an increase in guest authorship of market newsletters. Enjoy the time off, Glenn Williams Jr.!)
Earnings Season Pause: The majority of companies have already reported their quarterly earnings by August, leading to a temporary lull in major market-moving news and announcements. For that reason, deals, announcements and headlines get pushed into a busier September.
Lower Trading Volumes: With fewer participants actively trading, there's less liquidity in the markets, which can contribute to decreased price swings when there are few headlines or news releases to trigger market repricing events.

It's important to note that while August typically experiences lower volatility, it's not a hard-and-fast rule, as reduced trading activity and lower liquidity can magnify significant moves when they do occur. This seasonal illiquidity doesn't afford market participants much in the way of market depth that can absorb news shocks or reprice major events. And in the rare event they do occur during the illiquid summer months, they can be meaningful (see the Quant Crisis of August 2007, the U.S. credit rating downgrade in August 2011, the Chinese yuan devaluation in August 2015), keeping traders glued to their laptops and Wi-Fi or forcing them to end their vacations prematurely.

So where to from here? Will market leadership and breadth expand in digital assets beyond bitcoin and ether and in equities beyond mega-cap artificial-intelligence technology? Are the majority of the year-to-date gains a result of bearish positioning into the most anticipated and consensus recession of modern financial history? Have inflationary pressures subsided? These are only a few of the many questions to consider during this August reprieve as we wait for the winds of the market to pick back up and propel us into another eventful second half of the year.

— Todd Groth, CFA, head of index research at CoinDesk Indices

Institutional Outlook

The Right Way to (Passively) Invest in Crypto

Passive investing strategies have gained popularity in crypto, following the trend set in traditional finance — where benchmark-tracking ETFs and index funds are a huge force. But it's important to engineer indexes that can grapple with the shortcomings and inefficiencies of the nascent asset class of digital assets.

Smart-beta indexing – a primer

Indexes weighted by market capitalization long dominated passive investing in stocks. They have their origins in "Modern Portfolio Theory," which traces back to the works of Harry Markowitz and William Sharpe in the 1950s and 1960s, respectively. Since the creation of the first index fund by John Bogle in 1975, market cap-weighted indexes have been considered the industry standard — not only from an academic practical point of view, but also from a practical one. It was only in 1992 that Eugene Fama and Kenneth French developed a three-factor model that empirically explained stock returns better and was an extension of the Capital Asset Pricing Model. In addition to the well-known beta, small-market caps and low price-to-book ratios were added as systematic risk factors.

Over the years, new factors and alternative weighting methodologies have been introduced, aiming to exploit market inefficiencies. Some of the most well-known factors include momentum, minimum volatility, quality and dividends. Alternative weighting methodologies include equal weighting, risk parity and maximum diversification.

A buzz term was eventually developed to describe this: smart beta. It was first put into practice in 2003 with the S&P 500 equal-weighted index. Since then, thousands of smart-beta ETFs have been approved for trading in both the U.S. and Europe. Currently, around $1.7 trillion is managed this way in ETFs in equities in the U.S. alone. Despite their apparent success, however, this represents a relative pittance versus ETFs weighted by market cap.

Why engineering smart-beta indexes matters in crypto

In the world of crypto indexing, benchmark creators have brought over market cap-weighting from traditional finance one-to-one. That approach, however, may not lead to optimal results, especially in the relatively nascent and evolving asset class of cryptocurrencies. It can result in significant market concentration in just a couple of constituents such as bitcoin and ether, thus defeating the fundamental goal of index investing: diversification.

Another mistake made by many crypto index providers is defining the market universe too broadly, creating indexes that are not investable or not sufficiently liquid, especially during crises. To be tradable on traditional exchanges, the underlying index constituents must demonstrate a minimum level of liquidity across widely accessible liquidity venues. Therefore, liquidity-based index exclusion criteria significantly narrow the investable universe.

Additionally, in the crypto sector, it is essential to establish qualitative inclusion criteria. Unlike in the stock world, where companies are thoroughly examined by regulators, banks and auditors before being listed on an exchange, crypto projects and tokens are subject to limited due diligence, resulting in unforeseen debacles such as Terra/Luna and FTX. Rigorous analysis can help avoid such situations.

To address these issues, it is important to avoid the common pitfalls of market cap-weighted indexes and limit the investment universe to the top coins by market liquidity.

While the possibilities are almost endless, we have decided to build an index that is based on a combination of risk parity and market capitalization. The risk-parity weighting scheme aims to balance the risk contributions of index constituents resulting in an index that over-weights smaller coins compared with a market cap-weighted one, achieving higher diversification. Although there may be market phases where such an index lags behind the overall market, there is a high probability that the index will outperform the market over an entire market cycle.

– Gregory Mall, CFA, head of investment solutions at SEBA Bank

Takeaways

From CoinDesk Deputy Editor-in-Chief Nick Baker, here is some news worth reading:

GETTING FOCUSED: As discussed last week, Michael Saylor's MicroStrategy is raising up to $750 million, probably to buy more bitcoin. So, we subsequently decided at CoinDesk to take a look at how the past year has gone since Saylor stepped down as CEO of the company to become executive chairman, leaving MicroStrategy's original business (software) in the hands of someone else so that Saylor could just focus on laser eyes (buying BTC). He was down a billion dollars on his BTC a year ago and things got worse soon after following FTX's collapse. But, today, MicroStrategy is nearly back in the black. Things aren't so bleak anymore.
BETTER ODDS: One of the hot questions at the moment is whether a spot bitcoin ETF will get approved soon. Analysts at Bloomberg Intelligence believe the odds have gone up to about 65%. Meanwhile, the race is on to get an ether ETF listed. Crypto (Bitcoin specifically) was originally created, of course, partly in reaction to the Wall Street bailouts after the 2008 crisis. But Wall Street firms are increasingly running the narrative in crypto, and if these ETFs (from the likes of BlackRock) get approved, crypto OGs may be surprised how much money floods into the sector. Who knows how that shakes things up?
MORE STABLE: PayPal is a big deal in payments. Now it's angling to be a big deal in stablecoins by issuing its own: PYUSD. Notably, PayPal reportedly put the project on hold early this year amid regulatory scrutiny. Given the pressure regulators have placed on crypto this year, does an apparent resolution signal easier days are ahead — or are upon us?
SHIBA DEFI: Decentralized finance is going through a rough patch. (Though some disgree that the end is nigh.) Shiba inu (SHIB) is apparently betting that DeFi needs more memes and the project is attempting to become a player. No surprise, its meme coin soared on the news.

Want more? For the latest news affecting the crypto markets, listen to CoinDesk's Markets Daily podcast.

State of Crypto: Policy & Regulation

It is now more important than ever to set industry standards and align on practical short-term and long-term objectives through pointed conversations with the best legal minds and Washington D.C.'s most important decision makers.

Join us at State of Crypto: Policy and Regulation on October 24 in Washington D.C. for an unprecedented opportunity to evaluate, dissect and ultimately shape crypto regulatory frameworks that support a vibrant, secure and healthy future for the digital economy.