ABSTRACT: This article will attempt to connect the dots between the traditional investing landscape and the cryptocurrency space, which are wholly related and on a crash course to be woven together. A few possible scenarios will be laid out that may come to be in the future and may help to edify planning for investors and enthusiasts alike.
Whether for better or for worse cryptocurrencies are interwoven with the larger economy. They are priced and are bought or sold in fiat at some point in their life cycle and typically are not accepted as tender for goods services as of yet. As a result, the crypto space is heavily influenced by the larger economy around it, especially the level of confidence in the stock market and its present lack of volatility as this article will contend.
As a result, it behooves us as investors, speculators, and enthusiasts to know what is going on outside of the ICOs, the price movement of Bitcoin and Ethereum, technological advancements, and other issues peculiar to the cryptocurrency space and pay attention to the larger financial landscape. It is the author's hope that this article may be helpful in connecting the dots between the traditional investing and crypto spaces because in the end they will be one and the same. After all, money, crypto, and the financial sector are part of the larger ecosystem of the worldwide economy. In short, it is best to pay attention to some of the following dynamics that are unfolding internationally.
Quantitative easing (QE), what?
There is a massive hanging axe over the head of the traditional investment space. Namely that axe is the pending decision of the world's central banks to "shut down the party" of the bull market. That party comes by the name of quantitative easing. Since the great recession the goal of central banks has been to increase inflation and thereby growth, as such central banks have begun the practice of printing money, lots of it. This practice is implemented by central banks which are buying their own Treasury Bills (t-bills) and securities in the stock market (i.e. printed money buying financial instruments). The original hope was that by injecting liquidity (money) into the stock market there would be more spending. Households would feel richer thereby more spending would lead to bigger business investment and more borrowing. These factors would coalesce in creating inflation and jobs. Unfortunately, only half of the plan was fulfilled as the money has virtually stopped at the stock market and not gone anywhere else as many new credit issues for companies have been used to buy back stocks. These factors have raised asset prices to nosebleed levels.
Many people believe this to be some kind of conspiracy theory or an outright lie, but it is most assuredly happening without any other intention than to bolster asset prices. In short, it is not a conspiracy nor was QE implemented to hurt anyone. However, the best intentions can sometimes yield the scariest results. Because the money has stopped moving after it bought the securities, what we have seen is a ballooning of asset prices in the traditional market space and a crashing in yields on bonds and bond futures. For instance, in the last year alone the stock market on net has doggedly climbed up to ever increasing new all time highs (ATHs). There has not been a 3% correction in over a year. To put it into context, risk assets have only historically acted this way before massive corrections.
Even more tellingly people have begun to talk about the stock market as a money market account. "Should I just put some money in the S&P 500 for a few months to generate returns?" Not taking into account the risks of owning risk assets is becoming a hallmark of the past trading year. As such, central banks the world over are now mulling over how to decrease their balance sheets ("shut down the (printing money) party") and allow the market to start getting back to some semblance of normalcy.
Why not continue QE forever then?
The problem with continuing QE forever is that in the first place interest rates are extremely low, if not negative in some parts of the world. So, the thinking goes that if the next recession were to come to pass then central banks would not have any tools at their disposal to answer it. In effect, they could not lower interest rates more to combat deflation and spur growth.
The second problem is that with interest rates so low borrowing is extremely inexpensive, which ultimately leads to companies and regular people on the street being over-leveraged relative to their income. So, if the next recession or depression should come to pass then there would be no slack left in the economy to break it out of its potential malaise.
In sum, too much debt is unhealthy. In reality, it is likely the economy has had "too much debt" for several years now. However, it escapes the scope of this article to discuss that in detail.
Where's the volatility?
Since risk assets (stocks and securities) have done little else but climb, there has been a strange quiet in the stock market. This "quiet," so to speak, is the lack of volatility. Volatility can be explained simply as the movement of a stock price up and down and the magnitude thereof. So, if some stock just keeps climbing there really is not a lot of volatility. If a $100 stock on day 1 were to go down to $80 on day 2 and up to $110 on day 3, then there would be more volatility. However, at the present time there have been only relative movements of $100 on day 1 to $103 on day 5. These are only hypotheticals to illustrate the point.
Most professional traders are market makers who are paid by buying (or selling) a security at some price and holding onto it until a more favorable price is found for someone else. Those traders make the difference, and if the new price is efficient then they served the market by allowing the security to move among the hands of the interested buyers and sellers who found the "correct" prices for the security at the time. What has happened is that with the lack of volatility professional market makers are suffering very small returns as the price discovery mechanism is largely broken. Since everyone thinks the market is only going up then there is no need to perform price discovery. As a result, Goldman Sachs, JPMorgan, and other large firms are stressed trying to generate ways to perform their function of efficient price discovery. Not only are the big firms under pressure, but also every other trader in the space.
Regardless of how you may feel about central banks and trading firms/traders, it is important to understand the dynamics of what is going on. The previous point is extremely important because it explains current capital flows in different directions, including what it could mean for cryptocurrencies.
Where are the returns?
Professional traders and firms alike are pushed to make returns somewhere since the central banks have bought so many securities and crushed volatility. As a result, a number of strange outcomes have materialized. For instance, one of the more famous examples is that junk bonds at the moment are trading at near parity to government issued bonds in some parts of the world. To zero in on this dynamic a bit, that is to say government bonds that are backed by the government who can pay them by printing money, which means they are virtually riskless in terms of default, are trading at rates near junk bonds that have a much higher rates of default (imagine a loan for a start up company that makes pillows for birds or some other crazy thing).
The author supposes that this dynamic is having an effect on the Bitcoin market as well. As the large trading firms and smaller traders have been pushed down the quality ladder (i.e., the ladder: bonds to some currencies to stocks to junk bonds and now to crypto) looking for yields (gains, as is the common parlance in the crypto space) they have wound up in the highly speculative crypto markets. This dynamic materializes in the rush for the hunt for yield and JPMorgan releasing their own cryptocurrency while the bank's president maligns Bitcoin as a fraud at the same time. That is how fast the crypto space is moving and how fast the financial space is capable of moving in general when there is money on the line. The president of JPMorgan was not even aware he was speaking ill of technology his own firm was currently using!
Crypto comes on the scene
Less than the potential of being the next world currency, what has been attractive to professional traders, investors, and firms alike is the volatility in the crypto space. Because it has been largely insulated from QE's effects, Bitcoin, and crypto in general, displays extremely high volatility relative to the S&P 500. Also, because it remains a largely unregulated space the market itself among coins and tokens has even more volatility for a variety of reasons (See: Government, Regulations, and the Crypto Space). In effect, a mini gold rush is happening in the hunt for yields (think efficient price discovery) in cryptocurrency markets. But how does one enter into that market?
What has been especially helpful to crypto in general is that it has gone from some backend novelty to being largely accepted that one person will pay X amount of dollars for 1 bitcoin. If that had not come to pass then none of this would ever be possible. Although that may seem trite at the time of the writing of this article, with people still calling cryptocurrencies frauds it remains an important archimedean point to posit. Also, it suggests that cryptocurrencies are here to stay for the long run as Bitcoin gains traction in general, which ultimately leads to widespread acceptance of coin or tokens as stores of value.
Tellingly, selling securities as a brokerage requires consumer protection regulations. "Know your customer" (KYC) and other regulatory standards make it hard to sell Bitcoin outright to whatever investor from a brokerage because of its being seen as so speculative, unregulated, and new. This particular point undermines crypto's ability of going mainstream. However, what we are seeing is history in the making as the fight for the development and deployment of an electronically traded fund (ETF) for Bitcoin is underway. Effectively, an ETF for bitcoin would bridge the crypto marketplace directly to the stock market and all the liquidity that is available there, which is looking for yield.
There still remain large obstacles to entering the crypto space in general. In the first place, the infrastructure, and the very architecture, that cryptocurrencies are built upon is not, at present, easily interoperable with how the US stock market functions, nor how capital gains and losses are realized. For instance, mostly all crypto is priced and traded in terms of Bitcoin. To really dig in to find the volatility of this marketplace and get it to be accepted in the mainstream at the same time, one must first cross from Bitcoin over into the other altcoins. However, the first proximate step is making Bitcoin mainstream enough where it can tap into the vastly larger pool of liquidity available to publicly traded securities on the stock market.
So what happens next for Bitcoin?
This is the biggest question on everyone's mind. In theory, Bitcoin's having access to a larger pool of liquidity through an ETF would be bullish over the long-run if the market continues its undaunted climb upward. Also, the ETF would have to inventory Bitcoin, i.e. buy it. That is also very bullish in the near-term. Also, the ETF would mean potential, more-traditional passive investors would feel safer owning a sanctioned ETF share rather than directly buying and/or trading for Bitcoins in unregulated exchanges. After all, ETFs promise near constant liquidity. Another possible point is that an ETF would open up the floodgates of potential investment in Bitcoin, some say trillions. These factors suggest bullish signals.
However, if other crypto markets are any indication, the excitement for Bitcoin may lead to an immediate jump in price; however, after that jump the price could fall off to more conservative levels as larger Bitcoin holders are finally able to offload larger amounts of Bitcoin. That Bitcoin, having been locked up by the early adopters, did not have anywhere to go and get sold for decent prices without crashing some exchange. In other words, larger Bitcoin holders would be able to sell more efficiently through the stock market's liquidity pool. However, because Bitcoin has been evolving to be more a store of value than currency, as evidenced by other offerings whose technology is better suited to making direct transactions, it will be interesting to see if the ETF helps to finally form the evolution of Bitcoin as a store of value instead of a currency. As of yet, that remains to be seen and only time will tell.
Arbitrage
Also, with larger financial firms having access to Bitcoin markets arbitrage opportunities among exchanges are going to disappear over the mid-term. At the moment, an amateur trader can take advantage of an opportunity and arbitrage Bitcoin or any other coin with any other coin on any exchange manually. That dynamic is slowly going away as amateur bot programmers are creating programs that "arb" between exchanges and interpret data quicker than a human can manually. With the entrance of larger pools of liquidity to Bitcoin markets, financial firms will seek to protect their investment and take advantage of any price discrepancy. As a result, some of the fastest, most complex computers on Earth will be taking over arbitraging among the exchanges as large, deep resources are could be devoted to the task.
But what about the rest of crypto?
The other piece of the puzzle is the effect on the other altcoins. At present, Bitcoin is one of the chief entry points to the crypto space. Altcoins are universally converted into their value relative to Bitcoin - this is more a result of historical precedence and avoiding running afoul of financial regulations than it is because it makes things easier. Plus, most people have heard of Bitcoin, but, for instance, Ethereum does not hold the same intellectual impact as of yet on the average consumer. It is probable that in the near-term, because all other altcoins are largely tied to Bitcoin's value, that any increase in price and market capitalization for Bitcoin would mean an overall increase in the market capitalizations of all other crypto. In short, what's good for Bitcoin presently is good for the entire marketplace. As time progresses, it is unlikely that Bitcoin will have as much dominance in the crypto space, just as gold fell off as a store of value and meaningful conversion for currencies and between currencies. However, that could be in the longer-run.
A point worth mentioning is that it is not out of the question to see an Ethereum ETF and Ripple's XRP ETF come along shortly after Bitcoin's. In fact, it is rather easy to launch an ETF for any product once a similar product already has an offering. Getting interest in that ETF is another issue.
Potential threats and caveats
As the author mentioned earlier there is an axe hanging over the stock market and economy in general. It is widely accepted that once QE dries up volatility will return to the stock market and that a stock crash is in the offing if you watch any financial news. What they are most likely talking about is corrections coming back to the market, but it will feel like a stock crash at first. If that should come to pass it could kill Bitcoin's value since it would be connected to the stock market's liquidity pools. Liquidity dries up, so does Bitcoin. In effect, you would have the perfect storm for some big time value destruction.
That perfect storm could look like this: Bitcoin gets its ETF. The price of Bitcoin climbs on hype and excitement. A few months/a year later, the Fed announces that it is ending QE and raising interest rates because it no longer takes inflation as seriously in its decision making. The market begins to correct, which forces capital up the quality ladder. Bitcoin being seen by most investors as speculative loses value quickly. The old whales (larger Bitcoin holders) who are now dwarfed by capital inflows from the overall stock market cannot control the price of Bitcoin as they once could by stopping sales. The whales begin offloading large amounts to cover their losses. Bitcoin drops down to below ETF implementation prices, if not crashes completely. All other altcoins' values are damaged in the process and technological advancement in the space stalls for lack of investment interest.
This is merely a little bit of game theory, but tries to put together a possible situation involving overall market dynamics and Bitcoin. Ironically, the very thing that could bring the spotlight to crypto and push it into the mainstream could be its undoing.
At the moment, the crypto market owners' demographics, e.g. true believers and early adopters, keep it insulated from the vagaries of the larger financial space. They are going to hold on in perpetuity. The later adopters are probably more prone to getting beaten up during market corrections if the onboarding mechanism for crypto is made so easy as to just buy an ETF. In any event, this space is so new that there is very little historical precedence to draw on. (That alone makes the author scratch his head when he sees chart analysis given as gospel on some sites.) In any event, growth is coming and with growth come stumbles, and from the stumbles hopefully more growth moving forward.
Closing
In the long-run the technology is good and will continue to be good. Definitely it is worth mentioning that there should be faith in that. And in the long-run as well it is likely that blockchain technology will continue to gain acceptance. Yet, one should always be prepared for some bumps in the road. It was the hope this article would help elucidate some potential benefits and threats with cryptocurrencies when taking the larger picture into account. Moving forward it is advisable to take the rose colored glasses off and make sure you have more information. I hope this article helped in that regard and edifies your decision making. As always, make responsible decisions and take everything written and said by everyone with a grain of salt.
Let me know if there are any issues, questions, or concerns in the comments. I would love to hear from you. And please bear in mind that this is just one person's opinion.
Good luck!
We're all gonna make it!
Minderbinder
[Disclaimer: All the opinions expressed in this article are my own and are in no way meant to be construed as investment advice. All images come from either personal files or websites that allow free images and each has an inline citation for reference.]