Disclaimer: This post contains thoughts on crypto, a volatile and risky asset class. It is not investment advice, and you should do your own research. All information is for educational purposes only. Please don’t take risks with money you’re not willing to lose.

Conducted and written by researchers from Uniswap Labs, Circle, and the Copenhagen Business School, What Drives Crypto Asset Prices? examines the key influences of Bitcoin’s price movements over the past five years. Leveraging a vector autoregressive (VAR) model, the authors decompose returns during that time period into structural shocks meant to encompass both traditional financial and crypto-specific factors.

Shocks

In the context of this paper, shocks refer to the unexpected changes in economic conditions or market factors that significantly impact asset prices. The researchers define three structural shocks related to crypto’s underlying movements:

Monetary Policy

Monetary policy shocks represent changes in broader economic growth dynamics - reflecting the interconnectedness of cryptocurrencies with global financial markets. These can occur when central banks amend interest rates or the money supply (among other policy changes). Monetary policy shocks can be further broken down into contractionary and expansionary:

1. Contractionary monetary policy shocks happen when borrowing becomes more expensive (i.e. rates go up; asset prices generally fall)

2. Expansionary monetary policy shocks happen when borrowing becomes cheaper (i.e. rate cuts; asset prices generally rise)

Conventional Risk Premium

Conventional risk premium shocks highlight changes in the risk compensation required for holding traditional financial assets - reflecting shifts in investor risk appetite and portfolio rebalancing. These can be positive or negative:

1. Positive risk premium shocks happen when investors become more risk-averse ($$$ flows from risky assets to safer ones)

2. Negative risk premium shocks happen when investors become more willing to take risk ($$$ flows from safe assets to riskier ones)

Crypto-Specific

Crypto adoption shocks refer to changes in the intrinsic value and adoption rate of cryptocurrencies - reflecting innovation, regulatory changes, or shifts in adoption sentiments. These can be positive or negative:

1. Positive crypto adoption shocks happen when use and acceptance is increasing (prices rise)

2. Negative crypto adoption shocks happen when interest is decreasing (prices fall)

Crypto risk premium shocks accent changes in the risk compensation demanded by investors for holding crypto assets - reflecting factors such as market liquidity and volatility. These can also be positive or negative:

1. Positive crypto risk premium shocks happen when investors see crypto as riskier (prices fall)

2. Negative crypto risk premium shocks happen when investors see crypto as safer (prices rise)

Sign Restrictions

Vector autoregressive models often employ sign restrictions to make sense of the data. These can best be thought of as the imposed rules / assumptions that help distinguish between different types of economic shocks. In other words, they guide the model by establishing how variables (such as interest rates) are expected to move in response to specific shocks. In this study’s VAR, sign restrictions therefore define how the three aforementioned structural shocks should affect returns on Bitcoin, Treasury bonds, and the S&P 500.

Core Assumptions

• contractionary monetary policy shocks lead to lower Bitcoin prices, higher Treasury yields, and lower equity prices

• positive conventional risk premium shocks lead to lower Bitcoin prices, lower Treasury yields, and lower equity prices

• positive crypto adoption shocks lead to higher Bitcoin prices, but have an undetermined impact on conventional assets

• positive crypto risk premium shocks lead to lower Bitcoin prices and higher stablecoin market capitalization (extended model)

Output

Case Studies

In order to make this data qualitative, the researchers cite three of the most significant (price) events in recent crypto history - the pandemic market turmoil, the collapse of FTX, and the launch of BlackRock’s Bitcoin ETF.

COVID-19

During the first half of 2020, financial markets were heavily impacted by the global onset of the pandemic. Unprecedented and presumably destructive, investors quickly fled from risky assets like stocks / BTC to safe havens such as government bonds / stablecoins. As a result, the price of Bitcoin significantly decreased (-24% during March 2020) while the total market capitalization of stablecoins increased. The period can therefore be understood as risk-off, however “with larger declines in asset prices than were justified by the decline in fundamentals”.

Dominant Shocks:

• investors liquidate risk assets → positive conventional risk premium

• stablecoin demand skyrockets → positive crypto risk premium

• interest in BTC sustains → positive crypto adoption

FTX Collapse

As crypto-natives know all too well, FTX was one of the largest exchanges in the world before its collapse in November 2022. Amidst an already poor market, their unraveling sent investors into panic and industry sentiment rapidly worsened. The price of Bitcoin consequentially declined while the market capitalization of stablecoins also suffered (excluding a brief spike directly after the collapse). This period can thus be characterized by “large price movements in crypto markets, but little price movements in conventional markets".

Dominant Shocks:

• customers lose deposits → positive crypto risk premium

• industry hope diminishes → negative crypto adoption

IBIT Launch

Integral to this cycle’s first attempt at new highs, the world’s largest asset manager filed for (and later launched) a spot Bitcoin exchange-traded fund in October 2023. Upon this announcement, investors rallied around the newfound institutional acceptance. In effect, the price of Bitcoin soared. The period can be seen as “a significant shift in investor sentiment and market dynamics within the cryptocurrency sector”.

Dominant Shocks:

• perceived risk subsides → negative crypto risk premium

• market acceptance increases → positive crypto adoption

Takeaways

The model’s output and corresponding case studies highlight that most of the variation in Bitcoin’s daily returns can be attributed to crypto risk premium shocks. Conversely, while conventional monetary policy and risk premium shocks have some affect on returns, their influence is more significant over longer time periods. Moreover, the extended model proves that stablecoins frequently serve as a safe haven for crypto-natives during tumultuous markets.

In layman’s terms…

1. Crypto is influenced by both traditional and crypto-specific factors

2. Monetary policy has an important, but declining, role

3. Crypto risk premium is a critical driver of volatility

4. Crypto adoption plays a major role in long-term price increases

5. Stablecoins act as a safe haven during market stress

6. Crypto has limited spillover to traditional markets

In Sum

To be a successful investor in any industry is to understand the market forces that affect it. While PnL screenshots and headlines of newly minted millionaires delineate crypto participants as lucky, the opposite is actually true - in fact, less than 2% of day traders are profitable on average. As such, having a thesis along with core indicators that inform your bias is conducive to being on the right side of this statistic. Identify narratives that disrupt pricing and anticipate counterparty positioning.

View the full paper below: