Cryptic Connections: Spillovers between Crypto and Equity Markets

Tara Iyer

doi:10.5089/9781616358068.065.A001

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Cryptic Connections: Spillovers between Crypto and Equity Markets

Author:

Tara Iyer

0000000404811396

https://isni.org/isni/0000000404811396 International Monetary Fund

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Publication Date:: 11 Jan 2022

eISBN:: 9781616358099

ISBN:: 9781616358099

Language:: English

Keywords:: equity market indices S&P 500; emerging markets market index; equity index; equity price movement; crypto price spillover

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Crypto assets have emerged as an increasingly popular asset class among retail and institutional investors. Although initially considered a fringe asset class, their increased adoption across countries—in emerging markets, in particular—amid bouts of extreme price volatility has raised concerns about their potential financial stability implications. This note examines the extent to which crypto assets have moved to the mainstream by estimating the potential for spillovers between crypto and equity markets in the United States and in emerging markets using daily data on price volatility and returns. The analysis suggests that crypto and equity markets have become increasingly interconnected across economies over time. Spillovers from price volatility of the oldest and most popular crypto asset, Bitcoin, to the S&P 500 and MSCI emerging markets indices have increased by about 12-16 percentage points since the onset of the COVID-19 pandemic, while those from its returns have increased by about 8-10 percentage points. Spillovers from the most traded stablecoin, Tether, to these indices have also increased by about 4-6 percentage points. In absolute terms, spillovers from Bitcoin to global equity markets are significant, explaining about 14-18 percent of the variation in equity price volatility and 8-10 percent of the variation in equity returns. These findings suggest that close monitoring of crypto asset markets and the adoption of appropriate regulatory policies are warranted to mitigate potential financial stability risks.

Abstract

Introduction¹

Crypto assets are gaining increasing popularity among investors as an asset class. Launched in 2009, the total market capitalization of crypto assets has increased exponentially from less than $20 billion in January 2017 to more than $3 trillion in November 2021 (Figure 1, panel a). Much of this increase has occurred during the COVID-19 pandemic as trade in crypto assets has accelerated, leading to a twentyfold increase in the market capitalization of crypto assets between March 2020 and November 2021. While advanced economies, notably the United States, are among the most technologically prepared for the adoption of crypto assets (Cryptohead 2021), their adoption in recent times has been particularly pronounced in emerging market economies—with nine of the top 10 major adopters in 2021 being emerging market economies (Chainanalysis 2021). Bitcoin, the largest crypto asset by market capitalization, recently found its way beyond private markets with El Salvador becoming the first country to adopt Bitcoin as legal tender in September 2021.²

The rapid growth of the crypto ecosystem, including traditional crypto assets (such as Bitcoin and Ether) and stablecoins—which are digital tokens pegged to a market reference—has been fueled by technological innovation, the rise of decentralized finance, and increasing institutional and retail investor interest.³ In September 2021, for example, Bitcoin and Ether ranked among the world’s top 20 traded assets, competing with the market capitalization of some of the world’s largest companies (Figure 1, panel b). The market capitalization and trading volume of stablecoins have also increased, with the trading volume of the largest stablecoin, Tether, almost double than that of Bitcoin in several months during 2021.⁴

Although the risks posed by crypto assets were deemed minimal until a few years ago because of the smaller size of crypto markets and the limited interconnectedness between crypto markets and the regulated financial system (IMF 2018; FSB 2018), their widespread adoption could pose financial stability risks given their highly volatile prices, the rising use of leverage in their trading, and financial institutions’ direct and indirect exposures to these assets.⁵ Because of the relatively unregulated nature of the crypto ecosystem, any significant disruption to financial conditions driven by crypto price volatility could potentially be largely outside the control of central banks and regulatory authorities.

Against this backdrop, this note investigates the extent of interconnectedness and potential for spillovers between crypto and global financial markets by focusing on equity markets in the United States and in emerging market economies and analyzing the following key questions:

How correlated are movements in crypto and equity markets? Has this correlation changed over time?
How strong are the spillovers between crypto and equity markets, and have they increased over time?

The findings suggest that the interconnectedness between crypto and equity markets has increased notably over 2017–2021.⁶ For example, compared to pre-pandemic years, the correlation between Bitcoin price volatility and S&P 500 index volatility has increased more than four-fold, while Bitcoin’s contribution to the variation in the S&P 500 index volatility is estimated to have increased by about 16 percentage points in the post-pandemic period. For returns, the pattern is similar, with a significant increase in the correlation between Bitcoin and S&P 500 returns, as well as in the spillovers from Bitcoin returns to S&P 500 returns. Looking at Tether, the correlation between the volatility in its price and that in global equity indices has also increased significantly between the pre-and post-pandemic periods, though its returns have a small and negative correlation with equity returns indicating its possible use for risk diversification purposes.⁷ Spillovers from Tether volatility and returns to global equity indices have also increased but by a smaller extent of about 4–6 percentage points. Together, Bitcoin and Tether explain about 19–23 percent of the variation in the volatility of major global equity indices, and about 12–17 percent of the variation in their returns in the post-pandemic period.

The results also show that spillovers in the reverse direction from equity markets to crypto assets have increased in recent times. Moreover, spillovers in both directions—that is, from crypto assets to equity markets and vice versa—tend to increase during episodes of market volatility.

All in all, these findings suggest that crypto assets may no longer be considered as a fringe asset class and could potentially pose financial stability risks due to their extreme price volatility. Thus, regulators and supervisors need to closely monitor action in the crypto markets and the exposure of financial institutions to these assets, and design appropriate regulatory policies to mitigate systemic risks emanating from crypto price spillovers.

The analysis in this note extends the burgeoning literature on the interlinkages between crypto assets and other asset classes in several ways. First, while most of the studies have focused on the pre-pandemic period, the analysis here considers potential spillovers between crypto and equity markets in the post-pandemic period given the exponential growth in crypto asset adoption since the first quarter of 2020. Second, in contrast to earlier literature, which has focused mostly on traditional crypto assets such as Bitcoin, the analysis here also considers spillovers from the increasingly traded stablecoin, Tether. Furthermore, the study analyzes spillovers between crypto assets and equity indices in the United States and in emerging market economies, with the aim of generating a broader picture of the interconnectedness between crypto assets and international equity markets.

Crypto and Equity Market Correlations

As the market capitalization of crypto assets, notably Bitcoin, started to pick up in 2017, its price showed little correlation with major stock price indices such as the S&P 500 index (Figure 2). This, however, seems to have changed since the second quarter of 2020, as both Bitcoin and US stock prices have surged against a backdrop of easy global financial conditions and increased investor risk appetite.

Simple (unconditional) correlations computed for the pre-pandemic (Jan 2017-Dec 2019) and post-pandemic (Jan 2020-Nov 2021) periods corroborate these observations and show that crypto and equity market movements have indeed become much more correlated over time (Figure 3). Thus, the intra-day price volatility of two major crypto assets, Bitcoin and Ether, is now about 4 to 8 times more correlated with the volatility of the main US equity market indices S&P 500, Nasdaq, and Russell 2000 indices, compared to 2017–19.⁸ Similarly, correlation between the price volatility of Tether and US equity indices has increased significantly, and has switched from being close to zero in 2017–19 to about 0.3–0.4 in 2020–21.⁹ In absolute terms, the volatility correlation with US stock markets is the highest for Bitcoin followed by Tether, which have also been the two most traded crypto assets in recent months.¹⁰

A similar pattern holds for correlation with equity markets in emerging market economies captured by the MSCI emerging markets index.¹¹ The volatility correlation between Bitcoin and Ether and the MSCI index has increased three to four-fold between the pre- and post-pandemic periods, while that between Tether and the MSCI index has increased by more than that. It is also interesting to note that the magnitude of the correlation between volatility in crypto asset prices and the MSCI index is similar to that between crypto assets and the US stock indices.

Looking at the correlation in returns, those too have increased significantly over time, though the increase has been particularly pronounced for Bitcoin. In absolute terms, the correlation between Bitcoin and Ether and the US equity indices is positive and similar in the post-pandemic period. This is in contrast to the correlation between Tether and all major equity indices, which has been lower but negative in 2020–21—suggesting its use as a risk diversification asset during this time period. While it is interesting that stablecoins such as Tether could play a risk diversification role, other potential risks exist, including that they may not be fully backed by reserves in certain times (Griffin and Shams 2020) and the high observed failure rate of these digital currencies (Mizrach 2021).

The increase in correlations between crypto asset and equity returns since 2020 has been much more pronounced than for other key asset classes such as the 10-year US Treasury ETF, gold, and selected currencies (euro, renminbi, and the US dollar). Correlation with corporate bonds has also increased significantly and—as tends to be the case for risky asset classes such as equities—is positive with high-yield bonds and negative with investment grade bonds for Bitcoin and Ether (Figure 4, panels a and b), but the reverse holds for Tether (Figure 4, panel c). Interestingly, crypto price movements also appear to have become more correlated with the misalignment in US equity prices compared to the pre-pandemic years (Figure 4, panel d), suggesting that perhaps some over-optimism on the part of investors may be contributing to the surge in their prices.

Overall, these results corroborate previous findings in the literature of a weak initial relationship between crypto price swings and equity price movements but indicate that the link has strengthened significantly over time. This could be attributed to several factors, including the increasing adoption of crypto assets alongside traditional assets such as stocks and bonds in retail and institutional investor portfolios in an environment of easy financial conditions since the onset of the COVID-19 pandemic, as well as the growing acceptance of crypto assets for payment purposes.

Crypto assets thus appeared to have moved from the fringes to the mainstream as an asset class, raising the potential for spillovers to other asset classes, especially to equity markets, as explored in the next section.

Crypto-Equity Spillovers in the U.S. Market

To formally assess the extent of interconnectedness between crypto and equity markets and how that has evolved, the econometric approach proposed by Diebold-Yilmaz (2012 and 2014) is followed here and a vector autoregression (VAR) model is estimated to analyze the system-wide as well as pair-wise spillovers across different asset classes.¹²

The model is estimated using daily data for crypto asset (Bitcoin, Tether) prices and US equity indices (S&P 500, Russell 2000) over the period Jan 2017-Nov 2021, excluding non-trading days.¹³ The baseline specification considers crypto and equity prices as endogenous variables and includes oil prices and the 10-year US Treasury bill (T-bill) rate as exogenous variables to control for the potential effect of variations in commodity prices and financial conditions on asset prices.¹⁴ The VAR is estimated both for asset returns and for asset price volatility to gauge the extent of portfolio connection and diversification strategies across asset classes over time.¹⁵ Specifically, two estimation approaches are followed: first, the model is estimated for the pre-pandemic (Jan 2017-Dec 2019) and post-pandemic (Jan 2020-Dec 2021) periods separately and the magnitude of the spillovers is compared; second, a rolling-window estimation is done over the entire sample (2017–21) to compute the daily variation in spillovers to gauge the dynamics of spillovers during normal times versus those of market stress.¹⁶

Spillovers before and during COVID-19

Looking at the volatility and returns spillovers between crypto asset prices and US equity prices in the pre- and post-pandemic periods, several interesting findings emerge (Figures 5 and 6).

First, spillovers appear to have increased in both directions—that is, from crypto to equity prices, and vice versa. For example, volatility spillovers from Bitcoin and Tether to S&P 500 have increased by about 16 and 6 percentage points, respectively, between 2017–19 and 2020–21, whereas volatility spillovers from the S&P 500 to Bitcoin and Tether have increased by 13–15 percentage points (Figure 5). Similarly, return spillovers from Bitcoin and Tether to the S&P 500 have increased by 10 and 6 percentage points, while those in the reverse direction have increased by 12–13 percentage points (Figure 6).

Second, movements in Bitcoin prices are associated with a nontrivial share of the variation in US equity prices. Specifically, the volatility in Bitcoin prices explains about one-sixth of the volatility in US equity indices, while Bitcoin returns explain about one-tenth of the variation in US equity returns.

Third, Tether also contributes to US equity price movements though its share is smaller relative to Bitcoin given the relatively limited movement in its prices, and averages about 4–7 percent for volatility and returns.

Overall, these results are quite remarkable given that less than five years ago, the contribution of crypto assets to explaining the variations in US equity markets was one percent at the most and suggest a significant integration of the crypto asset markets with equity markets, most likely because of the increased adoption of crypto assets by retail and institutional investors, as noted earlier.¹⁷

Dynamic spillovers

Although the results above suggest that crypto and US equity markets have become more integrated since the onset of the pandemic, it is also useful to analyze the daily variation in spillovers to assess the dynamics during times of market stress relative to normal times.

Figure 7 shows the pair-wise directional spillovers between Bitcoin/Tether and the S&P 500/Russell 2000 indices, which suggest that spillovers tend to increase during episodes of market stress. For example, the March 2020 generalized market collapse led to a pronounced and relatively extended rise in pair-wise directional volatility spillovers between the crypto and equity markets. In terms of the magnitude of spillovers, however, equities (black line) emitted more volatility spillovers to the crypto market (blue line) than vice versa. There were also sharp spikes in equity to crypto volatility spillovers in early and late 2018, corresponding to sharp declines of more than 10 percent in the S&P 500 index.

In terms of returns (Figure 8), the magnitude of spillovers is generally less than volatility spillovers suggesting that cross-market volatility shocks have more of an impact than return shocks. Crypto to equity spillovers (blue lines) and equity to crypto spillovers (black lines) appear to be tracking each other fairly closely over most of the sample apart from a few episodes, including the months following the March 2020 market collapse where cross-market spillovers noticeably increased, with equity to crypto spillovers increasing more than vice versa.

Crypto-Equity Spillovers in Emerging Markets

This section extends the previous analysis to emerging market economies and analyzes the spillovers between Bitcoin and Tether and equity prices in emerging markets.¹⁸ As before, the spillovers are computed over two time periods: pre-pandemic (2017–19) and post-pandemic (2020–21). The baseline VAR specification includes the MSCI emerging markets index, Bitcoin, Tether, the S&P 500 index, and the Russell 2000 index as endogenous variables, while oil prices and the US10-year bond yield are included as exogenous variables to control for the potential direct impact of commodity prices and US monetary policy.¹⁹

The results show that as in the case of the United States, both volatility and return spillovers have increased from crypto assets to the MSCI index and vice versa (Figure 9). Specifically, volatility spillovers from Bitcoin to the MSCI index have increased by 12 percentage points (panel 1), while those from the MSCI index to Bitcoin have increased by 5 percentage points (panel 2). The same holds for return spillovers, with the contribution of both Bitcoin and the MSCI index to each other’s returns having increased by about 8–9 percentage points between the pre- and post-pandemic periods.

In absolute terms, Bitcoin explains about 10 percent of the volatility in the MSCI emerging markets index in 2020–21 and about 8 percent of the variation in its returns (see appendix, Tables A2 and A3). At the same time, the MSCI index explains about 7–9 percent of the variation in the volatility and returns of Bitcoin.

The interconnectedness between Tether and the MSCI index has also increased over time. Volatility spillovers from Tether to the MSCI index have jumped by about 5 percentage points from 2017–19 to 2020–21, while the spillovers from returns have increased by 4 percentage points. The contribution of the MSCI index to the volatility in Tether has increased by 8 percentage points while that to its returns has increased by 6 percentage points.

The spillovers between crypto assets and the US equity indices are qualitatively similar in magnitude and direction to the baseline model estimated earlier, indicating that the findings are robust to extending the model to emerging markets. Moreover, although spillovers from the S&P 500 index to the MSCI emerging markets index are still the largest in magnitude across all the asset classes considered here, it is interesting to note that they have declined over time, suggesting that the equity markets in emerging market economies are increasingly influenced by crypto price swings.

Conclusion

Crypto asset market capitalization is growing rapidly amid increasing demand from retail and institutional investors. The analysis in this note suggests that the interconnectedness between crypto assets and equity markets has increased significantly in the post-pandemic period, with two of the most traded crypto assets— Bitcoin and Tether—individually explaining about 12–16 percent of the variation in the volatility of global equity prices and about 7–11 percent of the variation in global stock returns. The extent of spillovers from crypto to equity markets tends to increase during episodes of greater market volatility and is significant for emerging markets, given their increased adoption of crypto assets in recent months.

The analysis here points to the need for further research to better understand these “cryptic” connections by investigating the channels of spillovers between crypto and equity markets, the direction of causality, and the risks crypto assets could pose to the financial system more broadly. Key drivers of the increased interconnectedness could include growing acceptance of crypto-related platforms and investment vehicles in the stock market and at the over-the-counter market, or more generally growing Bitcoin adoption by retail and institutional investors, many of whom have positions in both the equity and crypto markets. Given the increased interconnectedness between crypto and financial markets at large, the hitherto “light touch” regulatory approach toward crypto assets needs to be reviewed. Regulations should correspond to the risks crypto assets pose (BIS 2021), and oversight of the crypto ecosystem needs to be strengthened, including by addressing data gaps (IMF 2021).

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