With December 2018 Rate Hike Locked In, Headwinds Accelerate for Cryptocurrency Exchanges

CME’s Group FedWatch is currently assessing the probability of a 0.25% rate hike in the federal funds rate to be 82.7%. In the most recent FOMC minutes, the group indicated “Almost all participants expressed the view that another increase in the target range for the federal funds rate was likely to be warranted fairly soon.” Compounded with the accelerating hacker problem faced by the exchanges, the long popping of the crypto bubble, and an SEC tightening their grips on registration requirements, exchanges are looking at material headwinds to attract capital.

Major Cryptocurrency Exchange / Platform Hacks

Why do Interest Rates Matter?

The response of cryptocurrency asset performance after last 5 or 6 rate hikes (represented by the dotted black lines below) has had a negative impact on crypto price performance.  The chart below demonstrates that the collapse of the crypto bubble during Q1 2018 coincides almost perfectly with the December 2017 rate hike decision. All subsequent rate hikes had a negative impact on crypto asset performance.

Cryptos Versus Rate Hikes

The interest hikes hurt the exchanges in two ways. First, the exchanges are primarily comprised of non-interest bearing deposit accounts. As interest rates rise, traditional deposit accounts will become more attractive. Second, the lack of a futures / forward market for cryptos means the exchanges are forced to be long commodity / crypto volatility with limited choices for risk management. Another item that compounds the issue is that these exchanges lack cash flow diversification such as fee-based services offered by traditional banks.

One area still unexplored is the impact of an inverted yield curve on the price performance of cryptos. Will they become more popular for individuals given the signal of a future recession? Will retail investors try to avoid Federal Reserve exposure by shifting to more digital asset classes? Per the chart above, the 10-2 spread is now sitting at 0.11%. In the past two decades, the 10-2 spread has never reached this level without the yield curve becoming inverted in the near future. The answers to these questions are certainly not going to be answered in the near future; however, observance of these trends may signal future retail investor behavior – especially as regulatory, security, and customer service standards begin to mature.

Change May be Coming

The innovative spirit of the blockchain community has not turned a blind eye to the problem. Coinbase recently invested in Compound, a platform that enables cryptocurrency holders to earn ‘interest’ on their holdings. The goal of Compound is to created tokenized versions of fiat currencies (like the US dollar). Other players such as the Winklevoss brothers’ Gemini Coin, MakerDao, Tether, and other ‘Stablecoin’ projects recognize the importance of creating a digital asset replicating fiat currency. Key features of a winning technology will likely include a secure platform, low volatility, and corporate governance transparency.


Bitcoin Volatility: Evidence of Market Maturity After Cryptocurrency Craze

Since the inception of Bitcoin and the concept of ‘digital assets’, institutional and retail investors kept their distance (and rightfully so) given the extreme volatility in prices, uncertainty around regulation, and questions around consumer adoption. Not only was the concept of Bitcoin foreign, but potential opportunities surrounding the digital currency and its underlying technology were also quite nascent.

As investors and entrepreneurs increased attention and resources to trading, mining, and building tangential services around these digital currencies, we have witnessed a bumpy road to stabilization and maturity. A study of market cycles demonstrates the relative boom and bust of any new industry. A particular article in Hackernoon shows a great example of this by overlaying BTC prices on stock market performance during the inflating and pop of the dotcom bubble.

In order to attract capital and accelerate a new growth cycle, trading statistics of cryptocurrencies need to be more in line with traditional asset classes. Evidence of that trend has already been reflected in trading price data. Analyzing the trading data of the top cryptocurrencies (based on market capitalization), a decline in 30-day rolling volatilities and significant compression in the volatility spread between BTC with the S&P 500 and Russell 3000 indices were observed.

While there is certainly a long way to go until the industry begins to “mature” (with respect to long term cycles), the sharp decrease in implied volatilities points to certain tailwinds.

First, there have been a plethora of services and applications built with blockchain tech and successful companies in the space are now emerging. Payment services companies such as BitPay demonstrate various applications focused on consumer and business adoption. Ripple’s partnerships provides further evidence that there are tangible results that will disrupt status quo tech. The Zerocoin project has improved its capabilities and made meaningful progress towards secure transactions.

Second, investors are starting to reap rewards of their early investments in blockchain and recycle capital within the industry. The success of Coinbaseillustrates blockchain companies can attract significant investor attention and capital. Prior management teams that have exited these companies have been able to raise money for their own projects; their niches are focused on plugging gaps with current technology offerings.

Finally, large multi-national corporations are beginning to introduce new and specialized product lines for industry participants. For example, Samsung released a new chip to improve BTC mining profits. These new products will reduce the overall marginal cost to enter related markets, just as cloud computing decreased the capability gap between small and large corporations.

While we cannot ascertain where the winners will be (equity investors, miners, coin investors, etc.), there seems to be a long runway for investors and entrepreneurs to figure it out. What we can see is that the railroad is making its way to the wild west, both the numbers and trends point to opportunities for those paying attention.