How Stock Markets and Fed Policy Affect Cryptocurrenciesby@vladyslavzadorozhniy
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How Stock Markets and Fed Policy Affect Cryptocurrencies

by Vladyslav ZadorozhnyiJanuary 20th, 2023
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The cryptocurrency market is young compared to stock and currency markets that have existed for more than hundred of years. The distinguishing aspect of the crypto market is that it has low liquidity and a relatively small capitalization, which was $609 billion as of July 2022. However, despite the significant distance from institutional financial market regulators, the correlation between digital assets, the stock market, and Fed policy is noticeably increasing.
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The cryptocurrency market is young compared to stock and currency markets that have existed for more than hundred of years. The distinguishing aspect of the crypto market is that it has low liquidity and a relatively small capitalization. Despite all the turbulence it has gone through in 2022, its capitalization remains pretty sizeable, rising almost to $800 billion at the beginning of 2023.

However, despite the significant distance from institutional financial market regulators, the correlation between digital assets, the stock market, and Fed policy is noticeably increasing. Largely, this is due to the surging scandal that happened with the FTX crypto exchange and its CEO & founder, Sam Bankman-Fried. A former supporter of governmental policies towards crypto has received complaints from regulators, which led not only to the FTX crash but also to renewed discussions about enforcement actions.

In today's article, we will share how the stock market and the Fed affect cryptocurrencies today and what crypto investors should focus on in their analysis of the market situation.

How does the stock market affect cryptocurrencies?

The stock market has a very large capitalization and regulators that stop manipulative actions in the market. It is less manipulative because of its size and regulators, and, on the contrary, the cryptocurrency market is very manipulative because of various market makers that tailor the market up for themselves. But among all cryptocurrencies, BTC stabilizes faster, because it retains its unique properties, such as decentralization and anonymity. The two phenomena, the momentum effect and the reverse effect, are among the patterns that financiers pay attention to when analyzing the stock market. These effects are already evident in the cryptocurrency market as well.

The momentum effect is a situation in the stock market when stocks and bonds that have grown in the past continue to grow further.

The reverse effect is the opposite situation, when it is profitable to invest in shares that have recently fallen in price.

In the case of the momentum effect, this anomaly is most evident with bitcoin and ether: these strong cryptocurrencies still dominate the market in terms of their value. When the time comes for the reversal effect, when the cryptocurrency falls heavily, its collapse continues for a long period of time. If momentum and reversal effects replace each other over several years on stock exchanges, then trading with cryptocurrencies can show a short-term momentum effect that fades within a month. After approximately four weeks, there is a strong reverse effect. That is, in fact, the same type of market effect that is observed in both crypto and other markets, but in the first case, everything happens much faster.

There is also a correlation between the fear factor of investors in the stock and cryptocurrency markets. In order to assess the level of fear in the stock market, the VIX volatility index is used. Studies show that this index can be a useful tool for predicting periods of high volatility in the prices of bitcoin and other crypto assets. At the same time, tracking the volatility of crypto assets can be a useful tool for predicting periods of volatility in the stock market. American entrepreneur Warren Buffett aptly spoke about working with this indicator: "Be fearful when others are greedy, and greedy when others are fearful."

Before cryptocurrency became widely adopted around the world, the bulk of players in the crypto market were just a small group of enthusiasts. The situation changed in 2020, when another bull market for bitcoin began. More and more institutional investors came to the market, and the correlation between the crypto and stock markets became even more clear. The explanation for this is simple: capital from traditional stock markets began to move to the crypto market, and hence the trends and anomalies of the first could be applied to the second.

The positive impact of stock market trends is manifested in the ability to predict the tendencies of the crypto market. However, negative trends also affect crypto: the volatility of US indices is reflected in cryptocurrencies, and stock market sentiment is transmitted to the digital asset market. The latter trend is mentioned by Tara Iyer and her IMF colleagues Tobias Adrian and Mavash S. Qureshi in the IMF blog.

How does the Fed policy affect cryptocurrencies?

The Federal Reserve System (Fed) has a base lending rate at which banks provide short-term loans to each other. That is, if a bank needs to transfer funds to a client, but does not have enough of its own reserves, it can borrow capital from another financial institution for a short period of time at a minimum interest rate. The global economy is dependent on the Fed's policy, and the crypto market, with a large share of borrowed funds today, demonstrates a similar dependence.

Changes in the base rate significantly affect the state of the financial system and the stock market, affecting the value of various asset classes. Today, changes are also reflected in cryptocurrencies: a decrease in the Fed rate leads to an increase in the capitalization of bitcoin and other digital assets, and vice versa. This is because cheap money encourages investors to invest in new technologies, startups, and other risky instruments, including cryptocurrencies.

The Fed's recent decision to raise its benchmark rate by 75 basis points, to 1.5-1.75%, has resulted in a decline in the bitcoin rate, which has dragged down all altcoins.

Why is this happening? An increase in the base rate increases lending interest for individuals and legal entities, and investments become more expensive. Due to these harsh conditions, investors tend to choose assets with predictable returns rather than risky ones, which include bitcoin.

Such ups and downs with changes in the Fed's base rate will occur as long as cryptocurrencies remain high-risk assets for investment.

The US Securities and Exchange Commission's (SEC) Cryptocurrency Division has already filed dozens of cases against cryptocurrency and blockchain-related projects. Crypto enthusiasts call it a deliberate effort to create more tools to influence the digital asset market. The Commission explains these proceedings as an attempt to combat those who seek to take advantage of investors in crypto markets.

Thus, in 2019, the creator of Telegram, Pavel Durov, planned to launch an ICO (initial coin offering) of the TON blockchain project, but the Securities and Exchange Commission forbade him to do so. According to the documents published by the Commission, Durov's company considered Gram tokens as securities and the ICO was organized improperly. After this failure, Durov gave his developments to enthusiasts who still hoped to bring the project to an end.

Another high-profile example of how the Securities and Exchange Commission is trying to influence new projects in the cryptosphere is the case of Ripple. The Commission filed a lawsuit against Ripple that set a precedent for the future of all digital assets in the United States. According to the Commission, Ripple (XRP) is a security, not a digital asset, and all its sales are considered illegal.

If the SEC wins, it will change the way crypto companies operate: digital assets will have to comply with the strict reporting and registration rules applicable to securities. It is believed that Ripple's victory will be an overall victory for the cryptocurrency.

Such high-profile cases affect the cryptocurrency market, often collapsing the price of altcoins by tens of percent. Ripple's CEO noted that regulators such as the Securities and Exchange Commission are keeping the US away from the potential of cryptocurrencies. "The SEC seems quite content to let the US continue lagging behind – all in the name of protecting their own jurisdiction at the expense of US citizens," he tweeted.

In contrast, there are examples of close and, at times, quite friendly cooperation between regulators and crypto enthusiasts. The controversial Sam Bankman-Fried (SBF), CEO and co-founder of the recently bankrupt FTX crypto exchange, once even lobbied for regulation of the industry. SBF supported the proposed bill in the US to introduce greater government control over cryptocurrencies. Moreover, the former director of the Commodity Futures Trading Commission (CFTC), the institution that regulates the US derivatives market, became the head of policy and regulatory strategy at FTX. However, sympathy and dinner parties with representatives of government regulatory agencies did not save Bankman-Fried from a complaint brought by the Securities and Exchange Commission (SEC) about an "unlimited line of credit" between the cryptocurrency exchange and its subsidiary, hedge fund Alameda Research.

The skeptical attitude of regulators towards cryptocurrencies is explained by the fact that they are trying to maintain the status quo in relation to the established financial system and continue to control investors through well-known regulatory tools.