The cryptocurrency Chimera: Is Bitcoin digital or fool’s gold?
Patrick Tan, CEO, Novum Technologies analyses the relationship between Bitcoin and gold.
The cryptocurrency Chimera:
Is Bitcoin digital or fool’s gold?
Patrick Tan, CEO & General Counsel, Novum Alpha & Novum Global Technologies
What's a Chimera?
The human desire for classification goes as far back as human memory. From prehistoric cave paintings to Darwin’s contributions to the science of evolution, finding patterns, associations and neat categories to pigeonhole the chaos of the world has brought comfort for generations.
Yet current conventions and cultural mores have helped to undercut the hitherto clarity with which the modern world has been classified, categorised, and dissected. Historical institutions such as the definition of marriage and even sexuality have given way to genderfluidity and same-sex unions.
To assume that the world is static outside of human invention is therefore more a function of our predisposition towards order, than it is a reflection of our reality.
So imagine the horror and fear that was struck in the minds of the ancients when faced with the Chimera, a Greek mythological monster that was described of as a fire-breathing hybrid creature. The Chimera was typically depicted as having the head of a lion, with the head of a goat protruding from its back and a tail that ended with the head of a snake and was often portrayed in Greek mythology as wildly imaginative, implausible or dazzling.The earliest literary reference to the Chimera can be found in Homer’s epic, Iliad, where the creature was described as:
A thing of immortal make, not human, lion-fronted and snake behind, a goat in the middle, and snorting out the breath of the terrible flame of bright fire
So when Bitcoin started to enter into the consciousness of a wider investing population, outside of its more technocentric origins, regulators and investors alike struggled to grapple with this investment Chimera. Was Bitcoin a security or more akin to a currency? An asset in the digital image of gold? Or maybe a speculative instrument and therefore mere puffery?
In the early days of Bitcoin’s rise to prominence, no less than the U.S. Securities and Exchange Commission, the Commodities Futures Trading Commission (CFTC) and the U.S. Federal Reserve all simultaneously claimed and disavowed jurisdiction over Bitcoin and Bitcoin transactions.
Given its Chimera-like nature, it was no surprise then that both investors and regulators, struggled to grapple with the nature of the Bitcoin beast – too complex to categorise, but too dazzling to ignore.
But the difficulty with which to categorise Bitcoin and other cryptocurrencies has not been for want of trying. The CFTC for instance officially decreed cryptocurrencies like Bitcoin, as a commodity, just like crude oil or gold. The CFTC unilaterally declared that Bitcoin as a virtual currency is a digital representation of value, which functions as a medium of exchange, a unit of account and a store of value. And though lacking in legal tender status in any jurisdiction, Bitcoin and other cryptocurrencies are distinct from fiat currencies.
So that settles it then, Bitcoin is a commodity.
But simply labelling Bitcoin, or any other cryptocurrency for that matter a “commodity” does not in and of itself make it so – it just makes it easier for the labeler to order their universe.
Because ascribing a label such as “commodity” or “security” to a nascent asset class (for that matter, even the use of the label “asset”), brings along certain connotations and expectations with those who transact, store or trade in that asset class.
And that brings us to our current discussion, whether or not Bitcoin possess the quantitative qualities which we commonly ascribe to existing asset classes, only to find that Bitcoin may truly be a Chimera of an asset class – making it a thing altogether wildly imaginative, implausible and dazzling.
The value for investors especially is not so much the label of the asset class, but its function, quoting Chinese leader Deng Xiaoping:
No matter if it is a white cat or a black cat, as long as it can catch mice, it is a good cat.
Are Bitcoin and gold correlated?
Because of the quality of data that can be derived from cryptocurrency markets, Spearman’s rank correlation coefficient or Spearman’s ρ (rho) is used as a non-parametric measure of rank correlation (statistical dependence between the ranking of two variables) because it assesses how well the relationship between two variables can be described using a monotonic function.
The selection of Spearman’s ρ is deliberate because much of the volatility data that can be gleaned from Bitcoin’s price movements in the bulk of markets is tied to two opaque datasets. First, the bulk of Bitcoin is traded in Tether (USDT), the dollar-based stablecoin, for which allegations of Bitcoin price manipulation have been made. Second, as trade volumes from a variety of cryptocurrency exchanges are also alleged to be heavily manipulated, filtering the data for the purposes of calculating correlation is challenging at best and impossible at worst.
Hence, instead of trying to layer an opaque variable – volatility – to correlations between gold and Bitcoin, it would be more helpful to assess the monotonic relationship (whether linear or not) between the two asset classes.
If there are no repeated data values, a perfect Spearman correlation of +1 or -1 occurs when each of the variables is a perfect monotone function of the other.
Intuitively, Spearman’s ρ will be high when observations have a similar (or identical for a correlation of 1) rank between the two variables and low rank when observations have a dissimilar (or fully opposed for a correlation of -1) rank between the two variables.
Spearman’s ρ was also selected because it is appropriate for use for both continuous and discrete ordinal variables. And given that Bitcoin is traded 24/7, whereas gold is not, Spearman’s ρ, represents an acceptable compromise for the formulation of a general correlation coefficient between the two asset classes.
For brevity, Spearman’s ρ or the Spearman correlation coefficient can be represented as follows for a sample size of n, the n raw scores Xi, Yi are converted to ranks rgXi, rgYi and rs, computed as follows:
- ρ denotes the usual Pearson correlation coefficient, but here applied to rank variables,
- cov(rgX,rgY) is the covariance of the rank variables, and
- σrgxσrgy are the standard deviations of the rank variables.
In this analysis, I have included the data set of the time series covering the period from October 3, 2013 to as late data as is available for the purposes of analysis, February 18, 2020. The selected time series covers several market fluctuations, including the sharp fall in Bitcoin’s price after the hack of the world’s first Bitcoin exchange, Mt.Gox as well as other periods of economic stress.
The assets utilised for this analysis are gold prices in USD per oz, S&P500 Index and Bitcoin. For conventional assets, the closing price or index points of each trading day is used from Datastream with a GMT timestamp. For Bitcoin, the data is an average of data from both Coindesk.com and CoinMarketCap.com, which themselves use weighted averages of Bitcoin price data from various sources, also with a GMT timestamp.
Unlike conventional assets, Bitcoin is traded non-stop and in order to synchronise the datasets, the hours for which gold and the S&P500 are not trading, the last done price of the asset is taken as a datapoint.
Applying the Spearman Correlation Coefficient to the data produces the chart in Figure 1, which demonstrates a weak correlation between Bitcoin and Gold. Events in time did however make the two assets seem synchronous, but specific events do not make a trend and the general price patterns of both gold and Bitcoin offer little by way of correlation.
Historical correlation data between gold and Bitcoin has vacillated between -0.15 and +0.25 which is at the weaker end of the spectrum for correlation, with -1 being zero correlation and +1 representing perfect correlation.
Figure 1: Spearman Correlation Coefficient for Bitcoin vs Gold for the period 3 October 2013 to 18 February 2020
And while recent trends in gold and Bitcoin prices have suggested a short-term correlation between the two asset classes, the immediacy of the data does not make a long-term trend.
Using a 60-day correlation coefficient, data from Bloomberg suggests that beginning this year, the two 60-day correlation coefficient of the two assets had flipped from negative to positive above the trailing one-year daily average (Figure 2).
Figure 2: Rolling 60-day correlation coefficient between Bitcoin and Gold. (Source: Bloomberg)
Using a rolling 60-day correlation coefficient, what is observed is that while there is a positive correlation between gold and Bitcoin, that correlation is moderate at best.
Over a longer data series, Spearman’s ρ demonstrates that Bitcoin’s correlation with gold has been minimal, often trending towards 0 at regular intervals.
One observation is that while there may at times be short-term correlations between Bitcoin and gold, over the long run, such correlations are statistically insignificant.
To see what a short-term correlation between Bitcoin and gold looks like, consider this graph provided by Bloomberg after Iran’s missile strike on U.S. assets in Iraq, in retaliation for a U.S. drone strike on Iran’s General Qassem Soleimani, in Figure 3.
Figure 3: Bitcoin and Gold prices after the Iran missile strike (Source: Bloomberg)
Whilst not quite moving in lockstep, the 24-hour tracing of the price of Bitcoin and gold were certainly more than inspired.
So, are Bitcoin and gold therefore short term partners when it comes to correlation? Tinder for asset classes? Choosing to hook up and then making their own ways thereafter?
Like gold that’s not been tested in fire
Because gold is considered and well documented as a safe haven asset, a more valuable analysis of Bitcoin and gold’s relationship is in the way both assets behave in times of financial stress.
And it is during these specific periods that the inconsistent behaviour of Bitcoin presents itself.
In view of the “flight-to-quality” phenomenon (Hammoudeh, S.M., Yuan, Y., McAleer, M., & Thompson, M. A. (2010). International Review of Economics & Finance, 19, pp 633-647.) and safe-haven categorisation, during times of market turmoil or distress, the behaviour of the asset class is of particular interest.
Up to 2018, the stock market, represented by the S&P500 saw a period of relatively stable growth, marked by two short periods of market distress and significant shock-like declines during the stock sell-off of August 2015 and again late 2015 and early 2016.
In 2018, the S&P500 suffered one of its worst years in recent history, losing 6.59% in a year fraught with volatility. Bitcoin fared no better, with the bellwether cryptocurrency giving up over 70% in that year alone. In terms of correlation though, the S&P500 and Bitcoin showed hardly any correlation whatsoever (Figure 4), which in and of itself does not make Bitcoin a safe haven asset.
Figure 4: Spearman Correlation Coefficient for Bitcoin vs S&P500 for the period 3 October 2013 to 18 February 2020
More indicative is Bitcoin’s relationship with gold when overlaid during this period as well (Figure 5).
Figure 5: Spearman Correlation Coefficient for Bitcoin vs S&P500 (Gray) and Bitcoin vs Gold (Blue) for the period 3 October 2013 to 18 February 2020
During the period of August 2015 and late 2015 and early 2016, it is observed that Bitcoin’s correlation with gold trended negative, when investors fled to safety in gold, but abandoned more speculative assets such as Bitcoin. The same can be observed in 2018, when the S&P500 saw its largest single-day point drop, Bitcoin had close to zero correlation with gold.
Several conclusions can be drawn from the data.
First, it can be observed that correlations between gold and Bitcoin drop to zero or negative values in times of market distress.
In the first downturn, of August 2015, an observable change from positive to negative correlation and a turnaround during the subsequent market recovery was noted. The fall in correlation during the second period, from a high of +0.03 in late October 2015 to -0.11 in early January is quite significant. The behaviour can be expected especially if the safe haven property holds true and clearly reflects the “flight-to-quality” hypothesis in times of market distress.
The same pattern is reflected in late 2018, when a selloff in stocks saw a decline in the price of Bitcoin as well, while gold surged.
Given that the dataset does not include a prolonged market downturn, such as the financial crisis of 2008, the market reversals in 2015, 2016 and 2018 suggest that the “flight-to-quality” hypothesis postulated by Hammoudeh et al. persists.
More surprisingly however, gold may not even be a safe haven. From 2014, there are negative correlations in times of stable upward movements of the S&P500, making it entirely possible that gold acts more like a hedge than as a safe haven asset in recent years.
More surprisingly however, gold may not even be a safe haven.
What makes the Bitcoin vs. S&P500 correlation fundamentally different from the correlations of gold and the S&P500 is the behaviour of the two asset classes during market distress. Interestingly, correlations are steeply increasing from a negative to a positive relationship when the S&P500 is a downward trend, which indicates that Bitcoin has a tendency to follow the downturn. While gold prices tend to increase with the “flight-to-quality” Bitcoin prices decrease along with the markets and risk appetite.
Zooming in on 2017, when Bitcoin’s price surge started in the second quarter, Bitcoin and gold are uncorrelated on average in the second and third quarter of 2017, remaining firmly in negative territory. Yet in the fourth quarter, gold and Bitcoin seem to couple again, coinciding with strong price increases in Bitcoin, decoupling again shortly after when Bitcoin drops while gold surges upwards, leading once again to the observation that there is no stable correlation between Bitcoin and gold.
The correlation with between Bitcoin and gold is characterised by positive and negative spikes with no general tendency, yet one would assume this correlation to be positive and stable if one believed Bitcoin to be similar to gold.
And while gold may be more akin to a hedge than a safe haven asset in its purest sense, Bitcoin may be neither, coupling with markets during bearish environments, as it did in 2018, with correlations rapidly turning positive.
From 2016 to 2018 especially, there are observable inverse movements of correlations of gold with Bitcoin and the S&P500. When correlations increase between gold and the S&P500, Bitcoin correlations decrease with the S&P500, which strongly suggest that gold and Bitcoin have a different quality of connectedness with the markets.
Under current market conditions, safe haven assets are few and far between and in recent years, gold has demonstrated that it may be behaving more of a hedge as opposed to an outright safe haven asset.
In view of this trend, the comparison of Bitcoin to gold is like trying to categorise the type of animal a Chimera is – it is an exercise in futility.
Bitcoin returns have an asymmetric response to market shocks, which is of the same direction than precious metals, but these price increases lead to an increase in volatility. Considering the extreme price increases observed for Bitcoin, this finding is not surprising.
The Spearman Correlation Coefficient provides evidence that Bitcoin behaves completely different from gold, particularly in times of market distress. While there is sufficient evidence to confirm a “flight-to-quality” property for gold, Bitcoin shows a positive coupling effect and declines when markets are declining in shock-like situations, as can be observed in 2015, 2016 and 2018.
Coinciding with a massive surge in equity markets in 2019, Bitcoin also demonstrated a positive correlation with the S&P500 at a time when its correlation with gold trended negative, suggesting that Bitcoin, for now at least, is no hedge against equity investments.
But given that the sample data did not include a prolonged period of economic malaise and the relatively youthful and unsophisticated nature of cryptocurrency markets, it may be premature to rule out Bitcoin’s “gold-like” properties.
For now, based on the available data, Bitcoin, as an asset, does not resemble any other conventional asset from an econometric perspective.
In the short to medium term at least, Bitcoin and cryptocurrencies in general, will remain highly volatile with potentially large drops in price, as investors will continue to take profit at the peak of price movement. But unlike established asset classes, regulatory classification and oversight of Bitcoin and other cryptocurrencies will have an outsize influence on investor appetite for these nascent assets.
To liken Bitcoin to gold at this juncture at least, is more alchemy than chemistry.