IMF: The increasing correlation between stock and crypto markets is a risk to financial stability

The movements of the crypto markets and the traditional stock markets have converged more and more in recent years, as a study by the IMF shows.

The crypto market has seen greater adoption in recent years, with its global market value rising from $ 620 billion in 2017 to $ 3 trillion in November 2021. After a price correction lasting several weeks, this value is currently at 2 trillion dollars, which is still four-fold growth since 2017.

A new study by the International Monetary Fund IMF also shows an increasing correlation between crypto assets and the traditional financial market. The report notes that this “limits their perceived benefits in risk diversification and increases the risk of contagion in financial markets.”

Before the pandemic, cryptocurrencies were barely associated with the major stock indices. The same was reported in mid-November last year. From this, the suitability of cryptocurrency as a risk reducer and as a hedge against price fluctuations in other asset classes was derived.

However, this situation has turned 180 degrees after the central banks’ response to the crisis in 2020. Financial conditions became more favorable and investor appetites rose. As a result, both crypto prices and stocks rose in value. The report gives an example of Bitcoin and the S&P 500 stock index. Their correlation was almost zero in 2017-2019, but increased 36-fold in 2020-2021. Similar correlations can also be found between crypto assets and stocks in emerging markets. The return on Bitcoin and the MSCI Emerging Markets in 2020-2021 was 0.34 – a 17-fold increase over previous years.

Stocks and cryptos are synchronizing

In addition, the study shows that the correlation between cryptocurrencies and stocks is higher than the correlation between stocks and other assets. These include, for example, assets like gold, investment grade bonds, and stable fiat currencies. According to the IMF experts, this suggests that the benefits of risk diversification are significantly less than what was originally thought.

Rather, it increases the likelihood of spillover effects in investor sentiment between different asset classes. Financial spillover occurs when fluctuations in the price of one asset trigger the same fluctuations in another asset. According to the IMF study, the spillover between Bitcoin and stock markets, such as the S&P 500, increased significantly in 2020-2021 compared to 2017-2019. Similar behavior was observed with stablecoins, albeit to a lesser extent than with bitcoin. Spillover, according to the study, often occurs in volatile financial markets, such as in March 2020, or when Bitcoin gets hit again, as in early 2021. These “co-movements” enable the transmission of shocks that can destabilize the financial markets,

IMF: Crypto regulation absolutely necessary to minimize risk

The study concludes with the following recommendation:

“It is therefore time to adopt a comprehensive, coordinated global regulatory framework to guide national regulation and supervision and to mitigate the risks to financial stability posed by the crypto ecosystem.”

This regulatory framework should apply to the common use of cryptocurrencies and to financial institutions trading in cryptocurrencies. In addition, the anonymity of the industry should be lifted and gaps in data should be “quickly closed”. Not only will this improve understanding of the crypto industry, but it will also help mitigate the risks associated with its rapid growth.