Unlikely Bedfellows? A Look at Bitcoin and the Federal Reserve | FTX.com
By Donald Gray
Originally published on FTX.com on July 22, 2022
In the wake of the 2008 global financial crisis, a group of programmers, cryptographers, and computer scientists worked alongside a pseudonymous figure named Satoshi Nakamoto to launch a peer-to-peer payment network that would redefine finance in the digital age.
Bitcoin was the first successful application of blockchain technology, a novel networking protocol that leverages decentralization and transparency to verify transactions. Unlike conventional currencies, which are issued and regulated by central banks, blockchain ushered in the era of genuine peer-to-peer payments. The technology birthed a new class of digital assets called cryptocurrencies-- currencies that operate off of computer code and could work independently of the whims of any central institution or governing body.
Amongst all the centralized banking institutions in the world at the time, early Bitcoin adopters saw independence from the US Federal Reserve as a particularly appealing quality. Some even saw the nascent cryptocurrency industry as a way to opt out of the existing financial system altogether and create an entirely digital economy free from the influence of traditional finance.
The ethos of Bitcoin, as laid out in Nakamoto's original white paper, is one of decentralization, transparency, and borderless connectivity - principles that run counter to the often opaque and centralized decision-making of the Federal Reserve.
But as the cryptocurrency industry has matured and achieved widespread adoption, its relationship with traditional markets has shifted in several ways. Today, Bitcoin still exists outside of the banking system, but cryptocurrency valuations have begun to show high levels of correlation to conventional capital markets in recent months.
So what does this mean for the future of Bitcoin? Suppose cryptocurrency valuations perform more like tech stocks than a wholly independent asset class. Does this mean we should start looking toward traditional markets and macro trends for cues on the industry's future?
To answer this question, we'll need to dig a bit deeper into how Bitcoin, and the cryptocurrency industry as a whole, fit into the current macroeconomic landscape.
Bitcoin and the Wider Macro Picture
As much as Bitcoin may differ from traditional fiat currencies in terms of its decentralized infrastructure, the reality is that it still exists within the confines of our current macroeconomic system.
While Bitcoin is not subject to the same inflationary pressures as fiat currencies - owing partly to its limited supply of 21 million coins - it's still susceptible to broader macroeconomic forces. This means that regardless of its independence from central authorities in terms of governance, Bitcoin prices are still influenced by factors like global trade tensions, GDP growth...and, yes, the monetary policy and interest rates set by institutions like the Federal Reserve.
In other words, while Bitcoin may not be under the direct control of the Federal Reserve, it is today very much influenced by the policies and decisions of the world's most powerful central bank.
But if Bitcoin was created as an alternative to the traditional finance system, why are the crypto markets seemingly taking cues from the Federal Reserve today? To understand this, we'll need to look at the historical relationship between Bitcoin and traditional finance.
Turbulent Beginnings: Bitcoin and the GFC
The global financial crisis gets little press these days. Still, the series of events kicked off by the collapse of Lehman Brothers in September of 2008 had far-reaching consequences that are still being felt today-- consequences that have more or less defined the economic zeitgeist we've been living in for the past 14 years.
The crisis was initially kicked off by subprime mortgage lending practices and leveraged financial products backed by these mortgages in the United States. These mortgage-backed securities transformed what would have been a severe but manageable crash in the US housing market into an existential crisis that saw the failure of several major financial institutions and a cascading series of effects that eventually engulfed the global economy.
In response to this crisis, central banks and governments worldwide took unprecedented steps to prevent an even deeper global economic collapse. In the US, the Federal Reserve lowered interest rates to near-zero levels. It implemented an aggressive quantitative easing regimen that saw the Fed's balance sheet expand from $800 billion in September of 2008 to over $2 trillion by the end of that year.
While these measures successfully staved off an even worse crisis, they also had several unintended consequences. One of the most significant of these was the creation of asset bubbles in several different markets, including stocks and bonds, bringing about a state of stagflation- economic conditions characterized by high inflation and low growth.
In response to this dismal economic environment and the devaluation of global currencies, people began to look for alternative stores of value less susceptible to manipulation from central banks and world governments. The government's subsequent decision to bail out the banks that had caused the crisis - while necessary to prevent an even worse collapse – fueled a widespread loss of faith in the traditional financial system.
It was in the midst of this economic turmoil that Bitcoin was born.
As if to emphasize the importance of this moment in history, Satoshi Nakamoto, the protocol's pseudonymous creator, inscribed a newspaper headline from 2009 that reads “The Times 03/Jan/2009 Chancellor second bailout for banks” onto the first-ever block on the world's first blockchain.
Over the next decade, Bitcoin would grow from a novel concept on the internet's fringes into a household name. The unique combination of a fixed supply, decentralized governance, and censorship-resistant transactions made Bitcoin an attractive store of value in an era of quantitative easing and asset bubbles, and waves of retail and institutional investors began adopting the asset.
Running on its own network and removed from the global banking system, Bitcoin maintained correlational independence from traditional markets for most of its existence. However, this would change after Covid-19 shuttered economies worldwide and sent shockwaves through global financial markets.
Bitcoin and the Covid Economy
The Covid-19 pandemic nearly brought the global economy to a standstill. In the spring of 2020, it was apparent that the world was in for a collective economic shock, but the extent and severity of the economic downturn were impossible to predict.
With the specter of 2008's financial crisis hanging heavily over the economy, the Federal Reserve injected unprecedented liquidity into the market while simultaneously lowering interest rates to near-zero levels.
These inflation-inducing measures highlighted Bitcoin's use-case as a hedge against inflation, and its price began a steady climb after the new reality of life under Covid-19 became clear.
The social and economic effects of Covid-19 will be studied for decades, but one of the most profound effects of this era was the entrance into the market of millions of new investors.
The combination of stimulus checks, a population restricted to the confines of their own homes, and the advent of social trading drove a new class of investors into both traditional and digital markets, with many young investors drawn to 'riskier' assets like cryptocurrencies and high-growth stocks.
As the revolution in mobile investing began to blur the lines between the cryptocurrency and stock markets, Bitcoin and the broader cryptocurrency market began to show higher levels of correlation to traditional high-growth assets like tech stocks in conventional markets.
High liquidity and low-interest rates in the markets also gave cover for increasing numbers of institutional investors to venture further into the cryptocurrency space. With firms like Grayscale, Paypal, and Merill Lynch all making either direct investments in cryptocurrency by adding digital assets to their balance sheets or structural investments in the space by incorporating support for cryptocurrency into their product offerings, increasing levels of institutional investment signaled a new era of mainstream adoption for the cryptocurrency space.
All these factors contributed to the historic bull run to Bitcoin's all-time high in November 2021.
But while institutional investment in Bitcoin is widely regarded as a bullish signal for the digital asset's price movements, it's also important to remember that this type of investment, especially from publicly traded companies, forms a direct link between the cryptocurrency space and traditional capital markets.
In other words, while institutional investment is a welcome development for the cryptocurrency industry, it increasingly exposes digital assets to the same macroeconomic forces that reign over traditional markets. Recent history shows that the Federal Reserve is the most powerful of all these forces.
2022: Year of the Bear?
2022 has been a tumultuous year for cryptocurrency and the global economy. Worldwide, With mounting geopolitical uncertainty fueled by events like Russia's invasion of Ukraine, historic levels of inflation, and a lingering pandemic wreaking havoc on the global supply chain, governments, and central banks worldwide have been forced to take action to stabilize their economies and quell inflation.
This has taken the form of a sharp reversal from the recovery era's loose monetary policy in the US.recovery era's. In January of this year, the Federal Reserve announced a regimen of quantitative tightening (effectively removing liquidity from markets) and impending interest rate hikes to cap inflation that’s running above 9% at the time of writing.
The Fed’s simultaneous rise of interest rates and reduction of market liquidity prompted an overall downturn in both traditional and digital markets, with high-growth assets like tech stocks and cryptocurrencies receiving the brunt of the selling pressure.
The cryptocurrency space, which began showing higher signs of correlation to tech stocks in the fall of 2021, has also moved in tandem with the stock market’s Fed-induced downturn.
The precipitous decline of crypto markets in the spring of 2022 unearthed systemic issues at several major firms across the industry. The spectacular meltdown of algorithmic stablecoin TerraUSD and its sister coin Luna revealed a vast network of over-leveraged financial contracts between many high-profile firms in the space, conjuring memories of the mortgage-backed securities that kicked off 2008's economic meltdown.
The overall result has been a perfect storm of factors that put immense downward pressure on cryptocurrency prices in the first two quarters of 2022.
Since the Federal Reserve's change in monetary policy, the total market capitalization of all digital assets has declined from its all-time high of over $3 Trillion to a market cap of under $1 Trillion at the time of writing.
Liquidity has dried up from exchanges, and prices across all digital assets are down. The cryptocurrency market has entered a clear bear phase, but does this mean t