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 that the industry faces the existential threat that some in the media have portrayed?
Furthermore, does this mean that the asset class forged in resistance to the global banking cabal will be forever susceptible to the trends and whims of the traditional financial system?
The answer to both of these questions is a resounding no, but this year’s turmoil may present an inflection point for the cryptocurrency industry. To maintain the space’s independence from centralized authorities, we may need to retool how we think about investing in digital assets.
A New Way to Look at Crypto Investing
While a bear market is not fun for anyone in the short term, these periods have historically presented industry-wide growth and rejuvenation opportunities.
Despite the immediate pain points of the recent market declines, it's important to remember that the long-term picture for cryptocurrency remains as bright as ever. The principles of decentralization, transparency, and borderless connectivity that form the basis of the blockchain industry are as sound now as when Satoshi Nakamoto released the Bitcoin white paper in 2008.
To protect these tenets and decouple the industry from the influence of central banking, though, we'll need to rethink our approach to cryptocurrency investing at the individual level.
Until now, cryptocurrency headlines have been dominated by price speculation and the market's reaction to economic trends and forces. Despite taking place almost every day, technological breakthroughs in the blockchain space rarely find their way into the mainstream media, and why. When they do, it's often in the context of another market upswing or drop.
The media's myopic focus on price movements has led to a situation where many investors are more concerned with when to buy or sell than what they're buying or selling. This mentality has contributed to the recent correlation between cryptocurrency and traditional capital markets, which in turn introduces increased levels of centralization to our decentralized industry.
For those who see the potential for cryptocurrency to be a world-changing force for good, a bear market provides the perfect opportunity to break the cycle of price speculation and invest in the long-term growth of the space. This not only positions investors to benefit when the bulls come home, but a wide-scale effort on this front would also help to shield the industry from macroeconomic influences.
Here are five tips for entering a cool crypto market:
1. Look for projects with solid fundamentals. In a bear market, a project's underlying infrastructure is often a better indicator of its future potential than current trend lines will show. Look for projects with practical use cases, strong teams, sound governance models, and vibrant communities.
2. Consider a longer-term investment model. During periods of volatility, reacting to short-term price movements is always tempting. By investing with a longer time horizon, you can avoid the FOMO trap and make more informed decisions about which projects are worth investing in from the beginning.
3. Diversify your portfolio. One of the best ways to manage risk in a bear market is to diversify your holdings across different projects and asset classes. Investing in a mix of established and emerging projects can protect your portfolio from the downside while still participating in the upside when the market turns around.
4. Incorporate new investment strategies. Bear markets present an opportunity to experiment with unique investment strategies and find what works best for you. If you believe in the long-term success of a project, dollar-cost averaging is a great way to build a position over time without having to worry about timing the market.
5. Stay up to date with industry trends and macro developments. The cryptocurrency industry is constantly in flux, and breakthroughs are happening all the time. But focusing on the sector exclusively isn't enough to make informed investment decisions anymore. Knowing macroeconomic trends and world events is just as important now, and understanding how cryptocurrency fits into the bigger picture will help you make more informed decisions about where to allocate your capital.
Bitcoin and the Fed: the Macro View
As more individuals and institutions incorporate cryptocurrency into their lives and businesses, digital assets will only become increasingly integrated into the broader global economy. With this in mind, completely decoupling cryptocurrency markets from the influence of centralized authorities like the Federal Reserve may not be possible or even desirable to some.
While it's difficult to pinpoint a direct correlational relationship between Bitcoin and the Federal Reserve, it's increasingly important to consider how macroeconomic trends could impact the future of cryptocurrency. The Federal Reserve's directives profoundly affect global markets, and these policies will likely continue to influence the cryptocurrency market in some fashion for years to come.
The cryptocurrency industry was founded on decentralization, transparency, and independence from centralized authorities. By refocusing our investment attitudes from price speculation back to the technology and teams behind projects that exemplify these ideals, we can strengthen the foundations of this industry and increase cryptocurrency's resistance to the edicts of centralized authorities like the Federal Reserve.
From this perspective, the current bear market may not be so much a crisis as it is an opportunity to build a stronger, more resilient foundation for the industry's future. It’s time to get back to the fundamentals and invest in a decentralized future we can all believe in.
Disclaimer: This article is for informational purposes only. The opinions expressed in this piece are the author's and the author's views alone. None of this is intended to be investment advice nor a recommendation to buy, sell or trade any specific asset. FTX bears no responsibility for any losses incurred due to the information or opinions this article presents. Before investing in any digital asset, please research and always remember to trade responsibly.