Blockforce Capital Monthly Market Commentary

Executive Summary

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Key Highlights

• Bitcoin significantly outperformed other major assets in May, returning 62% for the month, compared to the S&P 500 (-6.6%), the ACWI All-World Index (-6.0%) and gold (+1.7%)
• The S&P 500 had inflated volatility during the month of May, while gold’s volatility stayed relatively flat.
• Binance coin continues to outperform the broader crypto market, outperforming bitcoin by 307% YTD through the end of May.
• Since the digital asset market started its rally on April 1, 2019, Bitcoin Cash (BCH) was the only top 10 asset to outperform bitcoin, outperforming by 58% through the end of May.
• The Sharpe Ratio, often used to measure the risk taken for the reward received, remains strong for bitcoin at 3.54 YTD. Binance Coin (BNB) is the only top 10 digital asset supporting a higher Sharpe ratio than the largest cryptocurrency, with a reading of 4.76 YTD through May 31, 2019.
• May saw a substantial volume increase in the broader market, both in futures and spot currencies. Binance volumes are 5% away from monthly highs set in December 2017, while Coinbase’s volume is 67% away from its monthly high.
• CME/CBOE futures contracts saw a considerable volume spike in May, and have registered the highest level of open interest since the futures contracts were established in December of 2017, but there is a standoff between small speculators being overly bullish and large speculators being overly bearish.
• Bitcoin continues to be uncorrelated to numerous global assets, but top digital assets continue to trade with elevated statistically significant correlation.
• Bitcoin volatility has been lower than average year-to-date but popped its head above its long term average in May.
• Blockchain metrics continue to be an important source of data for overall blockchain adoption and health, and unique addresses are often a leading indicator.

Market Overview

Throughout May bitcoin and other digital assets experienced tremendous gains in relation to traditional assets, with bitcoin returning 62% for the month, compared to the S&P 500 (-6.6%), the ACWI All-World Index (-6.0%) and gold (+1.7%), as well as the two-year Treasury yield decreasing by 15%. Traditional markets have responded to the ongoing trade war with increased volatility, which also appears to be connected to debates over nationalism. The S&P 500 and other global markets were floating near all-time highs at the beginning of the month, with the S&P 500 topping out around 2950. However, the S&P was generally downward trending in May, closing on the month’s low of 2750. Conversely, the ongoing sentiment surrounding global markets has not phased the digital asset markets, as the appreciation of the prices of this emerging asset class continued to gain significant ground since the beginning of the year, a healthy sign that the ongoing crypto winter has changed seasons. To see the live version of the following graph, click here.

Gold/ S&P 500 Deviation

What is most surprising about the recent traditional market volatility is that gold, commonly used as a hedge against market uncertainty, has not performed well in the current volatile stock market environment. The volatility of gold and the S&P 500 are usually similar — as equities become more volatile so does the price of gold. However, the difference between the two assets’ volatility has experienced a considerable divergence and is currently the highest it’s been during this 10-year bull run. As shown in the chart below, gold’s volatility has flatlined and, at the same time, the volatility of the S&P 500 has increased substantially.

Digital Asset Dispersion

Asset price appreciation in digital markets has not been without uncertainty, as many digital assets have lagged bitcoin’s performance since the beginning of the rally in early April. In 2017, altcoins significantly outperformed bitcoin, whereas this rally was started (and has been primarily led) by bitcoin. We believe this paradigm shift is due to new entrants dipping their toes into the marketplace with allocations to bitcoin instead of a top coin passive index or altcoin exposure. In fact, out of the top 10 digital assets by market capitalization, Bitcoin Cash is the only cryptocurrency outperforming bitcoin since the rally started.

Bitcoin’s continued dominance of altcoins is changing the historical narrative that altcoins present a greater risk-reward opportunity in the cryptocurrency marketplace. In 2017, many of the top 10 altcoins outperformed bitcoin by either hundreds or thousands of percentage points. Conversely, in 2018 most altcoins underperformed bitcoin. So far, throughout the first five months of 2019, only three of the top ten coins have outperformed the flagship digital asset. It’s becoming clear that the recent rally is being led by bitcoin, and as the asset class matures it’s unlikely we will see the type of altcoin performance we saw in 2017.

From a risk management perspective, this is extremely intriguing, given the fact that the asset class is nascent and evolving considerably fast. The overall narrative that altcoins possess an enhanced risk-adjusted return does not apply to the asset class like it did in 2017. This furthers the case that professional risk management is needed in order to take advantage of the increased risk-reward versus other asset classes. An easy way to quantify this is to examine Sharpe Ratios, which measure the return received by the amount of risk taken. Given the amount of risk that altcoin assets have exhibited year to date, it is surprising to see that bitcoin provided better risk-adjusted performance when compared to all but one of the top 10 altcoins. The only altcoin with a better risk-adjusted return than bitcoin in 2019 has been Binance Coin, with a Sharpe Ratio of 4.76, compared to bitcoin’s Sharpe Ratio of 3.54.

Volume

Bitcoin trading volume has exploded over the last few months, across both institutional futures contracts and spot markets, but the landscape is changing. On May 12th, the derivatives exchange Bitmex saw a record $10 billion in notional trading volume, although it should be noted that those volumes are unavailable to traders in the United States. Spot market exchange Binance is experiencing volume levels near its all-time highs from 2017. On the other hand, Coinbase’s spot market exchange is still 67% off its 2017 peak volume, but it has posted a 165% month-over-month gain in bitcoin volume.

The Commitment of Traders Report from the CFTC (Commodity Futures Trading Commission) often helps shed light on growing institutional demand for various futures products. The results appear to show that the general mindset of large asset managers continues to be bearish, while small speculators continue to grow more bullish in unison. The varying perceptions between institutions and smaller investors are important because large asset managers can significantly influence the price of futures contracts due to the trillions of dollars they manage versus the current market capitalization of bitcoin. Both groups are at odds and continue to increase their positioning.

Lastly, open interest in the CME and CBOE contracts skyrocketed in May, with a 165% month-over-month change — and a change of over 344% since their December 2017 debut. As bitcoin trends out of its speculative faze, it will be imperative to look at trading volume metrics as an indicator of the overall interest from both long-term holders and new market entrants. It’s apparent there is growing interest in the asset class given the significant increase in open interest as of late, with the open interest metric tracking contracts that are open on either side. However, while the current data does not point to a bullish view, with larger speculators establishing bearish positions, it does indicate that people are taking notice of the asset class and developing an opinion with their assets. The growing futures interest on both the long and short sides, coupled with increased volatility, may align in the future as the perfect storm for traders, but it will likely be a rocky investment period for long term holders. This reaffirms our belief that it is as important a time as ever for active management in such a volatile asset.

Correlations

At Blockforce, our team is comprised of a mixture of financial professionals, quantitative scientists, and statisticians. On top of digital assets being an emerging asset class, one of the reasons we chose to dive into digital assets is that the asset class features the curious characteristic of being a macroeconomic experiment with massive amounts of quantitative data — something that doesn’t happen very often. However, the relatively early age of the asset class means there is also plenty of misinformation. The reason we mention this is because there are often misrepresentations about the correlation between different digital assets or digital assets and traditional assets, and we want investors to be appropriately advised and informed.

Specifically, we want to point out that a few recent articles have incorrectly quoted that bitcoin is negatively correlated to the S&P 500. The issue with that statement is that the analysis is based on the correlation of prices, not returns, which leads to the use of non-stationary data that allows the calculation to pick up on general market trends instead of corollary convergences/divergences. Investopedia provides a sufficient explanation, or for a more comprehensive exploration of this topic, take a look at pages 15–18 in Anticipating Correlations.

Here is a brief overview of correlations versus broader global markets:

Correlations are generally a moving target, but historic averages usually ring true and assets typically fall in-line with expectations. We are currently seeing a rare deviation between bitcoin’s correlation to gold and its correlation to the S&P 500, as the correlations are now deviating from the long-term averages over the past two and a half years. Gold is slightly positive, while the S&P 500 is similarly negative. We expect a reversion to the mean near zero to take place in the near future. It’s also interesting that both are deviating more than average at the same time. Historically, gold is the proven risk hedge and bitcoin is the volatile up and coming asset used to manage risk against traditional equity and bond markets.

Several defining factors are making the case for bitcoin as a global market hedge. The recent correlation dispersion of gold versus global equities, the general market uptick in volatility, and the ongoing trade war with China are all contributing events. Furthermore, the Chinese Yuan has sold off versus the US dollar. Bitcoin, on the other hand, continues to be a steady uncorrelated asset versus the Yuan, while gold has been waffling back and forth. Bitcoin has been banned in China since the People’s Bank of China began prohibiting financial institutions from handling cryptocurrency transactions in 2013. They have continued rolling out regulations in 2017 and 2018 to ban cryptocurrency trading platforms and mining. This hasn’t stopped the growing interest in digital assets though. Baidu, the largest search engine in China, has seen a steady increase in searches for the word “bitcoin” since the most recent rally started. Also, while outwardly skeptical of cryptocurrency, China fully supports the underlying blockchain technology. Mass adoption of blockchain applications is included in the countries’ five-year economic plan.

Digital Asset Correlations

In traditional markets, assets are typically more correlated during extreme volatility and downward trends. Digital assets are no different, as investors typically sell hastily in risk-off scenarios and there is more dispersion in upward trending markets. The first three months of 2019 were reasonably rocky, with the year starting in sell-off mode after a December 2018 rally. A $100 million bitcoin buy order hit the tape on April 1st in what appears to have been the end of the bear market. Most correlations of the top altcoins have ticked down from their 2018 bear market levels, but are still well above their averages from the latter half of 2017’s parabolic bull run.

Binance Coin continues to stand out amongst its peers, returning 437% year-to-date, compared to bitcoin’s 131% return, as of May 31, 2019. As one of the few cryptocurrencies with a tangible use-case today¹, it continues to gain ground against other altcoins and is generally uncorrelated versus its peers. In contrast, Ripple’s XRP token has historically exhibited lower than average correlations to other cryptocurrencies but has recently been trending more in-line with the broader top 10 altcoins.

Correlations track how assets are trending together and may shift over time, especially in an emerging asset class like digital assets. As projects begin to receive adoption, their fundamental use-cases will emerge and stratification between more viable and less viable digital assets will ensue. Conversely, broader macroeconomic forces may impact and increase the correlation during risk-on/risk-off events. If you are interested in tracking correlations, check out our daily correlation matrix or our rolling historical correlation heatmap.

We study changes in correlation over time to understand how underlying shifts in sentiment affect portfolio risk. Another way to examine disruptions from the norm is by evaluating trading range deviations, similar to a pairs-trading model. As an example, there have been four times this year when the residual spreads of ether and bitcoin have approached or exceeded two standard deviations. During the first and third event ether outpaced the returns of bitcoin, and the second and fourth event resulted in bitcoin outpacing ether. The most recent deviation took place on May 4th. At the time, bitcoin had rallied 40% since April 1st, while ether was only up around 14%. As two historically highly correlated assets, this event was an uncommon occurrence, which signaled to us that we should expect to see ether catch up with bitcoin’s rally. A few day’s later, ether rallied significantly while bitcoin sold off slightly.

Volatility

Volatility is one measure of risk that investors can use to gauge risk-adjusted returns. Most people involved in the digital asset markets are speculating on the long-term hyper-growth of the emerging asset class, which typically brings substantial volatility. Investments should have a greater expected return when they have a higher expected risk, and just because an asset is more volatile does not mean that it has a higher asymmetric performance profile. However, we have found that this shouldn’t be taken as a blanket statement. Assets’ risk/reward profiles must be studied to protect investor capital. This was briefly discussed in the section above when discussing Sharpe Ratios — the general thought in the digital asset market is that altcoins possess an enhanced asymmetric return versus bitcoin. Historically, bitcoin is about eight times as volatile as the S&P 500, and three to four times more volatile than crude oil and platinum — often viewed as the most volatile “traditional” commodities.

Aside from our general passion about digital assets and blockchain, one of the main reasons we continue to create products in the digital asset space is because we see that most asset managers are structuring venture capital type products, with little to no risk management, in one of the most volatile assets that our generation will encounter. Hedge Fund Research, Inc., a widely cited traditional asset data provider that tracks hedge fund performance, reported that their HFR Cryptocurrency Index was down 70% in 2018, just a few percentage points better than the flagship cryptocurrency, bitcoin. For some investors, this may be acceptable, but it is our view that most institutional investors cannot deal with the stomach acid of such a significant drawdown. Risky assets are not bad, as they often provide an elevated risk/reward ratio if managed appropriately — that is why speculators are generally interested in things like emerging and frontier markets, venture capital investments, commodities, marijuana stocks, and digital assets.

Bitcoin has spent a majority of the last year under its long-term volatility average of 76%, but it recently ticked back above this level in May, closing the month with a 60-day volatility reading of 80%. Traditionally, volatility will decrease over time as an asset becomes more institutionalized and there are more market participants. We expect that the growing institutionalization of this asset class will continue to tamp down expected volatility over the long term, but assume that the general declining trend will see periods of elevated volatility like we are currently seeing in the marketplace.

Altcoins are usually riskier assets than bitcoin and on average have a higher volatility reading than bitcoin given their smaller market capitalization and emerging nature. As stated earlier, the current rally is being led by bitcoin’s outperformance versus many of the smaller digital assets. However, altcoins continue to have elevated risk characteristics compared to their larger counterpart even with their performance lag. As shown in the chart, bitcoin is often the least volatile digital asset, a sign that investors chasing performance in altcoins may not enjoy the same risk-adjusted return that bitcoin has recently offered. If you are interested in tracking the volatility of top digital assets, the Blockforce team has put together a volatility tracker that can be viewed here.

Thus far, we have been discussing historical volatility, which is a backward-looking signal that helps us understand the general risk of an asset. Skew has an incredible number of tools and data to help understand bitcoin options and futures characteristics. For traditional assets, this data is readily available via Bloomberg but has been much harder to come by in digital assets. Implied volatility helps investors recognize where the market thinks volatility will be in the future. There are often periods where implied volatility is mismatched with realized volatility, creating opportunities for trading or potential mismatches in a risk-managed strategy. According to Skew’s data, market participants believed that bitcoin volatility would be higher than what was realized in May even with the relative increase in realized volatility. This is not uncommon, especially in nascent assets that are speculative. These implied volatility numbers may also be inflated due to a lack of liquidity, but it gives a general sense of how much participants paid for future protection.

Blockchain Data Analytics

Blockchains present an incredible opportunity to measure statistics that are not available for traditional markets. Network health, participation, transaction costs, and many other factors are readily (and freely) available for those interested in alternative data points. Understanding what could potentially be a leading or lagging indicator to price movements is essential in both quantitative trading and risk management.

One of the most exciting developments thus far has been tracking unique wallet addresses versus the price of bitcoin, as they have been a leading indicator of bitcoin’s price moves. This data analysis has helped our firm gauge overall market health, but it has not been predictive of short term price disparities given the amount of noise in the signal (the chart has a nine-period moving average to help smooth it out). The below graphic shows the overall correlations of bitcoin’s price versus several quantitative blockchain factors. As you can see, each of the signals’ correlation shift over time. While the signals help gauge overall sentiment, they are not predictive of short-term price returns. Despite the fluctuating relationships, the data points are invaluable to scoring algorithms, factor-based analytics, and machine learning models.

Looking forward to next month

Tracking all the developments and market moves in May only leave us more excited to see how the rest of this month and upcoming months play out as well. If you would like to receive this monthly market commentary again next month please sign up here.

The opinions and data presented herein are for informational purposes only and should not serve as the basis of any investment decision. Information is given in a summary form and does not purport to be complete. Information and data have been obtained or derived from sources believed by Blockforce Capital to be reliable, however, Blockforce Capital does not make any representation or warranty as to its accuracy or completeness. The sole purpose of this material is to inform, and in no way is intended to be an offer or solicitation to purchase or sell any security, other investment or services, or to attract any funds or deposits.

DISCLOSURE: Blockforce Capital manages investment vehicles that invest in and hold digital assets, including the digital assets discussed in this article.

Footnotes

¹ (link: Binance Coin (BNB) is the native digital asset that runs on the Binance chain protocol. BNB was established with a total supply of 200 million tokens, however, Binance will destroy a variable amount of BNB tokens each quarter, based on trading volume, until 50% of the total supply is destroyed, resulting in an eventual total supply of 100 million BNB. In addition to being the native token running on the Binance chain, BNB also allows traders to trade on both the Binance exchange and Binance decentralized exchange with discounted trading fees, both by using BNB to pay for fees and by providing tiers of lower trading fees based on a combination of the account’s monthly trading volume and BNB holdings.