Why did Bitcoin crash? We may need to rethink Bitcoin's hedging properties

Since the creation of Bitcoin by Satoshi Nakamoto in 2008, its peer-to-peer, decentralized nature has been seen as a stark contrast to traditional assets. While so far we believe that Bitcoin does not have intrinsic value support, as Bitcoin becomes more known to society, its distribution becomes more decentralized, and factors such as production and energy consumption costs contribute to the gradual increase in the price of Bitcoin.

Over the past eleven years, Bitcoin holders have given Bitcoin multiple labels, such as payment, dark web transactions, digital gold, and more. However, with the development of blockchain technology, Ripple has emerged in the payment sector, and digital currencies utilizing blockchain technology like Libra are on the horizon. In the dark web, Litecoin and various privacy coins such as Monero, Zcash, etc., have replaced Bitcoin as the mainstream payment currencies.

With Bitcoin's favorable performance during several geopolitical crises in 2019 and the first half of 2020, advocating Bitcoin as a "digital gold" has become increasingly common. However, during the global asset market "black swan" event caused by the 2020 COVID-19 pandemic, Bitcoin did not perform as expected, experiencing a rapid drop from around $9,000 to a low of $3,800 after the oil crisis. Has the myth of Bitcoin as a hedge been shattered? Or is this story similar to the narratives of payment and dark web transactions – just stories? Next, we will analyze Bitcoin's hedging properties from multiple perspectives.

Liquidity Drought

It is well known that the core requirement for any tradable asset in the market is strong liquidity. Insufficient liquidity may lead to excessive impact costs when opening or closing positions, and in extreme cases, a shortage of liquidity may result in competitors outpacing each other. Unfortunately, Bitcoin's liquidity currently does not meet trading standards. Although the daily trading volume in the Bitcoin market approaches $50 billion (Coinmarketcap data, excluding exchange volume manipulation), observing whether traditional financial markets are buying Bitcoin, we can see that the CME Bitcoin futures open interest has been declining this year, indicating that institutional traders using Bitcoin futures as a hedging tool through compliant futures exchanges are not many.

Furthermore, Coinbase's USD trading pair with USDT has been consistently discounted, indicating that compliant users on Coinbase are net sellers of Bitcoin rather than buyers. In contrast, during the early 2019 Bitcoin bull market, Coinbase was consistently at a premium, meaning that whales and institutional investors were entering the market. The liquidity drought between Bitcoin and traditional markets has led to hedging funds not considering Bitcoin as their first choice during crises. Therefore, the foundation for discussing Bitcoin's hedging properties does not exist.

Relatively High Prices

The recent trend in Bitcoin's price is interesting. Initially, driven by the U.S.-Iran conflict crisis at the beginning of the year, Bitcoin quickly rose from around $7,000 to near $9,000. In addition to the anticipated geopolitical crisis (further details will be outlined in the next section), a major reason for the speculation was the internal speculation story of "supply reduction." In theory, supply reduction should lead to supply-demand imbalances and price increases. Unfortunately, in the cryptocurrency world, "supply reduction" is just a speculation gimmick.

If we compare Ethereum and other altcoins with Bitcoin, it is clear that during the early 2019 bull market, Bitcoin's price increase was notably greater than that of altcoins. This phenomenon can be understood as Bitcoin being boosted by incoming capital, triggering a rally, with altcoins following suit. However, the recent rally at the beginning of this year was completely different. BSV, BCH, ETC, ETH, and other altcoins initiated the rally, with Bitcoin slowly catching up, but its price increase was not as significant as the doubling or tripling of these altcoins. The market focus then shifted to undervalued coins like XTZ, LINK, rather than Bitcoin, which was about to undergo "supply reduction."

This illustrates that this rally was driven internally, with market dynamics triggering external factors, and no new capital influx occurred. For external funds looking to enter the market, the high point of $9,000 compared to the low point near $6,800 is about 1.4 times higher. Continuing to enter at such high levels presents inappropriate risk-reward ratios, let alone fulfilling so-called hedging demands. For market makers and whales, this rally involved significant leverage, leading to high futures positions. Continuing to push the price higher would require closing profitable futures positions, requiring substantial capital, while the bullish sentiment, with a long-short ratio at one point reaching 3:1, and a bullish funding rate exceeding 100% annually, indicates higher odds of a downside breakout. Therefore, the foreseeable trend is a downward breakthrough.

For them, the uncertainty of inflowing funds bringing hedging demands is uncertain, but the certainty of liquidating futures positions following a crash is definite. Between certainty and uncertainty, every rational economic actor would make a choice.

Expectations vs. Unexpected Events

Asset price movements can be boiled down to two core elements: game expectations and realization of expectations, and odds. These two points are easy to understand. For example, if the U.S. and Iran are currently in a tense relationship that could trigger a local war, investors would bet on the possibility of war between Iran and the U.S. based on appropriate odds. The situation could unfold in three ways: no war, war, or war with a much greater intensity than expected, such as Trump ordering a missile strike that kills the leader of the Revolutionary Guard. The first and second scenarios would mean investors' game expectations have been met, and they would receive the appropriate returns based on the odds they placed. However, if the third scenario occurs, it means that an unexpected event has happened, leading to more risk-averse investors entering the market. Investors who placed bets earlier would receive higher returns or losses than expected odds, which is the unexpected event.

A "black swan" event can be broadly understood as an unexpected event. The Bitcoin price plummeting due to the killing of the leader of the Revolutionary Guard is a natural occurrence, as is the widespread outbreak of the COVID-19 virus. However, the intensity between these two events is entirely different. The U.S.-Iran conflict has been ongoing for some time, and the use of force by the U.S. is within some people's expectations. Therefore, there is a reason for funds to enter the Bitcoin market to speculate on the need for Bitcoin as a hedge in case of a real war, especially when Bitcoin's price is low at that time. The odds of the bet are sufficient, so if an unexpected event occurs, Bitcoin will rise accordingly. In contrast, the COVID-19 virus is different. After spreading widely in China, with only a few cases in countries like Japan and South Korea, just when everyone thought the virus had been epidemiologically controlled, it surged in Europe, Iran, the U.S., and other regions. This is a completely unexpected event. Analogous to the Iran geopolitical crisis that is the killing of the leader of the Revolutionary Guard, Iran launches missiles to attack the U.S. mainland, even sparking a third world war. In such an unexpected event, which is unknown to any investor, the first reaction for assets is to flock to U.S. bonds, the Japanese yen, ensuring their safety before venturing into hedge assets. Even if they decide to speculate, they will choose familiar varieties, not unfamiliar, illiquid Bitcoin. Therefore, during highly intense unexpected events, we cannot expect Bitcoin to react as quickly as gold, as from the perspective of capital trading operations and experiences, the first choice will always be familiar, widely recognized hedge assets, which is a human instinct.

Perhaps a Risk Asset

After discussing the reasons why Bitcoin is not a hedge asset, we can consider it as a risk asset. Here are a few perspectives:

Firstly, Bitcoin has shown some form of lagging correlation with U.S. stocks last year and this year. Although there is currently no statistically significant evidence, this observation is based on charts, event-driven factors, etc.

Secondly, Bitcoin is influenced by market capital, as it benefits from the liquidity in the market, i.e., the nourishment brought by central bank easing. This depends on two factors: firstly, when market liquidity is good, funds tend to allocate to high-risk, high-return assets. For example, several university endowments allocate a certain amount of cryptocurrency as an alternative asset allocation, and many high-net-worth tech company executives hold a certain amount of Bitcoin. This is because easing implies currency inflation, but when the real economy is not performing well, the price increase in assets cannot outpace inflation. Thus, the market and professional investors will seek high-risk, high-return products like bonds, etc., and Bitcoin, as the asset with the highest price increase over the past decade, naturally falls into this category. The second part is Bitcoin's speculative nature. With only 21 million coins in total, Bitcoin's fixed supply makes it perfect for speculation compared to the endless supply of fiat currency, opaque fundamentals of listed companies, and commodities with no visible production limits. Whether it's decentralization or hedging logic, Bitcoin provides speculators with a perfect story to attract new capital. With such excellent speculative attributes, when market liquidity is good, many users with dreams of getting rich quickly flock in. The resonance between easing, professional investors, and retail investors led to the late 2017 bull market.

Bitcoin is still a young asset, not even ten years old, compared to commodities, national sovereign credit currencies, which have been around for a long time, and U.S. stocks of century-old companies or thirty-year-old tech enterprises. Defining its asset attributes over a long period using current event-driven factors and price volatility may be inappropriate. This article aims to help Bitcoin investors better understand the asset they are investing in and hopes that investors can rationally assess the concept of hedging. In the long term, these minor fluctuations are just appetizers; Bitcoin's future is long, so let's wait and see.

This article is from our partner PANews

Further Reading

• Quantitative easing is a turning point? BitMEX: The "interest rate war" among central banks will push Bitcoin to reach $20,000 by the end of the year

• Bill Gates exits Microsoft, Buffett resigns from the board of directors, making it difficult for them to see Bitcoin rising together in the future

Join Telegram now for the most accurate blockchain news and cryptocurrency updates!