Although Bitcoin’s price hike could be due to a whole variety of factors, one possible cause is the increasing use of digital currencies as a hedging instrument. Anthony Pompliano certainly thinks so, having told Cointelegraph recently that he believes there is increasing evidence to support this view.
The world has arguably been teetering on the brink of a recession for months now. But recent events could be pushing the global economy even closer to the precipice. The coronavirus outbreak has choked China’s output, leading to predictions that it will trigger a global slowdown. Europe is facing its own challenges amid ongoing Brexit uncertainty, economic contraction in Germany, and the continuing strikes in France.
So, it’s unsurprising that investor attention is turning to the asset classes that do not correlate with the stock markets. The price of gold saw an uptick in the first week of February, as did the price of Bitcoin, which rose above $10,000 for the first time this year.
Pompliano is right in that diversifying an investment portfolio is one of the most basic hedging techniques. It means an investor reduces their risk exposure should any one asset decrease in value. In this case, holding Bitcoin as an asset uncorrelated to the stock market could offset against losses in a share portfolio.
More sophisticated hedging tactics involve taking multiple positions against the same asset using instruments such as options. Let’s say an investor buys 1 BTC for $10,000. The same investor could then purchase options with a strike price of $9,000 for a premium of $200 each. In doing so, they’re hedging against losses above 10% for a fee of only 2%.
Really, Bitcoin as a tool against volatility?
At first glance, the argument that traditional investors would turn to Bitcoin to hedge against volatility in the stock markets appears to be an odd one. It’s fair to say that Bitcoin’s volatility has dampened over recent years compared to what was observed before. But compare and contrast Bitcoin’s single-day drops with those on the stock market. During the last recession, the stock market underwent several single-day drops of around 5% to 7% between 2008 and 2011, but even in 2019, Bitcoin saw price drops nearly twice as steep in a matter of hours.
Furthermore, the price of cryptocurrencies is vulnerable to market forces that are less predictable than the traditional markets. For example, the most recent price pump from the start of February could be pinned down to nothing more than whales placing spoof orders, the kind of event that no amount of technical analysis could predict.
On the other hand, an increasingly diverse range of crypto derivatives provides ample opportunities to hedge on the price of BTC and other digital assets. When the Chicago Mercantile Exchange launched its first regulated options product in January, which became an immediate hit, illustrating that there is a clear appetite among institutions for new types of hedging instruments.
The crypto-derivatives trend isn’t just limited to institutions either. The retail markets for cryptocurrency derivatives have been booming. Last year, crypto exchange Binance opened up its derivatives markets, and others such as OKEx expanded their offerings. Furthermore, BitMEX posted a record trading day in June as the price of BTC hit its 2019 high, further reinforcing the argument that traders are eager for more ways to hedge.
Overall, despite the volatility inherent in cryptocurrencies, the arguments for it being used as a hedging instrument appear to stack up. The Financial Times even cites crypto as one factor threatening the gold markets.
However, not everyone agrees that using crypto as a hedging tool is a good idea, given its unpredictable behavior. Speaking to Cointelegraph, Alon Rajic, managing director of Money Transfer Comparison, said he does not believe crypto should be used to hedge risks:
“There hasn’t been enough time to test Bitcoin in different scenarios. Before 2017, most people haven’t even heard about it. So far, we’ve seen it rise and fall in times of succession and growth for the global economy, but have yet to see how it behaves in recession.”
Hedging opportunities in DeFi and beyond
The fast-growing DeFi and broader retail crypto finance sector now offers many hedging opportunities. At the most basic level, Ethereum users can hedge against price drops by locking their ETH into one of Maker’s collateralized debt positions to generate DAI. However, lending out the DAI on one of the many platforms that are now available also generates interest of up to 10%, further protecting against losses and offering the opportunity for passive income.
There’s a kind of poetic irony involved in the mechanisms behind using DeFi to hedge in this way. The interest levels on apps like Compound or Aave are far higher than one could typically earn on a traditional bank account. However, the reason for that — and the fact that users can leverage these tools to hedge against high volatility — is precisely because the underlying cryptocurrencies are themselves volatile. Andre Cronje, the chief architect at DeFi yield aggregator service Iearn.finance, provided Cointelegraph with some pragmatic advice for those looking for DeFi hedging:
“Focus on stable coin positions that aren’t directly correlated to the volatility of the market, but simply compound upside thanks to the volatility of crypto assets. As long as ETH and BTC are volatile, people keep borrowing stable coins. Pooled liquidity is the best option for hedging, 50/50 ETH/stablecoin.”
Of course, DeFi comes with other risks. The protocols are entirely software-driven, and although there hasn’t yet been any major incident to date aside from the bZx hacks that are yet to be fully explained, critics have pointed out potential vulnerabilities where single entities hold admin keys to decentralized finance applications. This perhaps explains why centralized counterparts to DeFi DApps are also currently doing so well.
Cred is one example of a platform that’s currently undergoing rapid growth, spurred on by the current bull market and a partnership with the Litecoin Foundation. Dan Schatt, founder and CEO, shared with Cointelegraph:
“It’s clear to us that customers have a tremendous appetite in passive earning on their crypto. We expect over the next two years, most custodial exchanges and wallets will offer passive earning opportunities, similar to the way banks operate today.”
S. Daniel Leon, founder and chief operating officer of Celsius Network, believes in a similar notion, and shared some numbers with Cointelegraph:
“Since the last bull run started, we have seen a dramatic increase in stablecoin loans followed by more deposits of different cryptos — a strong indication that our borrowers are using our product as a means of diversification and hedging. This trend has increased since the start of 2020, with a rise of 41.9% in new depositors. Once users join there is very high retention, and on average depositors add to their existing balance 1.5x a month.”
Hedging exposure with DeFi margin and derivatives
Although lending is by far the most popular form of hedging in the retail markets and DeFi segment, there are plenty of other innovative ways to hedge. Decentralized exchange dYdX enables hedging through short-selling and options trading of Ethereum-based tokens. While the derivatives platform Synthetix allows users to stake native SNX tokens to trade a variety of synthetic assets, called Synths, that track the value of their real-world equivalents. There are also inverse Synths, so users can hedge their exposure to any given asset.
Insurance is perhaps the oldest form of hedging and is also now becoming more available in the DeFi sector. Nexus Mutual is a decentralized fund where users pool their ETH to provide risk insurance. For example, one type of cover protects against financial loss caused by a malicious actor misusing a smart contract. Although the current pool wouldn’t quite cover the full losses incurred by the 2016 DAO hack, for example, the underlying principle seems solid.
The increasing prevalence of hedging is yet another indicator that the cryptocurrency markets are maturing. Within DeFi and retail crypto finance, the introduction of hedging tools is a signal of recognition that the segment needs some of the same tools used by the traditional financial market if it’s to sustain itself in the longer term. However, the adoption of crypto as a means of hedging against the risk of a recession is perhaps one of the clearest signs yet that Bitcoin is now gaining a firm foothold in the financial sector.