Market News

The link between digital assets and mainstream finance is strengthening

BITCOIN IS BACK. Since Donald Trump’s election victory on November 5th, the world’s dominant cryptocurrency has surged to new heights above $100,000 a unit, enjoying a rise of 138% since the start of the year. Altogether, the world’s cryptocurrencies now have a market capitalisation of almost $4trn—making them more valuable than the entirety of Britain’s stockmarket.

Holders of digital assets certainly have reason to be excited. Mr Trump has nominated Paul Atkins, a lawyer and head of a crypto-advocacy group, to lead the Securities and Exchange Commission, America’s main financial regulator. The incoming administration is surrounded by Silicon Valley moguls who believe that regulation and enforcement have held back the crypto industry. A proposal by Cynthia Lummis, a Republican senator, for a government reserve of 1m bitcoin may be absurd, but it no longer seems impossible.

As such, today’s crypto surge looks different from earlier booms. Rallies in 2017 and 2021 dovetailed with rising excitement over new crypto use cases. The most fanatical believers envisaged a future in which the tech would take over the financial world, displacing stodgy existing institutions. This time, there is less hyperbole. Bitcoin, in particular, is being whipped into shape by large, mainstream investors. And so the way the market behaves is changing. The utopian exuberance of earlier crypto adopters is giving way to a more institutional and mercenary climate.

Hedge funds are the most prominent members of the new wave of investors. In the third quarter of the year, even before bitcoin’s recent surge, BlackRock’s bitcoin exchange-traded fund had grown to become the fourth-largest ETF in the hedge-fund world, with a long position worth $3.8bn. A survey by PwC and the Alternative Investment Management Association suggests that 47% of traditional hedge funds now invest in digital assets, up from 21% in 2021.

When it comes to decentralised finance and web3, the optimistic (and often deluded) fads from the last great crypto surge, investor interest has waned dramatically. Some $7bn has been raised by startups in these fields this year, according to Crunchbase, a data provider, roughly the same as last year and far below the $34bn raised in 2021. The VanEck Digital Transformation ETF, which invests in a bundle of crypto-adjacent firms, is down by more than 40% from its high in 2021. The floor price of non-fungible tokens (NFTs) issued by CryptoPunks on the Ethereum blockchain may be up by 20% this year, but it is down by almost 70% from its high in 2021.

In its focus on untrammelled speculation, the current rally is much more straightforward. What matters for new owners of bitcoin is the prospect that the line will continue to go up. Crypto is a highly volatile asset that prospers in relatively brief periods of rising risk appetite, a feature that its new owners value. Very few hedge-fund managers booking a triple-digit return on bitcoin will lose sleep over whether crypto will fulfil the lofty aims of early adopters.

The changing of the guard is more than just a transition from shorts and t-shirts to chinos and Patagonia gilets. Indeed, it is already altering how crypto markets move. Research by Alexander Copestake and Davide Furceri of the IMF and Tammaro Terracciano of IESE Business School suggests that crypto is becoming more closely bound to other risky asset markets, as it is now connected by institutional investors who own both. As a result, the market has become more sensitive to monetary-policy changes by the Federal Reserve, since demand for the asset is more closely tied to the overall appetite for risk in stockmarkets. Financiers and asset managers are not in the business of HODLing—crypto parlance for buying and holding assets indefinitely, no matter the news. They will sell to take profits and offset losses suffered in other asset classes.

If the regulatory threat to the industry does recede, it seems likely that the institutional adoption of crypto will accelerate, especially when it comes to bitcoin—tying the market closer still to more traditional ones. Crypto’s true believers will find themselves in an awkward position. Bitcoin and its ilk might be rallying but the surge is being driven by the increased institutionalisation of the asset class. That will make it more ordinary, and more linked to the ups and downs of the regular financial world, which advocates had hoped to replace. At least they can comfort themselves with simply enormous profits.