Bitcoin & The COVID-19 Crash
By: Galaxy Digital Research
Tags: Covid 19, Economics, Bitcoin, Cryptocurrency

Originally Published April 10, 2020 [GDR Archive]

Summary. We review the macroeconomic backdrop as the COVID-19 crash unfolded through the lens of Bitcoin, dive into the events of Black Thursday 2020, contextualize the decline in asset prices, peer into Galaxy’s proprietary OTC trading data, and discuss the macro implications of trillions of dollars of global stimulus on risky assets. We find that:

Widespread risk-off behavior began in mid-February across traditional assets, and digital assets were not immune from the broad selling. 30d correlations with equities reached an all-time high in early March, as BTC was swept along into global de-risking activity.

Digital asset markets experienced a forced unwinding of leverage on Black Thursday 2020. Leveraged positioning on the BitMEX exchange led to a cascade of margin position liquidations where the total liquidations triggered per dollar was greater than the liquidity per dollar in the system. Arbitrageurs failed to tighten the spread between BitMEX’s XBTUSD perpetual swap and spot exchanges for over 24 hours and spreads reached -$1200.

On a volatility-adjusted basis (z-score analysis), Bitcoin outperformed other risk-on macro assets and its digital asset counterparts during the COVID-19 Crash. Since Black Thursday 2020, Bitcoin has outperformed major macro assets.

Proprietary trading data from Galaxy’s OTC desk shows an uptick in trading engagement, new trading counterparties initiating long positions, and that bitcoin focus and buying has been stronger in the past few weeks, suggesting that some investors are taking this opportunity to accumulate bitcoin.

The recent fiscal spending and monetary stimulus is historically unprecedented, and policymakers are pointing toward additional fiscal and monetary actions. These activities will likely lead to a new paradigm of monetary debasement and inflation; inflation-resistant assets such as bitcoin and gold are likely to disproportionately benefit.

The COVID-19 Crash

A global pandemic

The COVID-19 pandemic that has now swept the globe first appeared on November 17th but didn’t make much of a splash until late December when doctors in Wuhan began treating a number of cases that included pneumonia as a symptom but had unknown origin. By January 23rd, the Chinese government locked down Wuhan with a total of 570 people infected, but it took until March for global markets to respond to the crisis as the depth of the pandemic came into focus. Accordingly, global markets experienced historic selloffs across all risky assets, as markets saw extreme risk off behavior with the global economy grounding to a halting stop. Existing narratives were put in a precarious position, when, in the middle of March, the bottom dropped out and Bitcoin lost -31.5% in 24h on what’s being dubbed Black Thursday 2020 and -48% peak-to-trough drop depending on which exchange is quoted. In previous research, however, including in a paper from August 2019 titled “Bitcoin & Macroeconomic Uncertainty” and in internal studies on correlations with traditional assets, we showed that Bitcoin has rarely behaved like a true macro hedge, but the sheer scale of the dislocation surprised many and exposed overleveraged pockets of the Bitcoin ecosystem.

Fig. 1 (a): Selected macro asset YTD performance

Fig. 1 (b): Macro asset performance since start of COVID-19 Crash, Fig. 1 (c): Macro asset performance since Black Thursday 2020

Volatility cometh

Fig. 2: S&P 500 vs. BTC price action (since February)

During February, it became increasingly clear that Bitcoin was closely tracking the performance of equities and acting as high beta asset to the S&P 500 (left). Around February 15th or 16th, Bitcoin appeared to have been part of the beginning of a broad risk-off flight across asset classes.

Still, Bitcoin and crypto markets appeared better positioned to weather an oncoming storm from COVID-19 than other markets. In the final days of February, realized volatility increased dramatically for equities despite staying nearly constant for BTC, an artificial sign of strength that may have wooed investors into an expectation of risk-off performance from BTC going forward. Bitcoin 30d realized volatility, which routinely sits in the 50s and higher, did not register any seismic shift caused by the emergence of widespread risk-off behavior, starting around February 19th. S&P 500 30d realized volatility, which typically sits below 20 and was ~10 in January and early February, began to increase dramatically with sharp equities selling. That is, the alarm bells went off in equities markets while crypto markets, touted for their uncorrelated status, appeared to be business as usual.

Fig. 3 (a): 30d realized volatility of selected macro assets, Fig. 3 (b): % chg in 30d realized vol of BTC and S&P 500

Emergent asset correlations

BTC showed an emergent strengthening rolling correlation with the traditional assets on February 17th and February 18th. Bitcoin’s correlation to most assets is typically 0.00 +/- 0.25. Rolling 10d-correlations, prone to variability, between BTC and S&P 500 briefly dissipated at the end of February. In early March, correlation strength between Bitcoin and other macro assets started to grow:

Fig. 4 (a): BTC-S&P 500 correlations, Fig. 4 (b): BTC-10Y correlations, Fig. 4 (c): BTC-Gold correlations

Since March 12th, the correlation between BTC and S&P 500 has been >0.50, making it the most persistent correlation with equities in Bitcoin’s history. 10d correlation with gold has reached elevated but not record levels of >0.40 for the last 15 days. The old maxim “all correlations go to one in a crisis” has held true, and another old maxim held once again: cash is king. Expectedly, BTC has had a negative correlation with 10yr Treasuries since February, which is a cash-producing asset (although hardly at the moment), as investors globally fled risky assets and sought safe haven assets. Interestingly, gold too declined during the crash, as any asset with a price tag became a source of liquidity, and even Treasuries declined for a brief moment after surging demand and collapsing yields.

Crypto markets & Black Thursday 2020

Macro backdrop

Bitcoin is a small dinghy in the global ocean of the financial assets, and the COVID-19 Crash was a tsunami that pulled everything under. Equities racked up large losses in early March as the COVID-19 outbreak began to eviscerate 10 years’ worth of gains fueled by low interest rates and corporate share buybacks. S&P 500 lost -7.6% on Monday, March 9th and -4.9% on Wednesday, March 11th as liquidity evaporated from markets and sellers fire sold assets. Redemptions across asset classes meant forced selling at exactly the time when money was needed to soak up the damage. The FRA-OIS spread, a measure of the rate spread between forward rate agreements and overnight indexed swaps, blew out to 51.2 bps by March 9th, the second highest level since 2009 following a brief period in 2011 during the Greek debt crisis. The FRA-OIS spread is a measure of the relative cheapness or expensiveness of banks’ future borrowing from one another. The spread expanded as the market began pricing in expectations of missed future debt obligations, which reduces banks’ operating balance sheets. Bitcoin, running a high correlation with risky assets, was along for the ride.

BitMEX Liquidations

On March 12th, the S&P 500 dropped -9.5% but BTC/USD fell -31.5% with a peak-to-trough loss of -48%. March 12th exposed that BitMEX and other derivatives platforms were overleveraged. BitMEX is a futures exchange for major cryptocurrencies like Bitcoin and Ethereum that regularly sees over +$1 billion in open interest. The XBTUSD Perpetual Swap contract for example has just a 1% margin requirement, but it is an auto-deleveraging-enabled contract. If the margin posted by a trader falls below the maintenance margin requirement, BitMEX’s liquidation engine will attempt to liquidate part of the position over a certain amount of time by posting an order until the margin requirement is satisfied. The liquidation engine mechanism produces a feedback loop where rapid gains or losses introduce new orders in the same direction, magnifying the effect of a price movement. The feedback effect is usually small because there is typically sufficient order book liquidity to soak up liquidated positions.

An initial price drop from the mid-7000 range in the morning on March 12th triggered a torrent of liquidations on BitMEX, which accelerated downward pressure. Under normal circumstances arbitrageurs will immediately pick up price discrepancies between spot prices on different exchanges. BitMEX XBTUSD perpetual swap contracts trade like spot and, as is visible, there was no spread between the two on March 11th. On the initial March 12th drop, arbitrageurs failed to keep BitMEX and Coinbase pricing aligned. Spreads between BitMEX perpetual swaps and spot exchanges indicate that the liquidation engine is creating order book pressure that does not exist on other exchanges. BitMEX’s low for the initial drop came at 11:01am ET and reached -$114 lower than on Coinbase ($5757 on BitMEX versus $5871 on Coinbase), showing signs of an emerging basis spread. Spreads of at least -$100 could be observed for 30 minutes to either side of that 11:01am low.

The liquidation engine was still actively deleveraging margin positions for about 5 hours between 10:30am and 3:30pm as spreads remained larger than -$20. Arbitrageurs stabilized price discrepancies around 3:30pm, suggesting that there was temporarily enough buy pressure on spot exchanges around the $6000 price to counteract the unwinding BitMEX leverage. A second major drop (in our estimation caused by a waning buy-side response to BitMEX’s still-deleveraging engine after arbitrageurs realigned spot prices) gave way to more liquidations. It’s also conceivable here that one or multiple parties saw what was happening on BitMEX and actively crushed spot price on a low-liquidity exchange to trigger further liquidations, likely profiting from a short position. Already thin liquidity was compounded with the further removal of liquidity by providers, creating open space for violent price falls. Meanwhile, the BTC chain got a bit congested, so coins couldn’t be moved quickly enough to close the widening spread between BitMEX and spot exchanges. Spreads exploded on the second drop reaching, remarkably, over -$1200 at one point and stayed over -$500 for around 4 hours.

Fig. 5 (a): BTC/USD spot and BitMEX XBTUSD perpetual swap, prices, Fig. 5 (b): BTC/USD spot and BitMEX XBTUSD perpetual swap, basis

As Alameda Research and FTX head Sam Bankman-Fried noted in a Twitter thread, “There’s a critical ratio: liquidations triggered per dollar / liquidity per dollar. Call this R.” An R above 1 can essentially trigger endless cascades of liquidations. Liquidity on the bid side of the BitMEX order book was just ~$20 million at one point, and it seems feasible that R exceeded 1. In short, the XBTUSD perpetual swap was heading to $0.

However, BitMEX’s liquidation engine stopped running for 25 minutes at the second bottom, pausing sell orders enough to allow the market to jump quickly back over $5000. CEO Arthur Hayes reported, adding a tremendous amount of intrigue, that it was a separate distributed denial of service (DDoS) attack that caused the liquidation engine to pause at 2:16a UTC, almost exactly the $3610 bottom that came at 2:26a UTC. It appears that an outside party was responsible for the DDoS, effectively protecting XBTUSD from further collapse. There are some claims that spreads stayed elevated because the network was so congested that arbitrageurs could not get capital on or off BitMEX to other exchanges, limiting efficiency. It’s unclear if that’s true or not, as transaction fees on Bitcoin were relatively high, but were 30x off all-time highs and were higher at other times in March. To us, it’s likely that the spread persisted because XBTUSD contracts were functionally trading at a <-$100 risk premium, as many traders had legitimate reason to believe the XBTUSD perpetual swap was simply going to zero. Open interest on BitMEX dropped from about 50% from >$1b to around $550 million. In sum, the events of Black Thursday 2020 showed the market that the system was extremely overleveraged and much of that leverage was simply unhealthy, bad leverage.

Contextualizing crash returns

On an absolute basis, bitcoin and crypto assets have underperformed equities, fixed income, and gold during the COVID-19 Crash, and just barely outperformed crude which has had a historic sell-off. However, this is not a fair comparison: assets must be compared on a volatility-adjusted scale in order to ensure one is not comparing apples to oranges. In other words, asset returns must be looked at on a Z-score basis (essentially how many standard deviations away from the norm is the return observation).

Utilizing the past year of performance data for major assets inclusive of the crash, we calculate expected monthly volatility (assuming 21 trading days in a month) and compare it with the performance of the assets for the month (21 trading days) after the crash starting February 19th. Fig. 5 (a) shows the performance of major assets during the crash, and Fig. 5 (b) shows that same performance normalized for each asset’s volatility (showing the asset’s performance z-score).

Fig. 6 (a): Macro asset returns — COVID-19 Crash (1m), Fig. 6 (b): Macro asset z-scores — COVID-19 Crash (1m)

Equities had an almost -3.4 standard deviation event, crude about -3.1, gold approximately -1.9, BGCI around -1.9, and BTC about -1.5. 10y Treasuries had a +2 standard deviation event during the crash. For normally distributed data sets (the caveat here is that asset returns are most likely not normally distributed and usually not centered with a mean of 0 but positive), 99.7% of observations fall within -3 and +3 standard deviations, so it really puts into perspective how poorly equities and crude performed during the crash. Moreover, a z-score analysis shows that on a volatility-adjusted basis, Bitcoin outperformed other risk-on macro assets and its digital asset counterparts during the COVID-19 Crash.

Fig. 7: Selected macro asset performance through April 9

Pulling the lens a bit further back, we do see that on a YTD basis as of writing, Bitcoin has outperformed equities, crude, and interestingly high yield corporate debt on an absolute basis, while it has only slightly underperformed Treasuries, IG corporate debt, and gold.

A peer into Galaxy trading data

View from Galaxy OTC trading data

Sometimes it’s helpful to take a look at proprietary data to get a different picture of the market. Utilizing our own trading data from our OTC desk, we can observe historical behavior and gain insight on current views and positioning. The highest volumes recorded since January 1st came in the first days of March, where we saw 7d average volume over 3x the volume at the start of the year, after approximately two months of balanced trading.

Fig. 8: Galaxy OTC trading volumes, 7d average, Index = 100

Institutional investors may have been early to recognize the havoc that COVID-19 could wreak. Peering into our buy-sell ratios from Q1, we see that Galaxy’s counterparties were relatively balanced with their bitcoin buying and selling (buy-sell ratios hovered around 0.5, or that the proportion of bitcoin buying was 50% of total bitcoin trading) and increasingly trading non-BTC crypto assets through mid-February (Galaxy OTC BTC/Alt Ratios shows a decline in the ratio from approximately 0.9 to 0.6). This behavior flipped around the start of the COVID-19 Crash in traditional markets, suggesting that counterparties were locking in profits while still in the +$8000 range and pulling back on altcoin trading.

Fig. 9 (a): Galaxy OTC BTC Buy/Sell Ratio, 3d smoothed, Fig. 9 (b): Galaxy OTC BTC/Alts Ratio, 3d smoothed

After Black Thursday 2020, Galaxy’s counterparties are continuing to accumulate BTC (Buy/Sell Ratio rising to 0.75 from roughly 0.5) despite the turmoil in the markets and are, as far as we can tell, using March as an opportunity to purchase at cheap levels. Moreover, we see that the focus has almost exclusively been on Bitcoin relative to altcoins suggesting that within the crypto space broadly, investors are perhaps viewing Bitcoin as the best risk-adjusted trade in the short term.

Into the unknown

Bitcoin, a safe haven asset?

With a lot of bad leverage washed out of the system from Black Thursday 2020, it’s unlikely that we should see another meltdown soon. But March accentuated that the laissez-faire character of crypto exchanges and other institutions/groups can be punishing for investors as exchanges serve up leverage far beyond what’s acceptable in traditional markets on experimental products and assets. It’s difficult to know what to make of this, but it’s hard to discount the possibility that it could be an irrevocable quality of the ecosystem.

What does that do to longer-term beliefs about this asset class? Six months ago, a passable thesis about Bitcoin might have said: “Bitcoin’s hard-coded deflationary quality, status as a bearer asset, and ease of transmissibility make Bitcoin an excellent store-of-value asset and it should behave like Gold.” Of course, most have noticed that it has behaved nothing like a store-of-value asset in the last year. An even better thesis about Bitcoin might have said: “All of the above can eventually be true, but additionally Bitcoin may also be the best form of collateral the world has ever seen. On measures like 24/7 availability, liquidity, speed and ease of settlement, and global acceptance, Bitcoin far exceeds common forms of collateral like real estate and equities. Its volatility leaves a lot to be desired compared to other assets.” In our estimation, reduction of volatility is a crucial step in achieving the long-term potential of this asset class. The events of March 2020 and particularly March 12th highlight how much stands in the way between crypto/Bitcoin as it exists today and its place as a store-of-value asset and monetary lingua franca that it may assume in the future.

Bitcoin still has the potential to be a safe haven asset in the long term, but at the moment it is lumped in with all other risk-on and risk-off assets as the COVID-19 crisis continues to unfold. The number of cases/deaths, economic shutdowns, and social distancing measures in Western countries have yet to peak, and the selling of BTC may not peak until the fair-weather holders and high-cost miners who hold BTC will become unprofitable post-halving (after it doesn’t magically double BTC’s price) and capitulate on their BTC positions.

Money machine goes brrr

The sheer amount of stimulus (trillions of dollars across consumer, corporate, and market funding) and debt monetization is staggering and historically unprecedented. We’ve been in uncharted territory for a long time from a monetary and fiscal stimulus perspective, and COVID-19 has pushed us deeper into the unknown. The Fed has slashed rates and pumped trillions of dollars of liquidity into the financial system, while Congress passed a $2t fiscal stimulus plan (~10% of GDP). Serious issues across the financial system remain: corporate bonds, particularly high yield bonds, have seen yields explode and liquidity dry up as concerns about corporations’ ability to pay back loans has withered amidst dwindling revenues from economic shutdowns. The explosion of volatility has forced many across the industry to cut back on their ability to take risk, just as the need for liquidity skyrockets between de-risking/de-leveraging and forced redemptions. It’s unclear whether the monetary and fiscal stimulus will prove fruitful. It might be a scenario of “too little, too late” after the US federal government bungled its initial COVID-19 response. Unemployment has seen a historically unprecedented surge, and that will only continue as COVID-19 spreads and inflicts maximum damage to the US and global economy.

Furthermore, the resulting impact of all this stimulus cannot be understated: trillions of dollars of stimulus, on the back of trillion-dollar deficits and aggregate debt levels. While we might see price deflation in the near future as a result of slack demand, declining real wages, and poor consumer sentiment, all of this money has to go somewhere at some point. To most, that points primarily to asset price inflation particularly where assets are inflation-resistant like equities, gold, and other hard assets. It’s become pretty apparent that public equities have a natural put option that isn’t usually priced into the EV of an investment: if equities tumble too much, the asset to fixed liability ratio of things like public pensions tumble and force the Fed to step in and support prices. Even the airline industry will get bailed out; these industries are deemed to be too big to fail despite spending 96% of FCF in the last decade on buybacks (perhaps avoiding $5 lattes could have saved them).

It’s unclear if/when the stimulus will impact real economy prices after the economy rebounds and aggregate demand (heavily influenced by fiscal policy moves) rises. If this cash somehow finds its way into the real economy, high inflation ends up being a reasonable probability, and hyperinflation not out of the question. The real deciding factor will be how the Fed and federal government act once it’s clear the economy rebounds: will they appropriately tighten? Will the federal government enter a period of austerity to pay back the vast amounts of debt it has issued? Will we ever return to a sound monetary standard?

In all of this, the 1) huge influxes of both fiscal and monetary stimulus, 2) monetary debasement, 3) the forthcoming “reflation trade” as the monetary and fiscal stimulus hits asset and real economy prices, and 4) the erosion of value of fixed-paying assets should point the global investor toward inflation-resistant assets. In many ways, the medium-term environment is perhaps a nearly textbook setup for Bitcoin: trillions of units of fiat money (the US is not the only economic behemoth combatting economic slowdowns with the same strategy) are being printed, asset and real economy inflation is more likely than not, and risk-on behavior will eventually return. Whether Bitcoin will benefit from this flow capital is anyone’s educated guess, but preliminary data suggests that we might be seeing the early innings of a global, secular reflation trade.