Part Two: The Many Stages of Bitcoin

From its starting point as a pure “programmers dream”, Bitcoin has grown into an asset class with a market value in excess of $1 trillion USD. How did we get here? The adoption phases of BTC’s “reverse IPO” are described in the previous article (Bitcoin Financialization: A tectonic shift in asset management) and today’s bitcoin trading behavior cannot be compared to what it was in 2013, 2017, or 2020. Bitcoin has changed so much over the years that we can potentially isolate several “Bitcoin trading behaviors”.

From 2010 to 2015, BTC traded like a penny stock or a micro-cap stock. With little adoption, parabolic movement and increases in volume led to 10- to 100-fold increases on the upside. However, without the ability to short, retail investors slowly capitulated in a classic penny-stock-like, slow-down trend. This BTC dark age, a scam-ridden period, ended with the Mt Gox shock, leading some countries to regulate and others to at least start paying attention.

Bitcoin II, the “second version”, came along in 2015 with a more mature set of players. The first of the regulated entities, market makers and trading firms started dipping their toes in the waters of digital assets. Derivatives appeared and the first sizeable Crypto futures contract on Bitmex captured a major portion of trading volume.

But the Initial Coin Offering (ICO) craze and boom-and-bust rally of 2017-18, reminiscent of the dot-com bubble, made Bitcoin look like the of 1999. In other words, it exhibited small-to-medium-cap trading behavior with a less parabolic rise but with a more abrupt yet still progressive downward trend.

New coins, projects, market participants and exchanges multiplied like hotcakes carving up liquidity. Weakened liquidity, multiple exchange hacks and forced liquidation of futures made crypto one of the most volatile asset classes.

In December 2017, Bitcoin III, the “third version” kicked off the regulated derivatives era with the launch of futures contracts on the CME and Cboe. For the first time Bitcoin futures were tradable by institutions around the world. That pushed the asset class into a period of CTA-commodity-like trading behavior, while at the same time it remained less parabolic in nature, with more controlled ups and downs. Traders now had the ability to short in an efficient way.

Retail demand exploded in 2020, led by investors staying home due to Covid lockdowns and “Robinhood-like” retail brokerage apps that popped-up around the world, coupled with more traditional retail brokers joining in.

Crypto derivatives quickly became a speculator’s dream. Bitcoin’s highly volatile nature meant it could easily rally three to five-fold in price and then drop 50% in a month. Anyone trying to replicate the Bitcoin risk-reward ratio of 1-to-3 or 1-to-5, would need to enter into option contracts on the most volatile growth stock available. However this would only apply to BTC spot instruments; looking at futures or options from “regulated” venues a trader or investor could multiply this ratio by two or five, entering the 1-to-25 risk reward area. Using international venues and perpetual swaps would multiply leverage by 10, 20 or 100, making it both a speculator’s dream but also liquidation hell in case of a downturn.

As a result, a “futures” and “perpetual futures” war started, with volume and open interest moving from one set of exchanges to the next, from Bitmex to Huobi and Okex, and then to Binance and FTX. New instruments were created to address the needs of retail investors and trading firms; OTC options with a market maker were made available on Deribit, structured products, ETP, ETF, certificates, synthetic directional or volatility contracts.

Algorithmic trading and excessive leverage led to many flash crashes during this period. Today some of this leverage has been reduced from 400x to just 20x at some venues. Flash crashes produced by forced liquidation have become more controlled with the introduction of measures to protect margined accounts with cross-margining or other collateral.

Bitcoin III was also a fairly uncorrelated asset. Looking at its correlation with the S&P500 over a 120-day basis as shown in the chart below, we see it oscillates between -0.2 and 0.2. The 20-day correlation moves from -0.4 to 0.4 in a sort of channel. We also see that market moves and correlation’s reaction is choppy, which is typical of illiquid assets with a layer of illiquid derivatives.

20-day and 120-day BTC to S&P correlation

source: TS Imagine

But 2020 marked a new beginning for Bitcoin, the financial Bitcoin, or as we call it, Bitcoin IV, the “fourth version”.

We can clearly see the correlation regime change. The 120-day correlation average of 0.4 and the 20-day average rose above 0.75 several times. This is characteristic of a correlated asset and marks the birth of the “Financialized Bitcoin”.

Retail demand exploded in 2020, led by investors staying home due to Covid lockdowns and “Robinhood-like” retail brokerage apps that popped-up around the world, coupled with more traditional retail brokers joining in.

This massive inflow of retail investors – some traders, others longer-term holders – has not only pushed prices up five-fold, it also put the final nail in the coffin of Bitcoin nay-sayers who were choosing between buying shares in Tesla, Amazon, or GameStop, or Bitcoin. This made Bitcoin a classic growth and risk-on asset.

Additionally, major events made 2021 a marquee year for crypto. Public and private companies, as well as sovereign governments, adopted Bitcoin as a treasury holding. Microstrategy, Block (formerly Square) and Tesla sent shockwaves through the market by announcing their Bitcoin strategies, especially when the latter disclosed its intentions and allocated 8% of its cash to BTC.

Accounting software for bitcoin, and even salaries paid in Bitcoins, are gaining traction and stacking BTC in companies is growing as a way to hedge inflation or for currency de-basing.

Ten largest publicly disclosed bitcoin holders

source: ARK invest

Four companies are now among the top ten holders of Bitcoin. What could potentially be even more significant is the recent announcement by KPMG Canada to add Bitcoin to its balance sheet. With one of the Big 4 accounting firms showing the way, what would stop other companies from following suit and adding crypto currencies to their treasury operations?

Exchange traded products, countries, and corporations held 8% of bitcoin's supply as on November 2021

source:ARK Invest

At the time of writing, just under 8% of Bitcoin is held by ETP/ETFs, countries and companies, which is not large in the grand scheme of things. Blackrock, the world’s largest asset manager with $10 trillion AUM, filed an application to launch a Bitcoin ETF and confirmed its intention to offer products based on the digital asset to serve client demands.

As we wait for the final stages of this “reverse IPO” process, regulation is becoming a reality in some countries. Switzerland, Germany and France are making progress and banks in Germany are now allowed to buy, sell and store crypto currencies. In June of 2021 Germany established the official Digital Security category, reducing the need for documentation. As a result, the first E-securities bearer bonds were issued in December. In November 2021 the Fund Acceptance Act allowed special funds to invest up to 20% of their holdings digital assets. Currently in a draft stage and expected to be implemented in 2022, German regulators are working to officially introduce crypto securities as an asset class.

Regulation is inevitable and is being implemented in one country after another. It will create a major negative shock initially as market participants may be caught off-guard. Eventually, regulation will be a huge plus for this asset class, pushing adoption to unseen levels worldwide. Soon, asset managers without crypto currency exposure in their offerings will be at a disadvantage. And as the asset class is evolving at such a fast pace, these managers will need to monitor bitcoin trading behavior, correlation to other assets and liquidity characteristics to assess how it fits into their strategy.


Alexandre Carteau
About the Author

Alexandre Carteau is the Head of Corporate Development and Digital Assets at TS Imagine. Alexandre has over twenty years of experience in a variety of product and business development roles in Multi-Asset Electronic Trading, Portfolio Management, and Risk Analytics.