Summary:

Data on Bitcoin’s performance during the advent of the coronavirus (COVID-19) misleadingly rekindled the debate of whether or not Bitcoin is “digital gold,” a decentralized store of value and safe-haven asset.

BTC’s behavior during the onset of COVID-19 was not evidence for or against this thesis; rather, BTC’s behavior may suggest that financial contagion “infected” both Bitcoin and gold, among other markets.

The biggest lesson for BTC from the COVID-19 outbreak so far is that it is functioning as a financial asset, and a risk asset at that — but that doesn’t necessarily mean it isn’t a store of value.

As the world was still actively working to understand the extent, ramifications, and possible solutions regarding the coronavirus (COVID-19) pandemic, crypto market participants witnessed a phenomenon that defies what many expect of Bitcoin: as the S&P 500 plunged, the price of BTC plunged with it.

Between March 4th and March 16th, the S&P 500 fell just over 21%, from $3098.49 to $2443.35, while BTC fell just over 44%, from $8755.47 to $4896.86.

These are the largest single-day losses fit that both BTC and the S&P 500 have seen over the last three years:

These coinciding S&P 500 and BTC losses have led many public figures and media outlets to either decry or reevaluate the popular narrative that Bitcoin is poised to function as “digital gold”: a store of value, like gold, that may retain its value during periods of broader financial downturn.

But you can’t understand the full story by looking at only part of the data. A different picture of BTC emerges when you compare its performance with gold’s over the same period:

Even though gold wasn’t as volatile as BTC, both showed losses during the first half of March amidst COVID-19 uncertainty — and these were still the largest single-day losses that gold has experienced in the last 3 years.

At first glance, this constellation of data could seem confusing to a trader: do the synchronized losses in BTC and S&P 500 mean BTC isn’t “digital gold” after all? How do we reconcile that with the fact that gold itself also showed losses during this period?

The truth is that these seemingly incompatible data actually demonstrate that the debate over whether Bitcoin is digital gold is the wrong debate to be having: in this early chapter of Bitcoin’s history, we aren’t seeing evidence of its “true function.” Rather, we’re witnessing Bitcoin’s participation in the financial contagion: during times of severe financial stress when correlations across almost all asset classes move towards 1, there is typically a flight toward liquidity, with investors moving to cash and deleveraging in a completely risk-off environment. This time around, BTC appears to be part of that movement, which does have interesting conclusions for its status as a financial asset — but not about any question of whether it’s digital gold.

To understand what that means and why it’s the case, we have to understand what black swan events are and how those events can bring about market movements we wouldn’t ordinarily expect to observe.

Pandemic Breeds Contagion

Popularized by Nassim Nicholas Taleb but finding its origins as early as the 2nd century, the term “black swan event” refers to a highly impactful event that is so rare that it is effectively impossible to accurately, reliably predict. The classic example of a black swan in recent history is the U.S. subprime mortgage crisis, which led to the Great Recession in 2008.

A more recent example of a black swan event may be the coronavirus pandemic.

Between mass quarantines, “social distancing,” shutdowns, and travel bans, the sweeping impact of this kind of pandemic is a classic case of the kind of global, unpredictable event that can theoretically throw a plurality of markets into uncertainty. Not only was the advent of COVID-19 unexpected, but it also remains unclear how long we will be coping with its impacts — only further stoking uncertain market conditions with each passing day.

In the crypto world, Bitcoin reached its highest volatility levels in almost 8 months on March 12th (UTC). That volatility kicked off when President Trump announced a ban on U.S. travel to Europe:

A half-hour later, Adrian Wojnarowski announced that the NBA was suspending their season:

A minute-by-minute graph of BTC’s 24-hour volatility shows how quickly the crypto asset became more volatile as these news stories broke and sank in, illustrations of how thoroughly COVID-19 would impact industries as massive as travel and major league sports:

Not only was the COVID-19 news’ impact on BTC volatility visible minute-by-minute: if we zoom out to a 6-month chart, we see that this was part of a ramp-up that’s brought BTC’s volatility to highs that we haven’t seen in well over half a year. BTC’s previous 30-day historical volatility high was 72.33% on November 21st, 2019, compared to 111.38% on March 16th, 2020.

The crypto market is far from alone in this increased volatility: in the last month of COVID-19 spreading and radically altering many aspects of markets and daily life, the VIX — the CBOE’s “fear” index that measures implied volatility in the stock market based on S&P 500 options — has seen a run-up in value since late February 2020, indicating the extremely volatile conditions that traditional markets have seen right alongside crypto markets.

In fact, these are the highest values that the VIX has registered since the 2008 financial crisis:

Almost exactly 22 hours after Trump’s address from the White House announcing the travel ban, the price of BTC fell 30.8%, from $5735.25 to $3969.32. The BTC volatility and trading volume were so beyond the norm that several crypto exchanges — most notably, the leveraged trading platform BitMEX — experienced full trading outages for extended periods of time. (SFOX remained fully operational during this time despite seeing 30 times its usual trading volume.)

This may have been at least partly related to mass market liquations that we saw in conjunction with news about the extent to which COVID-19 would be impacting industries, travel, and the global workforce: on March 12th, BTC futures open interest was cut almost in half, from about $3.75 billion to about $2 billion.

The major contraction of open interest could have potentially led to the dip in the underlying price of BTC — a trend that appears to have been the order of the day in many markets amidst the severe uncertainty surrounding COVID-19. In particular, since a significant amount of this open interest is leveraged, the amount of leverage that got sucked out is substantial — which, in turn, could have led to liquidations exacerbating selling pressure and volatility.

All of this is consistent with the phenomenon of financial contagion — not to be confused with the viral contagion that’s sweeping the globe. The precise nature of ‘financial contagion’ is the subject of significant academic debate, but roughly speaking, it describes the tendency of sharp, unexpected market downturns to propagate from one market to another. Simply put, when a black swan event makes things go bad in an unexpected way on a global scale, correlations between a multitude of asset classes can go to 1 as they decline in unison.

A modern example of financial contagion is the Great Recession of 2008: following the collapse of the housing market, global markets that are typically less than perfectly correlated collapsed in a highly correlated fashion, as shown by the precipitous collapses in global imports and exports on the below charts.