Where does price correlation come from?

Bitcoin is supposed to be uncorrelated or even negatively correlated to traditional assets and thus an important addition to any diversified portfolio. But especially since the crash of March 12th Bitcoin more and more often moves alongside traditional markets, especially equities. Where does this change originate from? As a safe haven asset, shouldn’t Bitcoin be uncorrelated or even negatively correlated? And why is correlation often non-existent just to suddenly spikes up out of nowhere to then fade out again (see chart, kudos to [https://twitter.com/cryptounfolded](https://twitter.com/cryptounfolded))? To answer these questions, we must first understand what drives correlation in the first place. Consider two stocks: both working in the same industry, say airline business. Ciovid-19 is a blow to the whole industry, so both stocks A and B decline in tandem: nearly perfect correlation. Then quarterly reports are due and company A presents surprisingly good results while company B shows surprisingly bad results. Stock price of A goes up while B goes down – negative correlation on that day. On average over the whole quarter correlation is still positive, although not perfectly 1:1 anymore. This makes perfect sense: stocks of both companies are mainly driven by industry exposure and the Covid-19 event, while the rest is idiosyncratic in relation to how well they manage the situation and their company in general. This is the standard explanation of correlation: two assets share a similar exposure and thus a similar price pattern. But can this view help to explain the changing correlation of Bitcoin with traditional equities? Yes, it can. To see why, let’s consider two case studies. **Case one: Crypto OG** Consider being an OG. You run some mining back in the days while Satoshi was still active on bitcointalk.org. You are a geek, a computer nerd, a fan of cryptography – you own a ton of Bitcoin but you have no clue about finance and do not own any stocks, bonds, commodities, funds or derivatives and might not even own a brokerage account. Over time and with every roller coaster of Bitcoin’s price you dig more into monetary economics and trading. You start to try to sell some of your precious coins when markets seem to be overheated: “These $7 are totally unreal, how can any person in his right mind pay so much for a Bitcoin when you could simply mine it on your laptop while sleeping? Sell!” (price went to $30 before it went down to $2 again). And you start to buy back when you think the price tanked already too much: “Price dropped now from $1,200 to $600 just because of Mt. Gox going belly up. This does not change any fundamentals – buy!” (price went to $220 before going back up again). You and your peers make up 90% of the crypto market and since no one is much interested in traditional markets, Bitcoin price action is completely uncorrelated. Although the best strategy in hindsight would have been to simply hold on to your coins, you outperformed all your peers who at some point sold all their coins waiting to buy back lower – just to realize they missed the train and buy back much higher. Then this crazy bull market in 2017 and January 2018 happens and your net worth explodes. You read about portfolio diversification and calculate your crypto exposure: 99.96% of your portfolio. By any means, that is unhealthy. You decide to “professionalize” and start by diversifying with the “conservative” rule to “only” hold 50% of your portfolio in crypto. You cash out 50% of your holdings, put the4se $50 million into stocks – some ETFs and, after about half an hour of research, you also toss in $1 million to some handpicked stocks in biomedicine and robotics. Every week you calculate your exposure to your assets and then rebalance. If Bitcoin went up compared to equities, you sell Bitcoin and buy stocks. If Bitcoin declined, you sell stocks and buy Bitcoin. Hello correlation: your diversification rule triggered the formerly uncorrelated assets to start becoming correlated – especially when prices move strongly. **Case two: Traditional fund manager** Now consider being a fund manager. You are well trained in finance and your clear focus on your career helped you to outperform your peers both university and the trading desks you worked for. Some of your old friends talk about “crypto” and the crazy gains that can be made there. But the focus on your work does not allow you to have any side interest and so you never read Satoshi’s white paper and in general remain unknowledgeable about crypto. Just like all your peers: no one in traditional finance is in crypto. Over the years you climb the career ladder and you grab a senior position at a large institutional investor. Your narrow focus widens. At the same time, crypto becomes more and more mainstream and with the bull run in 2017 you start paying attention to crypto. You immediately grasp the beauty of the concept and are well-trained to not bother about missed opportunities and do not listen to the voice in your head wining “I should have listened to my old friends back then”. Instead, you focus on the opportunities at hand and calculate how much the risk adjusted performance of the fund you are responsible would go up, if 10% were allocated to Bitcoin. In order to not sound too crazy you propose to allocate 5% of the fund to Bitcoin. While most board members think you are crazy, fortunately, your CEO is not originally trained in finance but has a broad background and a vast experience in spotting the rare occasions when someone presents a great idea. After only two meetings you convince your CEO and, in turn, the board to make the “bold and risky” move to allocate up to 1% of the fund to Bitcoin. It just needs to pass legal. The legal team feels safe but requires to cover their ass by first getting official approval from the regulator. About a year and a half later a one pager arrives stating that the regulator has no concern. Four weeks and a series of well-orchestrated and executed OTC trades $50 million were invested into Bitcoin. The internal requirement is to never have more than 1% exposure to Bitcoin and so the rule is made to rebalance Bitcoin and equity positions in real time when prices move. Hello correlation: this rule causes a correlation between traditional markets and Bitcoin. **What does this mean for Bitcoin?** While Bitcoin is not affected by the number of sales or quarterly earnings, these examples show how Bitcoin can still be correlated to traditional assets: by portfolio allocation. When one asset declines, the other needs to be sold to rebuy the declining asset – in effect the declining asset tanks less at the expense of the “unaffected” asset that now also declines. This is especially true for leveraged trading and when the market tanks and collateral needs to be sufficient to sustain positions. This exposure to portfolio rebalancing and need for collateral perfectly explains the drastic correlation spikes when traditional markets a) move strongly, and especially b) decline strongly. These two case studies also show how a shift in the strategies of the market participants (100% crypto vs. balanced portfolio) and a change of market participants in general (only crypto OGs vs. institutions entering) can change the link, that is correlation, between assets. The increasing correlation between Bitcoin and equity markets can thus be seen as a sign of market efficiency and “professionalism”, that is, existing market participants either become more sophisticated or leave the market, while new market entrants from traditional finance enter the space.