What Ends Crypto’s Correlation to Legacy Markets?


  • The Wall Street Journal – Bitcoin Price Falls Below $35,000 in Tandem With Stock Selloff
    The widespread adoption of cryptocurrencies might make them more sensitive to the stock market’s moves

    It is becoming a more common occurrence: When stocks fall, so does bitcoin. Bitcoin, the world’s largest cryptocurrency by market value, fell below $37,000 Friday to its lowest dollar value since August 2021, according to CoinDesk. The selloff continued into the weekend, with Bitcoin falling to below $35,000 on Saturday before edging back above that level as of Sunday afternoon. Bitcoin has nearly halved its record price from the fall. The drop came fast on the heels of a late-afternoon swoon in the stock market on Thursday.


Cryptocurrencies are often viewed as the farthest point on the risk curve, akin to leveraged stock positions. The growth of Decentralized Finance (DeFi) could help change the correlation between cryptos and stocks.


As the chart above shows, bitcoin has been positively correlated to the S&P 500 since August 2020. In other words, cryptocurrencies and stocks have been intertwined for some time.

Given this, bitcoin has acted as a 24/7 gauge of volatility for risk assets. This was evident this past weekend when BTC slumped as much as 15% from last Friday’s NYSE close and suggested the wild volatility in risk markets was coming.

Institutional adoption has likely driven this correlation higher, with many managers allocating a set percentage of their portfolio to cryptos.

What Breaks the Correlation?

Since cryptocurrencies are increasingly viewed as a leveraged bet on stocks, this correlation breaks when cryptos establish their own narrative. How does this happen?

The chart below shows the Total Locked Value (TVL) in Decentralized Finance protocols. This is the total value of the coins controlled by smart contracts in these protocols. Examples include coins in liquidity pools on automatic market makers like Uniswap or coins lent to, or borrowed from, banking protocols like Curve or Convex Finance. TVL is shown in both dollar terms (blue) and Ether terms (orange).



Note that TVL exploded from $17 billion on January 1, 2021, to $159 billion on May 10, 2021. TVL peaked at around $250 billion in October and has moved sideways since. In other words, the growth of TVL has stalled in dollar terms.

So why has TVL stalled? The lifeblood of DeFi, stablecoins, has shown much slower growth.

The next chart shows the value of US dollar-backed stablecoins in the top panel and the overall 3-month growth rate in the bottom panel. Currently, there are more than $150 billion of stablecoins outstanding.

But notice the bottom panel. Growth of stablecoins peaked last spring and fell hard. Now their growth rate is around 20%, near the lower end of the last several years.



Stablecoins can be broken down into two broader categories:

  • The centralized versions like USDT/Tether, USDC/Circle, and Pax. These are the coins that hold money in a trust in a regulated financial institution. Tether (green) and USDC (blue) are detailed below.
  • The decentralized versions of stablecoins, which are crypto-backed or algorithmic backed. Examples are Dai, TerraUSD, Frax, and Fei. These types of stablecoins are grouped together in the black line below.



The next chart shows the amount of stablecoins outstanding (blue) and the total TVL (orange). The bottom panel shows a ratio of the two measures.



We believe this ratio is important. It shows the ratio of TVL to stablecoins cannot go much beyond $2 in TVL to $1 in stablecoins. With roughly $150 billion in stablecoins outstanding, it is going to be very hard to get total TVL to push much beyond $300 billion. It is currently at $201 billion and peaked at just over $250 billion a few months ago.

Of course, this suggests the “fix” to TVL growth is minting more stablecoins. The problem with this is twofold.

  • We believe regulators are not going to let centralized stablecoins grow into hundreds of billions of dollars, let alone $1 trillion-plus. This includes USDC/Circle that has been playing nice with regulators. This is because regulators are still skeptical of the entire DeFi space and think stablecoins are a run waiting to happen. So, even if USDC/Circle grows to hundreds of billions and was properly backed, regulators fear an “event” that causes hundreds of billions of stablecoins to rush to redeem back to dollars, leading to instability in traditional markets. We do not share this concern.
  • Crypto/algo-backed stablecoins have a bad history of losing their peg of $1 against the dollar, and even going to zero.


DeFi needs massive stablecoin growth to see TVL grow to the point that cryptos can “break free” of the legacy markets. We believe this can only come about from decentralized crypto/algo stablecoins getting massive adoption. These coins cannot be controlled by anyone, like a regulator. Centralized coins have a ceiling and they may be close to that ceiling. Centralized stablecoin growth is very low.

The good news on this front is so far, crypto/algo stablecoins are handling the recent selloff/volatility well and their pegs are holding solid. MakerDAO pools are being liquidated, and prices of BTC and ETH have fallen 50% with few, if any, signs of stress.

Should this continue, we believe this selloff will give the confidence to resume stablecoin growth, allowing TVL growth to resume. Eventually, if TVL grows enough, then the correlation to legacy markets will break.

At that point, we could start asking if a truly new financial system has been born.