Avoid Bitcoin Risks: Who Is the Lone Ranger in the Digital Currency Market?

Abstract:
*The correlation between all mainstream coins and Bitcoin has strengthened during the slump. It is impossible to fully hedge against Bitcoin with mainstream coins at this time. The digital currency market remains a whole. It is difficult to find assets to hedge against Bitcoin.

*Mainstream coins with history are heavily correlated with bitcoin. The rising and falling of Bitcoin may be a future price predictor for those coins.

*Ethereum and Bitcoin are highly correlated. However, since 2020, the price of Ethereum and that of Bitcoin have tended to decouple.

*GT is less correlated with BTC price compared to BNB.

* In the future, Ether and UNISWAP tokens may be used to avoid risks in the digital currency market.

Applications:
*In long-term investments, when the price of Bitcoin collapses, alternative digital currencies are less correlated to Bitcoin. This can reduce short-term losses for investors, especially investors of derivative contracts.

*The decoupling characteristics of Ethereum and UNI from Bitcoin may represent the future development of digital currency or blockchain technology. With experience from Ethereum and UNI, investors may find the next digital currency that can be a safe-haven asset.

Finding a Safe Haven within the Market

Bitcoin remains the most important and influential currency in the digital currency market. Although the market share of Bitcoin has declined compared to its peak, it still accounts for 41.7% of the market capitalization even after a slump like on May 19th. Bitcoin’s importance is not only manifested in its market capitalization, but also in its price correlation with other digital currencies. The price change in Bitcoin can have an obvious and significant impact on the prices of other currencies. Bitcoin’s risk is always passed on to the entire digital currency market.

If investors can find a currency in the digital currency market that has a relatively weak correlation with the price of Bitcoin, that currency may become a safe haven for investors in case of Bitcoin dip, and a hedge asset in the digital currency market. The research in this article is based on the daily returns of Bitcoin and mainstream coins. The volatility and dynamic correlation between Bitcoin and other mainstream coins are calculated with GARCH and DCC-GARCH models. This article also tries to find a currency among mainstream coins that may become a Bitcoin hedge asset. This article also further studies the correlating trend between mainstream coins and Bitcoin, which future investors can refer to when they purchase asset portfolios.

Selecting a Mainstream Coin

Method De_script_ion
The DCC-GARCH model is a measurement tool for measuring conditional variance (aka volatility) and correlation coefficient (aka digital currency correlation). With the DCC-GARCH model, volatility and correlation coefficient data can be obtained without using MA. It can increase the sensitivity and accuracy of the metric results to the current data.

Correlation Measurement
Using the GARCH(1,1) and DCC(1,1) models, this study measured the dynamic correlation coefficients between the above mainstream currencies and Bitcoin. Below is a graph that shows the changes in the correlation coefficients between different mainstream currencies and Bitcoin. In each graph, the x-axis represents the date and the y-axis represents the correlation coefficient between that currency and Bitcoin. The higher the correlation coefficient, the higher the correlation between the price of that currency and the price of Bitcoin, and the more similar the price trend between the two. The lower the correlation coefficient, the less correlated the price of the currency is with the price of Bitcoin, and the two price trends are relatively independent of each other. When the correlation curve goes up, the correlation between the currency and Bitcoin price is also going up. When the correlation curve goes down, the price of the currency is gradually decoupling from the price of Bitcoin. During different time periods, there is a large difference in the correlation coefficients or in the trend of movement, which indicates that domain and time matter in their correlation.

Correlation Coefficients of Mainstream Coins and Bitcoin

Data source: Gate.io

As you can see, except for Dogecoin, the correlation between mainstream coins and Bitcoin shows a clear time-domain feature. There is significant division in the correlations of these mainstream coins with Bitcoin over various different time intervals. This suggests that the correlation between mainstream coins and Bitcoin is not stable and can change over time. During some time periods, certain mainstream coins may have a low correlation with Bitcoin and can be hedged against Bitcoin. In other time periods, that mainstream coin may have an increased correlation with Bitcoin and become a Bitcoin correlated asset. The relationship between Dogecoin and Bitcoin, on the other hand, is not generally stable as shown in the image. The correlation between Dogecoin and Bitcoin cannot be captured by the DCC-GARCH model. The following figure gives DCC-GARCH modeling results of the correlation between Dogecoin and Bitcoin prices.

Estimation results of DCC-GARCH model

It can be seen that the key parameter dcca1 has a value of 0 and the key parameter dccb1 has a value close to 1, which indicates that the structural relationship between the two correlations is full of variations. The correlation between the two lacks a stable structure and is often in a state of flux.

Bitcoin has obvious time-domain characteristics with these mainstream coin correlation coefficients, so this article will conduct an in-depth analysis about the post-2020 correlation coefficients.

Litecoin and UNI

Trend of Litecoin-Bitcoin correlation in 2020–2021

Data source: Gate.io

UNI VS Bitcoin Correlation Chart 2020–2021

Data source: Gate.io

Between 2020 and 2021, the correlation coefficients of LTC and UNI with Bitcoin have been relatively stable. LTC is highly correlated with Bitcoin, while UNI is least correlated with Bitcoin. The correlation coefficient between UNI and Bitcoin is below 0.4. LTC and Bitcoin share the same technical principles and use the same PoW mechanism. This homogeneity may explain the extreme similarity in price movements between the two. The decentralized exchange UNISWAP token, on the other hand, is the most distant from Bitcoin in terms of technicals and concept, which may explain the low correlation between UNI and BTC.

Ripple, Polygon and ADA

2020–2021 Ripple vs. Bitcoin Correlation Trend
Data source: Gate.io

The Ripple-Bitcoin correlation coefficient strengthened from January to April 2020. It weakened from July 2020 to April 2020. After May 2020, the Ripple-Bitcoin correlation coefficient strengthened once again.

2020–2021 Polygon VS Bitcoin correlation chart
Data source: Gate.io

Polygon’s correlation coefficient with Bitcoin price is relatively stable, basically fluctuating around 0.5 except for a significant drop in mid-July 2020. Compared with other currencies, Polygon does not have a high correlation with Bitcoin price.

ADA and Bitcoin correlation chart for 2020–2021
Data source: Gate.io

The coefficient correlation between ADA and Bitcoin shows huge fluctuation, close to 1 at its peak and 0 at its lowest. Overall, Ada still maintains a high correlation with Bitcoin.

Poca.com’s correlation with bitcoin oscillates increasing
Boka-Bitcoin correlation trend for 2020–2021
Data source: Gate.io

Polkadot
Since Polkadot launched, the correlation coefficient between its tokens and Bitcoin price has shown an upward trend. After May 2021, the correlation between the two reached a new peak. This is worth investors attention. Technically and conceptually, Polkadot is very different to Bitcoin. It does not intend to be used as a form of payment, but focuses on cross-chain linking functions. Its design, concept and application targets are different from Bitcoin. The high correlation coefficient between the two may be related to the fact that Polkadot still lacks substantial applications and active users. Although it has a promising future, it has not yet established its own ecosystem and cannot yet be separated from the value system represented by Bitcoin. The current value change of Polkadot is more based on the overall market sentiment. Fundamental investors in Polkadot are not yet in place.

Historically Long-Standing Coins’ Correlation to Bitcoin Increases with Bitcoin Risk
Bitcoin Daily Volatility Chart
Data source: Gate.io

The chart above gives a graph of the change in Bitcoin daily volatility between 2020 and 2021. It can be seen that the correlation coefficients of other digital currencies with Bitcoin has a similar trend to Bitcoin’s volatility, except for UNI and Dogecoin. During the slump on March 12th, 2020, Bitcoin price volatility had increased exponentially. The correlation coefficients of other digital currencies with Bitcoin also increased except for UNI and Dogecoin. ETH, ADA, BNB and XRP have correlation coefficients with Bitcoin that are close to 1. It indicates that the trend change of these currencies were the same as that of Bitcoin. At that time, none of these currencies could be a hedge asset against BTC.

BNB VS GT

2020–2021 BNB VS Bitcoin Correlation Trend
Data source: Gate.io

GT VS Bitcoin correlation chart 2020–2021
Data source: Gate.io

GT and BNB are the platform tokens of Gate.io and Binance. Their correlation coefficients with Bitcoin have similar trends. However, GT has a lower correlation coefficient with Bitcoin, while BNB has a higher correlation coefficient with Bitcoin. This could be related to the amount of coins traded on both exchanges. According to CoinGecko, there are 307 listed currencies on the Binance exchange, while there are 732 listed currencies on Gate.io. This allows GT to have more trading pairs. There is more BNB/Bitcoin trading on Binance.

When the Bitcoin price drops, users on Gate.io and Binance will exchange BTC for platform tokens first and then for stablecoins. If there are more transactions with Bitcoin, more sold platform tokens, and lower price of the platform tokens, the correlation with Bitcoin price will also be higher. Gate.io, on the other hand, has a relatively fragmented trading risk and less transactions with Bitcoin in GT trading volume, so GT prices naturally have a lower correlation to BTC. The token price of the exchange tokens and their correlation with BTC price is an important point of reference for investors when choosing a trading platform. When there is a significant drop in BTC price, choosing an exchange token with lower price correlation to BTC can reduce investors’ trading losses.

Ethereum
Ethereum’s correlation with Bitcoin rose sharply after 2018 and peaked in July 2020. After October 2020, the correlation coefficient between Ethereum and Bitcoin decreased, with a mean value of 0.82 to 0.72. Although numerically, the correlation coefficient did not change much, the price correlation between other veteran mainstream coins and Bitcoin increased during the same period. This furthered the decoupling of Ethereum and Bitcoin.

Trend of Ethereum-Bitcoin Correlation in 2020–2021
Data source: Gate.io

Ether VS Bitcoin Relative Price Trend
(Ether VS Bitcoin price = Ether price / Bitcoin price)
Data source: Gate.io

When the correlation between Ethereum and Bitcoin was declining, the price of Ethereum was increasing. It indicates that Ethereum has expanded its incremental value, while sharing the bull market success with Bitcoin. Other mainstream coins showed the same trend in correlation with Bitcoin pairs and their relative prices compared to Bitcoin. This suggests that the other mainstream coins are only sharing the bullish success of the overall digital currency market and have not expanded incremental value.

In its latest comprehensive report, Goldman Sachs pointed out that crypto prices are related to its usage. The higher the usage, the higher the price of the currency. Most of the three major applications of the crypto ecosystem — payments, DeFi and NTFs — are currently built on Ethereum, which increases Ethereum’s value. The change in Bitcoin correlation coefficient between Ether and UNI suggests that the token’s independent application protocol and application value may be the key to decoupling from Bitcoin.

By Gate.io researcher Charles.F
*This article represents the views of the researcher and does not constitute any investment advice.

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