Institutional top of mind | #2

Keep up with the top industry updates as we present bi-weekly market insights that are important to traders in the institutional space.

This week, Kelvin Lam, CFA, Head of Institutional Research for OKX, looks at two top-of-mind issues in this installment: How traders should think about their exposure in digital assets after the recent US downgrade, and what the surge in trading volume for altcoins signals for the greater cryptocurrency market.

Top of Mind: how to think about your crypto exposures after US downgrade

In the realm of financial markets, recent developments have drawn significant attention as Fitch Ratings downgraded the credit rating of the United States to AA+ from AAA. Fitch explained the downgrade reflects the expected fiscal deterioration over the next three years, erosion of governance, and a growing general government debt burden. Although the initial announcement has raised concerns and prompted questions regarding potential market implications, the reaction to credit spreads and other related market metrics has been relatively muted. This research article aims to evaluate the impact of the US credit downgrade by referencing the events of 2011 and exploring potential opportunities for Bitcoin and the cryptocurrency space.

TL;DR

• The US credit rating holds immense importance and significance as the US Treasuries play an important role in the global financial markets as a benchmark for risk-free rates. The dominance of the US dollar as an international reserve currency further amplifies the impact of the US credit rating on the global economic landscape. The last time the US credit rating was downgraded occurred in 2011 when Standard & Poor's (S&P) lowered the rating from AAA to AA+. This event created significant turmoil in the financial markets, resulting in increased volatility and a decline in stock prices. The downgrade was primarily attributed to concerns over the US government's ability to address its rising debt levels and political gridlock surrounding fiscal policy decisions. The downgrade also triggered global repercussions, as it undermined the perception of the US as a safe haven. Conversely, gold rallied strongly on the back of this market development as a safe haven.

Major assets performance table 1 month after S&P's US credit rating downgrade in 2011 Aug

Source: OKX, TradingView

• Historically, Bitcoin has exhibited a strong positive correlation with Gold, particularly during times of economic or market uncertainty. For example, during the recent banking crisis from March to April, Bitcoin and Gold showed a high positive correlation (>0.7) (Source: OKX, TradingVIew). If the fiscal situation in the US deteriorates further, resulting in an increase in government debt, Bitcoin's limited supply nature could potentially position itself as "digital gold". Compared to previous turbulent periods, Bitcoin is now better positioned as a safe haven asset due to its suppressed volatility (Source: Bloomberg), increasing institutional adoption, and longer track record. The reduced volatility could indicate improved stability, making it more attractive to risk-averse traders. The growing acceptance of Bitcoin by major financial institutions (as demonstrated by multiple spot ETF applications) enhances its credibility and liquidity as a safe haven asset.

• While the recent US credit rating downgrade had minimal impact on markets, it's prudent for institutional traders to prepare for potential future deterioration. Here are some strategies to consider:

• Increase exposure to Bitcoin: Based on the factors set forth above, Bitcoin has proven to be a more reliable safe haven asset compared to its previous volatile periods. Allocating a portion of investments to Bitcoin can be advantageous if trust in fiat currencies wanes. Bitcoin also offers diversification benefits when compared to traditional asset classes.

• Implement market-neutral strategies in crypto space: the wide array of trading tools accessible in the market facilitates the implementation of market-neutral strategies, thereby mitigating transaction costs and minimizing friction. Strategies like cash-and-carry, spreads trading, and cross-exchange arbitrage can generate delta-neutral returns, especially when market volatility picks up.

• Explore yield farming strategies: Engage in lending, borrowing, or staking cryptocurrencies within decentralized finance (DeFi) protocols to earn yields. While this strategy carries risks such as smart contract vulnerabilities and volatile rewards tokens, it offers idiosyncratic return that's uncorrelated to other major assets. Success in yield farming is highly dependent on the selection of DeFi protocol, the underlying tokenomics, and effective risk management strategies.

Top of mind: what a surge in altcoin trading says about the greater crypto market

• Despite total market trading volume experiencing a notable decline compared to levels from a year ago, an intriguing trend has emerged over the past two months: a surge in trading volume for different altcoins.

• The spikes in trading volume for these altcoins, while temporary, can be attributed to various factors. As traders actively seek opportunities, the market continuously rotates to different narratives.

• By delving into the related market microstructure data, there are valuable insights into the current state of the crypto market.

TL;DR

• Over the past two months, several altcoins have experienced significant increases in trading volume, driven by diverse factors during different periods. A summary of these tokens is presented in the table below, providing key insights into the drivers behind the trading volume surges in these altcoins. The chart below also depicts the trading volume of perpetual swaps on OKX for various altcoins during the past two months. While many of these surges in trading activity are short-lived, it's worth noting that another altcoin usually picks up the baton with market narratives quickly switching.

Source: OKX

• Analyzing the impact of altcoin activity on BTC and ETH, we see a clear connection between the two. The chart below indicates that on days when altcoin trading volume surged, we observed corresponding spikes in BTC and ETH trading volume, except for August 13, which was an exception due to the Sunday effect. By examining the order book liquidity data, we noticed an overall upward trend in OKX's order book liquidity (0.5% depth) over the past two months. However, when significant altcoin trading volume surges occurred, there was a noticeable drop in order book liquidity for BTC and ETH. This can be attributed to market makers shifting their focus and capital to altcoins, where volatility and profitable opportunities arise.

Source: OKX

• These observations shed light on the current state of the cryptocurrency market, highlighting its evolving nature and resemblance to traditional markets. It's common to see the market's strong reliance on narratives for trading signals in the early stages of a bull market, where traders actively seek new market information to guide their trading decisions. At the same time, the temporary drop in liquidity for major cryptocurrencies when altcoin trading volume surges, suggests that institutional players are still in the early stages of entering the market. Their participation is crucial for driving market development, enhancing liquidity, and fostering higher trading volumes. This signifies that the cryptocurrency market is still in its nascent phase, with potential for growth as institutional adoptions continue to expand. Lastly, this trend is likely to persist as Bitcoin continues to demonstrate historically low volatility with SEC delaying their decisions on spot ETF applications. It's worth noting that the weakened liquidity in BTC and ETH during altcoin trading volume surges can potentially trigger price volatility in major cryptocurrencies. Institutional traders should be prepared for such scenarios and carefully manage their risk exposure.