AdobeStock 189584444 6 The secret to successful crypto-diversification revealed!

The secret to successful crypto-diversification revealed!

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-The recent cryptocurrency crash raises numerous questions. With no cash flows or self-evident fundamental value, it’s unclear why cryptocurrencies should correlate with other asset classes.

-Since the onset of the Covid-19 crisis in 2020, the correlation between cryptocurrency and equities went from low and negative to consistently high and positive.

-A new mechanism to explain this new relationship is proposed, which relies on the trading habits of retail investors namely, the fact that crypto-oriented retail investors tend to trade cryptocurrencies and stocks at the same time and in the same direction.

-The key finding is that, at the micro-level, retail investors engage in cross-asset buying and selling sprees and that this behaviour became prominent in early 2020.

-A simple two-assets extension of the canonical Kyle (1989) model is used to show that these micro-level patterns can cause cross-asset correlation.

-The model relies on one key assumption, which stems from empirical observations: while two assets have uncorrelated fundamental values, they have correlated uninformed trading volumes.

-The implications of the model are tested using Swissquote data and stock returns. The results suggest that the correlation between stocks and cryptocurrencies is largely driven by retail investors trading habits.

 

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