Virtual Currency Volatility, CBDCs

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Virtual Currency Volatility, CBDCs

Two Disruption items today, both about digital currencies. A note for newer clients: many email systems code as spam any messages that mention the popular virtual currency whose name begins with “B”. We therefore refer to this asset as “B” in our work to get around that constraint.

#1: We’ve covered “B” since 2013 and our guiding principle has been to buy it when it’s boring and sell it when it is moving sharply higher and we feel like geniuses for owning/recommending it. It is the classic “instead of yellin’, you should be sellin’” trade. Yes, there are many investors who hold “B” through thick and thin, and that has been a viable strategy as well. Even those hardy souls, however, might benefit from considering more auspicious times to lighten up or add to positions.

To quantify the continuum between “boring” and “spicy”, we use the standard deviation of daily “B” price returns over the prior 100 days. The chart below shows this data, along with the asset’s price at various highs and lows for price volatility back to 2014. (Note: the prices noted are not “B’s” peak or trough prices, but rather the prevailing prices that occurred at turning points in vol.)

As the prices on the chart show, buying during periods of low volatility (between 2 and 3 percent, ideally towards the low end of that range) tends to yield positive future returns. The notable exceptions (September 2014, November 2018) came after especially large rallies (November 2013, December 2017) which took longer to burn off. Otherwise, the hit rate of “buy low vol, sell higher vol” is good.

It’s worth noting this pattern is exactly the opposite of what we see in equities. When it comes to stocks, you generally want to buy high volatility and sell low volatility. Also, as a stock’s market cap increases it usually sees less volatility. That’s not the case with “B”, which as the chart shows is just as volatile now (with a +$600 bn market cap) as it was in 2014 – 2015 ($5 – $10 bn market cap).

Takeaway: our volatility signal says it is still too early to take a shot at “B”. Trailing 100-day volatility is still above 3.0 percent (4.3 pct through yesterday) and even just in July we’ve had three +4 pct days. “B” needs to be “b”oring to create a sensible entry point for a trade or a longer term investment that doesn’t yield stomach-churning near term volatility. The good news from the historical record is that this day will come.

#2: The world’s central banks are working on their own versions of online digital currencies, but they have the same challenges any incumbent faces when a disruptive new technology starts to gain market share:

They wait too long to respond. “B” has been around for over a decade, and Ethereum since 2015. Even after their recent price declines, the combined value of these 2 assets is still +$800 bn. Virtual currencies were a curiosity when they launched, true … But capital markets and venture capitalists alike take them seriously now. Based on public pronouncements, neither the Federal Reserve nor the ECB are likely to have a central bank digital currency before 2025 at the earliest. That leaves a lot of runway for non-CBDCs to continue to grow.

They worry about their existing franchises instead of looking forward. While the Federal Reserve and European Central Banks are “studying” CBDC issuance, public comments from key officials make it clear they’re first and foremost concerned with maintaining the status quo. “Move fast and break things” may be disruptive tech’s mantra, but it is the exact opposite of how central bankers operate. As with the prior point, this gives privately owned virtual currencies opportunities to develop novel solutions without competition from central banks.

They fail to see developments in the larger world. Smartphones, just to pick one obvious example, have changed how consumers live their daily lives and they expect “money” to adapt to fit these changes. The private sector has done a lot on this front, with tech-enabled payment systems and user-friendly apps. But the rapid growth in virtual currencies shows central banks risk losing control of what defines “money” if they don’t adapt to evolving consumer and business preferences.

Takeaway: we’ve been giving CBDCs a lot of thought in terms of which public companies lose if central banks resist developing them, and the simplest answer is “banks”.

The single best reason for the Fed or ECB to go quickly and all-in on a virtual currency is that America and Europe’s banking systems are already being disrupted by alternative payment systems. PayPal, for example, has a larger market cap than any US financial institution except JP Morgan and Berkshire Hathaway. Ironically, central banks worry that a CBDC will weaken their banking systems, but that’s already happening. The only way to put traditional banks on an equal footing with disruptive competitors is to give them a technologically competitive currency. US large cap Financials, much as we like them for a cyclical trade just now, need all the long-term help they can get.