Preparing for a Financial Crisis: Gold or Crypto?

Introduction

It has been just over ten years since the last financial crisis left the U.S. economy in shambles: homes foreclosed, unemployment skyrocketed, and markets hit record lows in what was the worst financial crisis in the U.S. since the Great Depression. After a decade since the Great Financial Crisis of 2008, many now expect another one to hit soon. Analysts at J.P. Morgan recently predicted a 2020 financial crisis on the horizon. Ray Dalio, founder of top hedge fund Bridgewater Associates, stated in an interview with CNBC that “the current economic cycle is in its seventh inning,” hinting at a 2020 downturn. He advised investors to be “more defensive” in today’s stock market. Historically, investors have been able to hedge against financial crises by buying commodities such as gold. From the beginning of 2008 to the end of 2010, the price of gold rose 68%. And during the 1979 oil crisis, in the year 1979 alone, gold’s price increased by 120%. Because gold tends to retain its purchasing power over time and can gain value during financial crises, it is often used as a dependable safe-haven asset. However, in recent years, another candidate has emerged as a possible alternative to gold — cryptocurrencies.

Crypto as the New Gold?

Bitcoin was released in the wake of the 2008 Financial Crisis, the genesis block having the text “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” attached. The creation of Bitcoin is inherently linked to the crisis; the introduction of the Bitcoin white paper outlines how it serves as a solution to the intermediary banks whose irresponsible practices, such as extreme fractional-reserve banking and trading of high-risk mortgage-backed securities, contributed to the 2008 Financial Crisis. Experts speculate that the upcoming financial crisis would be caused by factors like the $1.5 trillion student debt bubble, Brexit, or the trade war with China instead of Wall Street banks, but Bitcoin could still be a solution for many during the next financial crisis. With the global nature of the possible causing factors, as well as the vast inter-connectivity of the global economy, the next financial crisis will not be one that hits only the U.S., just like how the 2008 Financial Crisis had significant adverse effects on economies all over the world. The next financial crisis would likely only worsen sociopolitical situations in tumultuous areas such as Venezuela and Hong Kong, where crypto adoption has risen or even become a part of everyday transactions to avoid capital controls on fiat currencies set by authoritarian governments. Furthermore, fiat currencies are prone to inflation, especially during times of financial crisis, whereas cryptocurrencies are either deflationary or are less susceptible to inflation than fiat. To get the U.S. out of the 2008 Financial Crisis, the Federal Reserve employed “quantitative easing,” increasing the rate at which money was printed. On the other hand, Bitcoin, for example, has a cap of 21 million bitcoins that can ever be mined, and the circulating supply will even less because of lost private keys. Bitcoin’s limited supply makes it a deflationary currency as demand increases and supply constantly slightly decreases from lost keys such that Bitcoin’s purchasing power increases over time, as opposed to fiat currencies, which decrease in purchasing power.

The Relationship (Or Lack Thereof) Between Crypto Prices and the Stock Market

The relationship between crypto prices and the stock market have been analyzed, but there are no strong, definitive trends between the two. In one analysis by CoinTelegraph studying the z-scores, which measures the strength of correlation between two assets on a scale from -1 to 1, the average z-score between the top five non-stablecoin cryptocurrencies and the S&P 500 was 0.06, which indicates a near-negligible positive correlation. This means that there is very little relationship between the cryptocurrency market and the stock market. Historical trends, such as the correspondence of the 2017 crypto bull run and crash to the similar trend in the stock market at the time, have led many to believe in a correlation between crypto and stocks, but can be explained by government policy affecting the crypto market. Immediately preceding the December 2017 crash in the crypto market, there was widespread confusion about false news concerning a potential cryptocurrency ban by South Korea and India. China also announced that they were to restrict access to foreign exchanges by setting up a firewall. Fundstrat’s Tom Lee has said of the relationship between crypto and stocks, “Cryptocurrencies have their own economy based on activity on that blockchain. Equities have their own economy based on earnings per share multiples. The institutional overlap is essentially zero.”

One stronger trend that is present within the crypto market is the relationship with the CBOE Volatility Index (VIX), which is colloquially referred to as the “fear gauge,” or a measure of the stock market’s expectation of volatility. The z-score between Bitcoin and VIX is -0.31, which equates to a moderate negative correlation. However, between the average of the top five non-stablecoin and VIX, the z-score decreases to -0.18. This trend may seem somewhat significant, but it is much less than the z-score between the S&P 500 and VIX at -0.66. Thus, there is a lack of historical data to suggest a bear or bull crypto market in the case of a financial crisis. But speculatively, it makes sense that an increase in adoption stemming from worsening political situations that result from financial crises would be a boon to the crypto market. Furthermore, the likely culprits of the next financial crisis are all in some way related to government policy that a substantial proportion of the population oppose. If a financial crisis erupts from one or a combination of these factors, many could turn to cryptocurrencies because of ideology, as crypto is ultimately financial instrument that avoids government institutions, and was initially propelled to the mainstream by ideologues.

A Potentially Better Bet: Gold-Backed Crypto

Perhaps the best hedge for the next financial crisis is a combination of gold and crypto: gold-backed crypto. Buying and selling gold can be tedious, and gold-backed crypto can circumvent physically dealing with gold, allowing for easier transactions and simpler storage methods. Gold-backed cryptos work by having one token redeemable to some fixed amount of gold, while simultaneously having a free market for exchange between fiat currency and the token. The incentive the free market provides to arbitrage trade with the party with whom the token is redeemable for gold causes the price of the token to be a near-match with the price of gold. With gold-backed cryptocurrencies, an investor looking to hedge against the next financial crisis with crypto can easily add gold to their portfolio through purely online means, which has historically been a good safe-haven asset.