• BBCA

How cryptocurrencies could behave with higher interest rates

In the 2008 crisis people’s life deposits were put at risk due to banks involvement in selling mortgaged backed securities to earn much higher profits while increasing peoples leverage and creating a mortgage bubble. Though, in 2009 while government intervention was being made through liquidity injections and lowering interest rates to keep an active system and secure deposits, the first cryptocurrency was being traded as an alternative to manage money without relying on financial intermediaries and instead using blockchain, a decentralized system to verify between ourselves the transactions and ensuring our deposits.

In the USA, the FED decreased interest rates from 5.25% in September 2007 to 0-0.25% in December 2008, and after the bankruptcy of Lehman Brothers similar measures were taken by the ECB reaching near-zero numbers since the end of 2013. However, the supply chain shocks due to the current Covid-19 crisis have caused levels of inflation not seen in the USA since the 90s, though putting in the map an increase in interest rates to contrast it.

Since 2008, the low interest rate environment and increasing banking regulation that reduces banking profit and savings return has incentivized the growth of shadow banking, fintech’s and cryptocurrencies.

Cryptocurrencies were created and have only been in a low interest rate environment which makes us ask the question:

How will cryptocurrencies behave with the upcoming high interest rates?

A key factor is how cryptocurrencies are seen as, money or speculative investments. Generally, higher interest rates increase the value of a country’s currency as they attract investment. Thus, although it’s a global currency, if overall interest increases due to the pandemic, if cryptocurrencies are considered money, they could have similar positive effects. However, interest has an inverse effect on stock prices as business costs increase and there are safer alternatives that now have more return. Are cryptocurrencies really money?

Money is characterized by 3 main functions: Medium of Exchange, unit of account and deposit of value. However, as currently few things can be bought with cryptocurrencies it’s not a unit of account and given their volatile price, they are a poor store of value. Therefore “the consensus is that existing cryptocurrencies do not provide the key attributes of money” and are speculative investments. Thus, if seen as investment, an interest rate increase should decrease their value. Going back to the birth of cryptocurrencies we see an explanation of this reaction. Higher interest rates would increase banks profit, make them more trustworthy and thus having a negative effect on crypto prices.

Trying to follow a more empirical approach, since European interest rates have remained too close to the zero-interest bound since the end of 2013 and at it since mid-March 2016, a correlation with Cryptocurrency prices cannot be established. However, after a daily average of 0.13 from 2009 to mid-December 2015 of the fed funds rate, an increasing interest rates approach followed reaching a maximum of 2.45 at the end of April 2019. Though a good sample to measure the correlation with crypto prices when interest rates increase. At the same time, in-mid March 2020 the rate was set at 1.1 and due to the COVID-19 pandemic they have a daily average of 0.08 ever since, though also having the low interest environment comparison.

The graph on the left shows the evolution of the federal fund & European interbank rate since the end of 2014. On the right the price evolution of the three main cryptocurrencies: Bitcoin, Ethereum and Binance Coin can be observed, with the last 2 graphed on a secondary axis due to Bitcoin’s price dimension.

Although not showing causation, as observed, from 2017 to 2018, when interest rates in the US were reaching their maximum after the 2008 crisis, we see a decrease a decrease in both Bitcoin & Ethereum prices, which in the case of Bitcoin, is recognized as its first bubble burst. At the same time, during covid when interest rates in the US came back close to the zero-interest bound, the prices of the three main cryptocurrencies increase. Following a numerical approach, there is a negative correlation between fed fund rate and the main cryptos ranging from 0.17 to 0.34. Thus, although it’s a low correlation, historical data leads to the conclusion that cryptocurrencies have been treaded as speculative investments and have a negative correlation with interest rates, though a price reduction is predicted with the upcoming interest rates rise to control inflation after the pandemic and supply shortages. Could the rising interest rates bring the second Bitcoin bubble burst?

The acceptance of cryptocurrencies is not the same as in 2017, as currently countries like El Salvador and companies like PayPal, Starbucks & Microsoft currently accept it as payment. Perhaps in the short run the rising interest rates will lower their price as still seen mainly as investments, but it might not have the same effect in the middle or long run.

Analysing it further, as higher interest rates shift to more stable investment options, the volatility of cryptocurrencies could decrease and though increase its acceptance which companies like Amazon and Tesla that have announced interest to accept it as payment could lead. This would make cryptocurrencies be seen as money, which has a proportional effect with interest rates. Of course, a lot depends on how much their public competitor, central bank digital currencies, advance and how much regulators will allow…

By Eugenia de Dios García

72 views0 comments

Recent Posts

See All