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Research shows emerging markets in crisis are turning to crypto. But can EM investors count on it as a hedge?

Jeffrey Cusack is a financial writer and tech researcher. A graduate of the London School of Economics, his research into the impact of national political interests on the development of cryptocurrencies led him to investigate how cryptocurrency activity is affected by the onset of a financial crisis. We present his research and commentary below.

Belief in cryptocurrencies’ natural suitability to the needs of emerging markets (EMs) has achieved wide acceptance within the crypto community, and the technical benefits offered by cryptocurrency are gaining recognition in international development circles. But what does it look like when EMs under severe economic stress actually use bitcoin to mitigate that stress? And has bitcoin been an effective hedge for investors with positions in those markets?

The question of bitcoin’s relationship to EM health has been grappled with before …unsuccessfully. In August 2018, Fundstrat’s Tom Lee predicted a recovery in bitcoin (BTC) due to an increase in the MSCI Emerging Markets ETF, under the belief that growing inflows into EM equities would spur bitcoin purchasing due to decreased risk-aversion. This proposed relationship between a single high-risk asset (BTC) and a diversified ETF (comprised mostly of major multinational firms with better credit than General Electric) was not borne out.

The year did, however, produce significant evidence of BTC’s utility to EMs in Turkey and Argentina. Global economic pressures and domestic weakness caused currency crises in both countries, during which time both countries saw significant increases in bitcoin trade volume. Their experience provides an excellent opportunity to evaluate the usefulness of bitcoin to EMs facing significant liquidity shortfalls.

What happens to crypto trade volume during a fiat currency crisis?

Venezuelans’ embrace of cryptocurrency is well-known; however, activity in a state without a functioning market economy cannot be generalized to emerging markets that possess functioning economies and an appreciable level of financial depth. The increased trade volumes seen in Turkey and Argentina provide far more convincing evidence of bitcoin’s usefulness when EM currencies falter.

The steep decline of the Argentine Peso (ARS) and Turkish Lira (TRY) began in May 2018 as growing returns from U.S. assets propelled significant outflows from volatile EM markets. The lira declined nearly 30% YOY, bottoming at -45% in August. ARS finished 2018 down almost 51% at 0.0266 USD, only slightly off its September lowpoint.

BTC:TRY trade volume chart.

A large spike in BTC:TRY trade volume from May to August of 2018. Source: CryptoCompare

Looking at trade volume data provided by CryptoCompare, on May 16th trade volume in BTC:TRY surged to 60.08 after having never breached 11.29 BTC during the two months prior. Volume peaked at 469 BTC on August 9th, one day before a policy announcement lead to the steepest one-day sell-off of the crisis (-14%). BTC:ARS trade volumes followed virtually the same pattern; however, the volume increase was less drastic, likely due to Argentina’s less-developed crypto trading infrastructure.

These increased trade volumes appear to have been dependent on the financial crises that prompted them. After bitcoin’s late-2018 global sell-off, by which point the lira and peso had stabilized, BTC trade volume in ARS and TRY declined significantly more than the global average. Near-term EM utilization of BTC is therefore probably contingent on local market conditions being tight enough to pressure moves into bitcoin; BTC trade volume increases were far more limited in Brazil, which faced significant economic challenges but managed to avoid a crisis.

Bitcoin & emerging markets: the bottom line for investors today

The experience of Turkey and Argentina demonstrates that trades into BTC provide an alternative source of liquidity to emerging markets in crisis. That these countries experienced increased trade volumes during 2018—a period in which BTC performed terribly—indicates that this utility is incentivized more by macroeconomics than crypto performance.

XRP:TRY trade volume chart

XRP:TRY trade volume showed the same pattern during Turkey’s currency crisis. Source: CryptoCompare

Looking at the performance of another cryptocurrency, XRP, and its trade volume with TRY, supports this. Although XRP had superior stability to BTC, XRP:TRY trade volumes followed a near-identical pattern to BTC throughout the year, rising sharply in May and falling precipitously in December. This implies that the stabilization of the lira, and market reactions to the Fed’s December rate hike, were largely responsible for the reduction in BTC trade volumes that occurred around this time.

In this context, while BTC can be considered a valuable liquidity backstop for EMs, it cannot be considered a reliable hedge against EM currency risk. Investors with positions in Turkey would have seen better returns by hedging short equity positions, volatility options, or gold. The former two assets are directly correlated to Turkish economic health, making them far more reliable hedges than BTC.

The possibilities for EM investors going forward

The current utility of BTC to EMs—however circumscribed it may be—points to a future in which cryptocurrencies could develop sufficiently strong relationships to emerging markets to be considered EM assets (for portfolio purposes). The ability to mitigate losses from currency depreciation, in-turn mitigating the cost of servicing foreign-denominated debts, significantly incentivizes the development of this relationship.

Integration of BTC into formal markets could be advanced through improvements to local BTC infrastructure, increasing its facility for legal trade and payment. Argentina gained eight BTC ATM’s last year, and if it continues to improve access to BTC via the peso, trade volume increases should be more in-line with the more dramatic increases seen in Turkey than the comparatively small increases that the country saw in 2018.

Thus far, emerging markets have had a decent start to 2019; however, near-term concerns such as slowing growth in China and global trade frictions present significant downside risks to emerging economies. EM equity indices have already shown sensitivity to these signs of risk, and Bank of America’s David Hauner has advised investors to hedge their EM holdings. There is therefore a significant probability that emerging market volatility will further affect the EM/cryptocurrency relationship over the near and medium-term.

One class of crypto-asset that may become increasingly relevant to emerging markets are “stablecoins”, which minimize price volatility by linking their value to the price of another asset. Stablecoins’ stability mechanisms may increase their attractiveness as an EM hedge asset, especially coins backed by assets that are historically strong during EM downturns (e.g., USD). But whether a stablecoin can gain adoption by EM consumers and industry is an open question. Cryptocurrencies are creating many new options that bear further investigation, and as cryptocurrency infrastructure such as ATMs and payment processors continue to be built out, investors should be alert to trends in which cryptocurrencies this infrastructure supports.

Jeffrey Cusack is a financial writer and tech researcher, a graduate of the London School of Economics.