In our recent paper, we conducted an empirical analysis to test how the outbreak of the Covid-19 pandemic affected the market for cryptocurrencies (“cryptomarket”). One year into the pandemic, this market seems to have boomed. For instance, when the pandemic erupted, Bitcoin – the world’s first cryptocurrency – could be purchased for about $7,300. Today, the very same token costs more than $46,800 – a staggering 640 percent rise. Other leading cryptocurrencies (e.g. Ether), showed similar (or even greater) increases. However, this upward trend is not necessarily obvious from a theoretical standpoint, as there are several forces that might drive demand up or down in response to a crisis.

One set of forces leads to potentially higher demand for cryptocurrencies during a pandemic. The fact that cryptocurrencies can be traded from anywhere in the world alleviates, to some extent, potential liquidity constraints that can arise if local governments restrict trading activities as part of a lockdown. As a result, cryptocurrencies become more attractive compared than alternatives. Furthermore, investors fearing that a crisis will lead central banks or political actors to interfere in the market may prefer to switch their investments into the decentralized cryptomarket. In other words, because cryptocurrencies are not managed by a central entity but rather operate automatically, they can enable investors to hedge some of the political risk and thus become more attractive.

But other, countervailing, forces may push down demand. Cryptocurrencies might become closely correlated with traditional financial markets in a time of crisis (even if there is no such correlation in normal times), so that the benefit of switching to crypto is negligible. Worse, the chaos caused by a pandemic might lead to at least two hazardous activities that can cause substantial losses. First, sophisticated investors may manipulate the price of cryptocurrencies (“pump-and-dump” schemes) by artificially driving up the demand in order to lure unsophisticated investors and then drop their holdings once the price is sufficiently high. This seems plausible if people demonstrate herding behavior, i.e. buy cryptocurrencies just because they observe others doing so. Second, even before the pandemic, cryptocurrencies were suspected of facilitating criminal activity. So the same features that make cryptocurrencies attractive during a crisis also make them lucrative for criminals (especially if crime is more attractive amid the chaos of the pandemic).  Anticipating this, people may fear that using crypto would expose them to criminal charges of money laundering, and hence they avoid trading.

We now know that the cryptomarket has flourished, so that the first set of effects seem to have dominated in the long-run. However, much of the uncertainty surrounding Covid-19 has been resolved, e.g. because vaccines have been developed and medical treatment has improved.

What is less obvious is how investors responded when uncertainty was still present. In a new  paper, we investigated how the market cap and trading volume of the top 100 cryptocurrencies correlated with the number of Covid-19 cases and deaths worldwide in the early days of the pandemic (January 2020 – mid-March 2020).  Our analysis yielded three interesting findings. First, we found a positive correlation between the number of new Covid-19 cases (as well as deaths) and the market cap of cryptocurrencies, giving a first indication of the upward tick in the market. Second, however, we found that the relationship between the spread of the virus and cryptocurrencies in our sample period had a U-Inverse shape, i.e. at first more coronavirus cases led to increased investment in the cryptomarket, but then the effect reversed (temporarily, as we now know).

Why should one expect such a reversal? It is possible that people were initially panicking – pulling out of traditional markets but returning to them after the dimensions of the crisis became clearer. Such behavior might be rational in the risk-hedging sense, due to the aforementioned benefits of cryptocurrencies. However, it is also possible that this observation is a reflection of either pump-and-dump schemes or a temporary wave of criminal activity.

The lesson for regulatory design is, therefore, complex. If our findings reflect rational behavior, the focus should be on the consequences of this behavior. Namely, our analysis pointed to a positive correlation between the cryptomarket and the S&P 500, so that if money were pulled from the stock market, it was not recovered in crypto. This raises concerns about systemic risk – as the cryptomarket seems to move with traditional markets during a crisis. These concerns are only amplified now, as the cryptomarket continues to gain momentum. Alternatively, if the effect can be attributed to pump-and-dump strategies or criminal activity, regulation seems needed even more. Then, the U-Inverse relationship we identified also suggests that the regulation is time-sensitive, so that what may be helpful at first may be pointless (or harmful) later.

This post comes to us from Hadar Y. Jabotinsky, a Cegla Visiting Research Fellow at Tel Aviv University Law School and a post-doctoral research fellow at the Hadar Jabotinsky Center for Interdisciplinary Research of Financial Markets, Crisis and Technologies; and from  Roee Sarel, a post-doctoral research associate at the Institute of Law & Economics at the University of Hamburg. The post is based on their recent joint paper, “How Crisis Affects Crypto: Coronavirus as a Test Case,” available here.