The Covid-19 pandemic is one of the toughest challenges the world has ever faced. What started as a local crisis in China has since spread worldwide—drastically changing life everywhere. Schools, businesses, and borders are shutting down and a state of emergency has been declared in the US, Europe, and other countries.

Financial markets have also fallen victim to the havoc caused by the virus, leading to some of the largest nosedives in history. The damages are likely to have a long lasting effect on the world’s economy. As history has taught us, in times of crisis it is especially important to mitigate systemic risk, ie the risk that a collapse of one firm or market will cascade into a full system crash.  Identifying weak links is thus crucial.  

In the past few years, traditional financial markets have been accompanied by a notorious ‘step brother’: the market for cryptocurrencies. In the cryptomarket, virtual tokens such as Bitcoin, Ether, Tether, and Ripple are continuously traded, providing an alternative for traditional stock markets. This nascent market begs an intriguing question: How do investors in cryptocurrencies respond to global crises, such as the one caused by the Coronavirus? And does this market pose a systemic risk which might affect the traditional financial markets? 

Interestingly, there are theoretical arguments in opposite directions. On the one hand, a salient advantage of cryptocurrencies lies in their decentralization: as the registration of transactions does not involve any central authority, investors who lose trust in governments and banks may decide to direct their capital into crypto, hoping that automation and accessibility of tokens (from anywhere in the world) will secure their funds. This seems particularly plausible, as many studies find zero (or weak) correlations between the cryptomarket and stock markets, so that investors may believe that cryptocurrencies can serve as a safe haven. On the other hand, correlation between the markets might emerge during a crisis, so that cryptocurrencies will cease to be a viable alternative. Moreover, information asymmetries may make it attractive to engage in ‘pump-and-dump’ schemes, where sophisticated investors lure uninformed investors into the cryptomarket by creating an artificial demand for tokens and then swiftly selling their tokens, leaving the uninformed investors with a loss. This is particularly worrisome if uninformed investors engage in herd behaviour, leading to cascades that end in a market crash. If such a crash in the cryptomarket is correlated with a crash in traditional financial markets, one might need to worry about systemic risk.

The empirical evidence on Covid-19 reveals some interesting insights, which can help make sense of investors’ behaviour during a time of crisis. In our paper ‘How Crisis Affects Crypto: Coronavirus as a Test Case’, we analyse the market cap and trading volume of the top 100 cryptocurrencies and check how they correlate with the outbreak of the virus in general and with the number of identified infections and deaths in particular. We find that, on average, each new Covid-19 case has led to an inflow of money into the cryptocurrency market, causing the value of tokens to increase. However, the relationship between the spread of the virus and cryptocurrencies has a U-Inverse shape, ie initially more Covid-19 cases led to higher investments in the cryptomarket, but there was a tipping point after which the effect reversed. 

This phenomenon has several competing explanations, which cannot yet be effectively disentangled (at least not before the dust settles). Among other things, it is possible that panic has induced people to pull out of markets entirely and store money ‘under the mattress’. It is, however, also possible that people regained back trust in financial markets following the extensive governmental policies to combat the virus. 

The lesson for regulatory design is a complex one. Notably, the correlation between crypto and stock markets implies that regulators should take the cryptomarket seriously, as it may have systemic importance. However, the cryptomarket may also offer a valuable alternative during crises, allowing capital to flow to (otherwise constrained) firms who use token offerings to raise funds or firms who accept tokens as a form of payment, thereby mitigating the risk that traditional financial markets will collapse. However, if a cascade in the cryptomarket is driven by pump-and-dump strategies, regulation seems ever more needed. Furthermore, the U-Inverse relationship we identified suggests that regulation is time-sensitive, so that what works at first may become pointless (or harmful) later. Regulators who consider intervening should thus observe the market carefully and avoid policies that are difficult to reverse.

Finally, the introduction of a new bill in the US Congress titled ‘Crypto-currency Act of 2020’ (presented via videoconferencing due to the virus) points at a possible heterogeneous regulation, where different authorities would handle different tokens. We do not find much difference between tokens in terms of responses to Covid-19, which may suggest that homogenous regulations could actually be preferable from the perspective of systemic risk prevention. 

Dr. Hadar Jabotinsky is a Visiting Research Fellow at Tel Aviv University Law School, Israel. 

Dr. Roee Sarel is a Research Associate at the University of Hamburg’s Institute of Law and Economics.