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June 9, 2021

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Bitcoin Market Dominance and Altcoin Returns

This article aims to investigate the relationship between Bitcoin market dominance, measured as the market capitalisation in US dollars of Bitcoin relative to the total universe of cryptoassets, and the dynamics of returns for non-Bitcoin assets, also known as “altcoins”.

Introduction

The textbook definition of market dominance is the strength of a brand, product, service, or firm, relative to competing offerings. Dominance can be expressed in difference ways. For instance, a firm can dominate a given industry based on share of sales or customers, geographical presence, earnings, etc. From a pure asset pricing perspective, market dominance is often expressed in terms of relative share of total market capitalisation, with market capitalisation of a given firm measured as the number of shares outstanding times the share market price, adjusted for stock splits, repurchases, etc.

Although perhaps too simplistic, dominance measures based on market valuations have been used extensively in the empirical finance literature. Market shares provide a useful, yet imperfect, indication of the weight of a given asset in the aggregate market portfolio. Regarding firms’ competition and market concentration, the European Commission state that a high market share over a long period of time can be preliminary indication of dominance. A dominant position can generally be identified as a market share of 40% or higher with respect to the total market capitalization.

Within the context of cryptoasset markets, market dominance is typically assessed by looking at the market capitalisation of a given asset with respect to the total universe of cryptoassets. The reason is essentially two-fold. First, a direct measure based on market values is somewhat easier to implement given the vast heterogeneity of cryptoassets. Being often based on different protocols, platforms, with different purposes and objectives, a more ad-hoc measure of market dominance than market capitalization, although desirable, may be difficult to implement. Second, a more granular measure of dominance is somewhat less relevant given there is one widely recognised dominant player in cryptoasset markets, namely Bitcoin (BTC). As a result, market dominance within cryptoasset markets is based on capitalisation and is often, if not always, referred to the weight of BTC with respect to alternative coins (“altcoins”).

BTC Dominance and Market Trends

Market participants and commentators often refer to BTC market dominance as a potential signal of change in the aggregate market trend. More specifically, the conventional wisdom posits that a high market dominance signals the relative strength of BTC vs altcoins, and the opposite. As such, a decreased relative weight of BTC in the aggregate market portfolio could signal an increasing relative value of altcoins.
This can be the result of competition among cryptoassets. More specifically, when an asset experiences a negative shock, investors may decide to move their funds to peer assets that are unaffected by the shock. Such trading behaviour would result in a price appreciation for peer assets due to an increased demand. This effect is known as a competition effect and it implies that the prices of peer assets should co-move in opposite directions in response to large idiosyncratic shocks.

Perhaps complementary, although not mutually exclusive, such inverted price trend between similar assets could simply be the result of risk-shifting and portfolio rebalancing strategies whereby investors short a given asset deemed to be riskier and / or less profitable, and invest in a competing asset pushing up demand and ultimately prices.

Although it is rather complicated to dissect competing effects within a highly heterogeneous asset class, it is perhaps instructive to look at the interplay between BTC market dominance and the average returns and risk exposure of altcoins.

Figure 1: Market Dominance and BTC returns

Source: Aaro Capital Research Notes: The left panel shows the market dominance of BTC (blue line) and the compounded returns of a buy-and-hold investment in BTC (1$ initial investment). The right panel shows the market dominance of BTC (blue line) and the price of BTC in USD. The sample period is from December 2016 to May 2021.

Figure 1. provides an initial insight into the relationship between BTC market dominance and prices. The left panel reports the market dominance of BTC and the compounded returns of a buy-and-hold investment in BTC (1$ initial investment). The right panel reports the BTC market dominance against the BTC/USD pair. Two facts emerge. First, there is a mild correlation between the returns on BTC and its market dominance. When market dominance is high, the contemporaneous returns of BTC tend to be high as well. Second, such mild positive relationship is not evidence by looking at the spot prices, possibly due to difference in scale. Competition and / or risk shifting would imply that when considering cryptoassets other than BTC, one should expect a somewhat different relationship between BTC dominance and returns. Figure 2 shows that this seems to be indeed the case.

Notice that the market dominance here is calculated as the market capitalization of BTC in USD divided by the sum of the market capitalization in USD of the largest 100 cryptocurrencies available in each day throughout the sample.

Figure 2: BTC Market Dominance and Altcoin Returns

Source: Aaro Capital Research Notes: The left panel shows the market dominance of BTC against the compounded returns of an equal-weight portfolio of the top 100 cryptocurrencies by market capitalisation, excluding BTC. The right panel reports the corresponding scatter plot. The sample period is from December 2016 to May 2021.

The left panel compares the BTC market dominance against a buy-and-hold investment in an equal-weight portfolio of the top 100 cryptoassets sorted by market capitalisation, BTC excluded. The right panel shows the corresponding scatter plot. Interestingly, and consistent with the idea of risk-shifting and portfolio rebalancing, there seems to be an opposite contemporaneous relationship between the profitability of alternative coins and BTC market dominance. This is particularly evident during the 2017/2018 period whereby BTC market dominance substantially fluctuated from 50% to 80%. The scatter plot on the right shows that significance of the strong negative correlation.

What is the Role of Aggregate Risk?

We now look into more details about the possible relationship between BTC market dominance and aggregate measures of risk, such as volatility and exposure to the aggregate market trend. The logic is simple: if risk shifting and portfolio rebalancing is one possible reason behind the interplay of BTC dominance and market returns, one could argue that by increasing the demand from BTC to altcoins the aggregate exposure of the latter to market forces increase.
Figure 3 reports the market dominance of BTC against the recursively estimated CAPM beta averaged across the top 100 cryptoassets sorted by market capitalisation, BTC excluded. The aggregate market portfolio is calculated based on a large cross section of cryptoassets, excluding stablecoins. Interestingly, the empirical results suggest that when the BTC market dominance decreases, the exposure of altcoins to the market portfolio, and thus to market risk, increases. Such inverse relationship is somewhat mechanical and possibly highlights increasing correlation of altcoins with the aggregate market trend relative to BTC.

Figure 3: BTC Market Dominance and Aggregate Market Risk

Source: Aaro Capital Research Notes: The left panel shows the market dominance of BTC against the average CAPM beta of the top 100 cryptoassets sorted by market capitalisation with BTC excluded. The market beta is estimated based on a rolling window of 30 trading days. The right panel reports the corresponding scatter plot. The sample period is from December 2016 to May 2021.

Competition due to risk shifting and portfolio rebalancing should imply that aggregate risk should be somehow correlated with the investment flows and therefore prices. While the dynamics of the aggregate market risk outlined in Figure 3 is interesting, it is also largely the result of the aggregate market composition and concentration that characterises cryptoasset markets.

Perhaps a more interesting picture could emerge by looking at the relationship between aggregate volatility and returns. Figure 4 reports the relationship between the BTC/USD return volatility, measured as the 30-day standard deviation of the daily returns, and BTC market dominance. The results highlight that a high market dominance tends to correspond with lower volatility in BTC returns. That is, when BTC volatility increases, the market value of BTC tends to deteriorate with respect to altcoins. Such inverse relationship could hint at a shift in demand due to portfolio rebalancing, that is, when BTC becomes more volatile investors re-calibrate their portfolio to share risk among alternative digital assets.

Figure 4: BTC Market Dominance and BTC/USD Volatility

Source: Aaro Capital Research Notes: The left panel shows the market dominance of BTC against the 30-day returns volatility of the BTC/USD pair. The right panel reports the corresponding scatter plot. The sample period is from December 2016 to May 2021.

Competition due to risk shifting and portfolio rebalancing should imply that aggregate risk should be somehow correlated with the investment flows and therefore prices. While the dynamics of the aggregate market risk outlined in Figure 3 is interesting, it is also largely the result of the aggregate market composition and concentration that characterises cryptoasset markets.

Perhaps a more interesting picture could emerge by looking at the relationship between aggregate volatility and returns. Figure 4 reports the relationship between the BTC/USD return volatility, measured as the 30-day standard deviation of the daily returns, and BTC market dominance. The results highlight that a high market dominance tends to correspond with lower volatility in BTC returns. That is, when BTC volatility increases, the market value of BTC tends to deteriorate with respect to altcoins. Such inverse relationship could hint at a shift in demand due to portfolio rebalancing, that is, when BTC becomes more volatile investors re-calibrate their portfolio to share risk among alternative digital assets.

Conclusion

In this report we investigate the relationship between BTC market dominance and the returns on altcoins with respect to BTC/USD. The empirical results suggest that:

  1. Higher market dominance tends to correspond with higher (lower) returns of BTC/USD (alt/USD). This suggests an inverse relationship between BTC dominance and relative prices of altcoins vs BTC.
  2. Decreasing market dominance of BTC correlates with increasing exposure to market risk of the altcoins, on average. This suggests that altcoins may command a higher premium being more exposed to market risk when the relative weight of BTC decreases.
  3. BTC market dominance tends to be negatively correlated with the volatility of returns on the BTC/USD pair. This suggests that aggregate risk and/or risk-adjusted returns of BTC vis-à-vis altcoins can be a driving factor in investment inflows to altcoins from BTC and vice versa.
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