Is decoupling on the horizon? Bitcoin and Ethereum may finally be able to break their 36-month correlation.

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Since 2018, Bitcoin and Ethereum have been trading in lockstep, increasing the risk exposure of crypto-only investment portfolios.

Anish Saxena, a New Delhi-based automobile dealer, made “incredible” profits by investing in cryptocurrencies in 2020, just as his business suffered from a coronavirus pandemic-induced lockdown.

“I had known about Bitcoin and Ethereum and dozens of other assets for years,” the 33-year old businessman said. “But I only got to invest in them after the lockdown pushed me and my family members out of work. And it helped us survive — big time.”

Saxena revealed that he had allocated roughly 80% of his investment portfolio to Bitcoin (BTC) and Ether (ETH), with the remainder split between Polygon, Dogecoin (DOGE), and Chainlink’s LINK. Saxena declined to reveal the exact amount of profit he made from his crypto-only investment.

He did, however, notice how, by deciding not to liquidate ahead of the May 2021 crash, he nearly lost half of his unrealised profits.

“I was liquidating cryptocurrencies based on my household demand for cash,” Saxena said. “While I am still in profits, seeing my profits decline by more than 50% has prompted me to get a huge portion of my investments back into cash.”

Correlation risks

Retail traders like Saxena have been put under pressure as a result of their over-reliance on the two most popular cryptocurrencies, Bitcoin and Ether.

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While their economics and use cases differ, both digital assets tend to move in the same direction. Their losses and profits appeared to be well-synchronized in recent history, demonstrating that their holders may see their investments grow rapidly during bull trends but risk losing a lot when the uptrend exhausts and reverses to the bearish side.

“If it is a pure crypto portfolio, then, of course, having two cryptos which are highly correlated with one another adds risk to the portfolio,” said Simon Peters, a crypto analyst at multi-asset brokerage company eToro.

“While the portfolio could see exceptional performance one month with the two cryptos making gains in tandem, you could also see huge drawdowns in a bad month as the cryptos move lower together.”

The realized correlation between Bitcoin and Ether has seldom dropped below 50% in the previous three years. Source: Skew

Liam Bussell, head of corporate communications at fiat-to-crypto gateway provider Banxa, on the other hand, referred to Bitcoin and Ether as liquidity backstops for crypto traders.

According to the executive’s comments to Cointelegraph, traders use their initial gains in the top two cryptocurrency markets to invest in mid and lower-cap digital assets, citing rallies in Dogecoin and across nonfungible token projects. He made the following observation:

“Once the market begins to slow, traders try to move back to liquid assets like BTC and ETH. This can offset declines for a short time but can’t maintain the market indefinitely. There are gains to be made in bear markets, but it is volatile coins, and the risk is high.”

Bitcoin and Ether trends throughout their histories. Source: TradingView

Furthermore, Peters advised traders and investors to hedge their crypto investment risks by investing a portion of their money in traditional financial instruments such as stocks, commodities, and fixed-income securities/funds.

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“Historically, crypto has shown itself to be pretty uncorrelated to other asset classes and offers better risk-adjusted returns,” the analyst explained.

Decoupling ahead?

Meanwhile, Peters emphasised that the Ethereum network’s transition from proof-of-work to proof-of-stake, known as Ethereum 2.0, may limit its correlation with Bitcoin.

In particular, one of the main features of the upcoming Ethereum blockchain upgrade, known as Ethereum Improvement Proposal 1559, is deflation, which intends to burn a portion of the transaction fees collected from users.

That could wipe out at least 1 million ETH tokens every year from the circulating supply, thus making the asset scarcer, according to crypto education publication Coinmonks.

Bitcoin exhibits a comparable scarcity by halving its newly issued supply rate every four years, a process known as halving. The cryptocurrency’s supply is limited to 21 million tokens.

“It’s possible that a decoupling between bitcoin and ether will occur following the completion of the 2.0 transition, as the ‘tokenomics’ — how ETH works on the 2.0 blockchain — will be different than it is now,” Peters said, adding:

“Demand for ETH could vary depending on staking reward yields at that time, which in turn could drive the price of ETH higher or lower independently from other cryptos.”

As for Saxena, the novice trader said he would “hodl” on to a portion of his BTC and ETH.

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“If business picks up again after a full economy reopening, I’m planning to invest consistently across Bitcoin, Ethereum, gold and mutual funds,” he noted.

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