Are Bitcoin & Ether Prices Really Correlated?

And does it actually matter?

Six and a half years after Satoshi Nakamoto unleashed Bitcoin onto an unsuspecting world, Vitalik Buterin launched a new form of cryptocurrency called “ether.”

This was nothing new in many ways, since many coins had already been created at this point, among them litecoin (2011), XRP (2012) and even the seemingly unstoppable dogecoin (2013). But ether is, by design, something a bit different.

Although it still uses a proof-of-work algorithm (at least, for now) and was built on Bitcoin’s original innovations, ether is more than just a cryptocurrency.

The terms “Ether” and “Ethereum” are often used interchangeably, but the reality is that the latter refers to the open source platform itself and the former is the currency (or “gas”) required to use it.

It is effectively a programmable version of digital value, allowing the development of applications that are not possible on the Bitcoin blockchain, such as Decentralized Finance (DeFi), non-fungible tokens (NFTs) and decentralized autonomous organizations (DAOs).

This, of course, led to a great deal of excitement at the time of launch, and much of the development in the fields listed above can be directly credited to Buterin’s innovation. In 2016 and 2017, there was even consistent talk of the “flippening,” where ether was expected to overtake bitcoin as the top digital currency in terms of total market value.

Of course, this never happened, but even so, the top two coins have often been linked in terms of price movements in anecdotal commentary.

However, does this actually stand up to scrutiny? What, exactly, do the hard numbers tell us?

A rising tide …

We already know that when comparing bitcoin and ether, we’re not really comparing like-for-like, since they have broadly different functionalities. It is also important to note that bitcoin’s supply is strictly limited, whereas ether’s is not. So, in theory, this should affect supply and demand dynamics over time.

That being said, the logical conclusion is that any correlation must, surely, be the result of these two being part of the same asset class, a phenomenon that can be observed in almost any market.

Consider, for example, the rise in gold mining stocks when gold itself rises, or any related industry when new tech breaks into the mainstream. In other words, there is always a correlation, even if it is short-lived, when global factors such as these comes into play.

On that basis, an increase in the interest, adoption and demand for cryptocurrency in general is quite likely to lead to an increase in the prices of all digital assets. This effect has been plainly observed over the last few years, as well as the opposite effect when a major negative development can send the market as a whole into a tailspin.

But, can we observe anything more specific when it comes to bitcoin and ether, and what exactly is the correlation between them?

Two peas in a pod?

Despite their different supply and application dynamics, there is actually a statistically significant correlation between the price of these two assets, and this can be easily seen in this chart from CoinMetrics:

The centre line (the “zero” line) indicates no correlation, and the range of variation is -1 (below the zero line) to +1 (above the zero line). A figure of -1 refers to a high negative (or “inverse”) correlation and +1 refers to a high positive correlation.

This chart covers the period from ether’s creation in 2015 to the present day, and a very strong price correlation from early 2018 is inherently obvious.

On it’s own, however, it doesn't tell us anything we don't know — because of the “rising tide raises all ships” phenomenon, we’d expect to see most other top assets moving in the same way — at least to a point.

While bitcoin’s positive price moves are likely to move the market as a whole, a small cap token that has made an announcement and seen its own value increase is far less likely to move bitcoin’s price directly.

In the case of bitcoin and ether, where the correlation appears to be especially strong, however, this raises a number of questions we might now seek an answer to. For example:

• Why didn’t it exist before?

• Why does it exist now?

• Will it continue to exist in the future?

• Does this tell us anything useful from a trading or long term point of view?

Before and after 2018

For the first two-and-a-half years of its existence, the bitcoin/ether correlation fluctuated wildly between positive and negative before settling at a fairly consistent 0.8+ after early 2018.

While this seems to imply that the two assets moved entirely independently before then, this needs to be looked at in the context of the market as a whole.

Ether was very young at this stage. It was experimental, unproven and considered even more speculative than bitcoin, an asset that was also very young and finding its way in the world, meaning that wild price fluctuations were common.

At the same time, the entire market was worth just a few hundred billion dollars, and large buy/sell orders were also able to influence prices very quickly. The combined effect of this meant that individual transactions on either side could change the level of correlation in real time.

Arguably this is no longer possible — at least to the same degree.

But then, in late 2017, the crypto market as a whole was exposed to enormous retail buying pressure, with almost all assets going through price discovery, followed, inevitably, with a correction and a long crypto winter. Ether fell in unison not only with all the new projects that had come about since its own creation, but with bitcoin itself.

It didn't matter that they were different projects, communities and assets — they were now viewed as equally “toxic” assets by the markets in general. And while that toxicity eventually passed, that broader correlation remained from that time onwards.

The future

The line on the graph is undeniably clear, and it would be easy to conclude that this trend is one that is likely to continue. In reality, of course, this could change at any time, especially as these assets have different development and adoption rates.

Bitcoin’s role as a first layer monetary solution is all but certain at this stage, as second layer (that’s “high speed” or “off chain”) solutions, such as the Lightning Network, Jack Maller’s Twitter integration and even mainstream payment operators like PayPal allow super-fast, super-cheap movement of value around the world on the Bitcoin rails.

And this is just the start. Development rates have accelerated, new integration and announcements are coming to the fore on a daily basis, and, just a few days ago, Bitcoin’s first major core code update for several years — known as “Taproot” — opened the doors to a whole new world of functionality to build on.

Ether, on the other hand, is not looking to secure the same position. As the native token for the Ethereum network, its job is simply to “power” the execution or movement of smart contracts, NFTs and tokens generated on the platform itself. This, in turn, means its success is directly linked to the level of adoption and use of Ethereum as a whole.

While it is currently a market leader, it is arguably under threat from new kids on the block, such as Solana and Cardano. At this stage it’s very hard to tell which players will ultimately succeed.

Many investors, especially those in the retail sector, are unaware of these key differences and tend to lump all digital assets together, something that is quite understandable given the very new nature of the market and the assets being discussed.

It will almost certainly take some time for those differences to be universally understood, at which point we may start to see some divergence in correlation.

The Trading View

In the short term, based on the above (and barring any major developments or upsets on either side) it is probably reasonable to say that broad correlation will continue to exist between bitcoin and ether for some time.

That means there is one trading consideration that should be borne in mind — highly correlated assets do not a diversified portfolio make.

In other words, if you are looking to create a truly diversified trading portfolio to reduce risk, the high correlation means you should consider only one, or other, of the options. At least that is what the theory says.

However, since we now know these are actually very different assets with different objectives, adoption rates, communities and speculative pressures, it would be logical to assume that they are likely to move independently at some point in the future.

At the moment, of course, it’s impossible to say when that might be.

So, while this is interesting from an analytical and graphical point of view, the underlying reasons for the current correlation should be taken into consideration.

Not only that, but true correlation is actually quite hard to prove and requires enormous amounts of data — are the markets really big enough to provide that level of data? A trillion or so dollars may seem a lot of money, but in global terms, it’s a rounding error.

Is it possible that it’s no more than a statistically interesting coincidence?

The bottom line

On the surface a correlation appears undeniable, but will it hold, should it hold, and is it for the right reasons?

More importantly, does any of this actually matter?

The best approach is to consider each asset on its own merits and consider any correlation, other than a broad market one, as something that is interesting — but not critical — to any investment decision.

After all, who knows how those charts will look in the next few years?

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