(Updated 17. September 2022)
My first exposure to cryptocurrency came through Bitcoin. As I researched further I learned about altcoins such as ETH and Doge and began to track their prices. It soon became clear that many altcoins often moved with Bitcoin. A 2019 academic paper documented connectedness across major cryptocurrencies. So I found myself asking, ‘Why do altcoins follow Bitcoin’?
Here's the short answer:
Altcoins follow Bitcoin for many reasons, including the historical availability of crypto trading pairs, Bitcoin acting as a market sentiment indicator, and the fact that many crypto traders denominate in BTC terms.
This trend is clearly apparent. However, it is not absolute, nor set in stone. For example, if the Bitcoin price increase by 10% you cannot simply assume all other coins will move by 10%. Some altcoins will outperform Bitcoin and some may even decrease in price. There are thousands of cryptocurrencies and financial markets are complex.
The chart below illustrates the Bitcoin/altcoin correlation for a few key altcoins. A number above 0.5 is considered a strong positive correlation:
(Source)
You can see that while Bitcoin is clearly correlated with most altcoins, the extent differs from altcoin to altcoin.
Similarly, correlations do change over time. In fact, the chart suggests that altcoins' correlations to Bitcoin may be weakening. We will explore these concepts in greater detail in this article.
Why Does Bitcoin Affect Other Coins?
Having established that Bitcoin does affect other coins, we now need to consider why. Altcoins follow Bitcoin for many reasons, including the following:
Bitcoin historically was the base currency in crypto trading pairs.
The success of crypto as a whole is tied to the success of Bitcoin.
Bitcoin is considered a market sentiment indicator.
Many traders denominate in BTC terms.
Many cryptocurrencies are essentially Bitcoin clones.
Below I explain in more detail each of these points.
Reason #1 - Trading Pairs
Historically, there were not many types of cryptocurrency. Bitcoin was the largest, oldest and most established by a significant margin. Similarly, reliable stablecoins were not widely available until late 2017. For this reason, it made sense that on most centralized exchanges all crypto trading occurred versus Bitcoin.
For example, if you wanted to trade ETH, you needed to trade it for Bitcoin.
This created a dynamic by which new investors needed to fund their trading accounts first with Bitcoin (thus increasing the Bitcoin price). The Bitcoin was subsequently trading for Alts (thus sequentially increasing Alts price).
In other words, most altcoins were bought with Bitcoin. This lead to a high correlation. This reason is less of a factor today, as stablecoins are widely adopted, but it still plays a large role in the correlation between altcoins and Bitcoin.
Reason #2 - Bitcoin represents the crypto industry
The best-known cryptocurrency, by far, is Bitcoin. Some even consider it synonymous with the industry as a whole. This was true historically and the perception remains valid today. Furthermore, the Bitcoin market cap still represents roughly 40% of the total crypto market cap. For this reason, the success or failure of Bitcoin is seen as being indicative of the probability of the success of other coins.
When the Bitcoin price increases many take this to mean the chance of a specific altcoin succeeding also increases. This results in a (slightly lagging) correlation between Bitcoin buying and altcoin buying.
Below you see a chart showing the percentage of the total value of the cryptocurrency market that Bitcoin holds:
I used this metric as context when evaluating historical "altcoin cycles" and "Bitcoin cycles," not as a precise forecast of the next move.
Reason #3 - Bitcoin as a market sentiment indicator
Many crypto traders were aware of the relationship discussed here. For that reason, I treated BTC price movements as one indicator of broader market sentiment.
For example, if the Bitcoin price suddenly jumps, many traders will quickly purchase altcoins in the expectation that altcoin prices should soon follow.
That buying pressure could increase altcoin prices and reinforce the observed correlation. Algorithmic strategies may also have contributed, although the size and timing of that effect were difficult to establish.
Reason #4 - BTC Denomination
Many active crypto investors and traders hold a long-term belief that Bitcoin will outperform the US dollar over multi-year timeframes.
As such, they may choose to measure their portfolio value in BTC as opposed to USD terms. If they trade altcoins, their default position will therefore be to trade back into BTC, which increases the degree of correlation between alts and BTC.
For example, if ETH increases significantly versus BTC, many traders will sell their ETH holdings for BTC. When applied at a large scale, this dynamic reduces price divergence between altcoins and Bitcoin.
Reason #5 - BTC clones
Many altcoins such as Litecoin and BCH are essentially clones of Bitcoin. They run on a similar proof of work consensus mechanism and rely on similar narratives to drive understanding of their value. It therefore stands to reason that as BTC’s reputation and price increases, these clones also experience an increased perception of value. This drives buying pressure and results in these altcoins largely following BTC’s price action.
Do ALL Cryptocurrencies Follow Bitcoin?
Having established the general trend of correlation, you may ask ‘do all altcoins follow Bitcoin’? The answer is quite simply, no.
Stablecoins are examples of altcoins that do not move in correlation with Bitcoin.
The price of these coins is pegged to specified fiat currencies, such as USD or EUR, or to other reference assets. This is intended to reduce volatility relative to unpegged crypto assets. Stablecoins aim to track their pegs, although deviations can occur.
Some protocols have also introduced coins that specifically move counter to Bitcoin price fluctuations. This allows traders to reduce the volatility and risk of their overall portfolio in uncertain market conditions. This is known as ‘hedging’.
These 'hedging assets' can also be used to ‘short’ the market, meaning they gain in value if the rest of the market is decreasing in value. One such token is Synthetix’s Inverse BTC (IBTC). This token is designed to move directly opposite to BTC. For example, should BTC increase 10% in value, IBTC is designed to decrease 10% in value.
In addition, some assets simply have not traditionally followed BTC price action. While their degree of correlation shifts over time, ATOM, LINK and XTZ are well-known coins that have on occasion demonstrated a negative correlation with BTC.
Stablecoin and hedging tokens deliberately do not correlate with BTC. These represent only a very small fraction of the total number of cryptocurrencies in existence. The very large majority of other coins more or less follow Bitcoin. So if BTC enters a significant price depression, most altcoins will follow and depreciate as well.
Will Altcoins Follow Bitcoin Forever?
The fact that altcoins follow Bitcoin is a long-established trend in crypto. But the question as to whether altcoins will follow Bitcoin forever remains open.
Firstly, as crypto matures, we are starting to see the industry break into clear sectors. For example, we have Decentralized Finance (DeFi), non-fungible tokens (NFTs), Store of Value (SOV) and other clear sector verticles. More sophisticated investors have moved beyond seeing the crypto industry as an undifferentiated entity.
This suggested that correlations between sectors could decrease as the market matured. For example, in Q3 2021, NFT valuations rose amid increasing media attention and celebrity endorsement. During the same period, DeFi coins underperformed Bitcoin and Ethereum amid concerns over transaction fees and protocol scalability.
The sample suggested that correlations between some sectors were decreasing. The chart below shows declining BTC correlation for the listed altcoins over the selected year.
New sectors can often diverge from Bitcoin significantly. For example, Chainlink (LINK) was the first ‘Oracle’ project to hit widespread adoption. This resulted in a remarkable price run from $0.48 in Jan 2019 to $3.4 in July 2019. While that may not sound excessive by crypto standards, Bitcoin was in a bear market during this period. As Oracles have become established, we subsequently saw an increased price correlation with Bitcoin.
Conclusion - Why Do Altcoins Follow Bitcoin?
Bitcoin leads Altcoins for many reasons. These include historic trading pairs, Bitcoin's dominant reputation and the perception of Bitcoin leading market sentiment.
Some crypto assets such as stablecoins and hedging instruments do not correlate with BTC. As the market matures, correlations between altcoins and Bitcoin may also weaken.
I expected correlations to weaken as the industry matured and viewed that as a healthy development. Greater differentiation could allow investors to assess projects more on their own merits rather than treating Bitcoin's short- and long-term movements as the dominant input.
To draw an analogy, would it be optimal for all shares to trade based on the Tesla stock price? Clearly not, and like the stock market, crypto needs differentiated assets and asset classes.