You are currently viewing How interest rates affect crypto— A primer on why higher interest rates negatively impact crypto markets |  by Andrew Nardez |  Coinmonks |  Oct, 2022

How interest rates affect crypto— A primer on why higher interest rates negatively impact crypto markets | by Andrew Nardez | Coinmonks | Oct, 2022

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The crypto bear market is in full swing, with total crypto market capitalisation falling from a peak in November 2021 of ~$3 trillion USD to under $1 trillion USD.

While multiple factors are behind this fall, a major driver has been the rapid increase in interest rates by central banks around the world in response to rising inflation.

But how exactly do higher interest rates impact crypto markets?


Higher interest rates negatively impact crypto markets in two ways:

  1. Lower investment inflows into the market: As interest rates rise, returns on cash (held in savings accounts) increase. Investors respond by holding more cash (a liquid and low risk asset) and less in crypto/other risk assets. This reduces the inflow of investments into crypto markets and increases outflows, putting downward pressure on prices
  2. Decreases implied valuations of crypto projects: Higher interest rates increase the discount rate applied to a crypto project’s cash flows, decreasing the valuation of the project and the market’s willingness to pay

Impact 1: Higher interest rates lower investment inflows and increase outflows in crypto markets (putting downward pressure on prices), by incentivising a shift away from crypto/other risk assets to cash

Investors (whether retail or insitutional) are faced with an ever present asset allocation question: With the limited capital I have available, what asset allocation will give me the best overall risk/return tradeoff?

While each investor will have their own risk tolerance which impacts asset allocations, interest rates have a powerful effect on the decision.

In the era of ultra low interest rates, there was little incentive to keep your assets in cash. Why keep money in a bank account that earns next to nothing? Futher, after taking inflation into account, it often meant the investor was making a negative real return (ie the interest earned was not enough to keep up with inflation, meaning you were losing money in real/purchasing power terms). This attitude was perhaps most famously epoused by Bridgewater Associates Founder Ray Dalio stating “Cash is trash”.

An ultra low interest rate environment naturally leads to investors to start seeking out other assets classes to invest capital in order to generate a return above inflation. And so precipated the “everything boom” as investors absconded cash and invested in riskier assets — leading to asset prices rising from property to crypto.

However, the rapid increase in interest rates (driven by inflation) have put this boom to an end. Investors now can put the money in bank accounts which offer attractive returns that are low risk and liquid. As rates continue to rise, cash will continue to become a more attractive asset class — meaning less inflows into crypto markets and downward pressure on prices (particularly as investors sell crypto to hold in cash).

Impact 2: Higher interest rates lower crypto asset values

While nascent crypto markets do not yet have a commonly accepted valuation measure, key valuations methods in other financial markets can give us a powerful guide into how crypto valuations are impacted by interest rates.

A key valuation method in share markets is discounted cash flow (DCF) analysis. DCF analysis relies on the fundamental assumption that the value of a share is a function to the cash it generates. Intuitively this makes sense — if one was given the choice of investing in two shares for the same price with one generating $100M cash per year and the other $10M, one would clearly prefer the company generating the $100M (assuming this cash flow would continue in the future).

DCF results in an estimated value of a share (eg, $1B) by summing up the companies’ projected discounted cash flows (see equation in the image below).

Basic discounted cash flow formula

To understand how interest rates impact valuations in DCF analysis, let’s break down “discounted cash flow” analysis into its component parts:

Cash flow: For a given share, a projection of the expected cash generation (using a financial model) is made over a period of time (usually in the range of 10 years). However, to find the true “value” of a company it is not sufficient to just add up all the cash flows from the model. This is where the “discounted” part comes in.

Discounted: Central to discounting is the concept of the “time value of money”. This can be best illustrated by the question: would you rather $1 today or a $1 in 5 years? Clearly one would take the $1 today as 1) You can now invest it to earn a return and 2) You would expect inflation to eat away at the purchasing power of that $1 over time. We can actually mathematically quantify the difference in $1 today vs $1 in 5 years through the “discount rate”. A discount rate is simply a percentage number that we can use compare cash flows over time. The discount rate consists of a risk free rate (being the interest rate on government debt) plus a risk premium (to account for differences in the risk profile of assets).

Lets do a quick example to illustrate. Say there is a company that generates $100 in cash flows each year for the next 3 years and then closes operations (so it doesnt generate any cash flows after that). Assuming the discount rate is 5%, this would imply a valuation of $272.

Example calculations for a company generating $100 per year for 3 years

Now lets say that the central bank has increased interest rates by 3%, increasing the discount rate from 5% to 8%. In this case the valuation has now fallen to $257 (~5.5% decrease).

Example calculations when the discount rate increases from 5% to 8%

What is interesting about the above is that the companies cash flows have not changed (still remain at $100), but the valuation (ie how much one would pay for it) has decreased.

Ok great, but how does this relate to crypto?

Another way of thinking of crypto projects is akin to traditional companies. Crypto projects are typically designed for a use case that is expected to generate cash flows in the future. Assuming adequate design, these cash flows are anticipated to flow back to holders (eg, through staking rewards, decreases in supply, reinvestment into the project etc.).

As a buyer of a token, one is in effect betting on the cash flow generation of a project. Speculation aside, this is why we see tokens increase in value when potential cash flow positive events are announced (eg, product/feature launches, partnerships etc.).

From this perspective, DCF analysis gives us a mental frame to understand why crypto market capitalization has been decreasing with rising rates — as discount rates rise, valuations fall.

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