Our contributing columnist Ruobin Gong, writes:

“Correlation is not causation” is among the most widely recited tenets of statistical literacy. It is somewhat odd for a concept to be better known for what it is not than for what it is. For correlation, the statistician is quick to warn of its danger because we are too aware of its irresistible allure. The human mind looks at correlation and sees a sketch of the concomitant movements of the universe, a symphony of time and space, and a testimony to the marvels of natural law. We swear to not put our trust into correlation, yet we lean on it for directions, hints, and advice, so much so that our slanted posture sometimes betrays the oath to do otherwise.

Recently, correlation assumed a new role as a financial regulatory device. (The story takes a little bit of time to unpack, so please bear with me.) On January 10, 2024, the US Securities and Exchange Commission (SEC) approved a number of spot Bitcoin exchange-traded products (ETPs), making them available for trading on national security exchanges in the US.¹ (The word “spot” means that these ETPs are backed by actual Bitcoin holdings rather than, say, Bitcoin futures.) The approval is kind of a big deal, because it means that people may soon be able to make Bitcoin-backed investments using their retirement accounts—the 401(k)s and the 403(b)s (hello, my fellow public school employees)—without having to wade through the near-mythical obscurity surrounding the trading of Bitcoin or Bitcoin itself.² Interestingly, the peace of mind that is now on offer to the public to dabble in the cryptocurrency is the result of a long legal battle, the better part of which the SEC spent on resisting the very idea of granting such an approval.

The SEC had its rightful concerns. It was worried that the exchanges who offer these spot Bitcoin ETPs would not be able to prevent fraud or market manipulation of the Bitcoin prices, nor be able to shield the investors from these risks. Previously, in order for the SEC to approve any ETP for trading on an exchange, the exchange must demonstrate that it has a “comprehensive surveillance agreement” with a “regulated market of significant size” related to the ETP’s underlying asset, so that fraud or manipulation of that underlying asset can be detected and deterred through this market.³ This rule works for ETPs backed by most assets, such as gold and soybeans, and it even works for ETPs backed by Bitcoin futures, which have been trading in significant quantities at the Chicago Mercantile Exchange (CME) since 2017.⁴

But spot Bitcoin is a different animal. Bitcoin prides itself as a digital-native, blockchain-enabled, non-sovereign currency, whose whole point of existence is that it need not be traded on any regulated market. In the eyes of the SEC, that’s why Bitcoin is fundamentally distinct from gold, soybeans, even Bitcoin futures because, simply put, there is no way for Bitcoin to be directly surveilled by an exchange. As such, the SEC could not approve an ETP backed by it.

If the above made sense to you… well, it shouldn’t. The SEC’s logic leads to the bizarre outcome that an ETP backed by Bitcoin futures can receive approval, but an ETP backed by Bitcoin cannot, despite the fact that Bitcoin futures track—you guessed it—Bitcoin. Last August, a federal court told the SEC that it had failed to adequately explain its reasoning and that it’d better go back and think over the whole thing again.⁵

The moment has finally arrived that our heroine, Correlation, enters the scene. Having mulled over the matter, the SEC revised its decision by endorsing a ground-breaking argument. It examined the price returns data at different temporal resolutions over the course of more than two years (March 2021 to October 2023) and concluded that the prices of Bitcoin and the prices of Bitcoin futures are “consistently correlated.” In the approval order, the SEC cited analyses that showed Pearson correlation calculated over the price returns time series of Bitcoin and Bitcoin futures yields more than 92% for hourly data and more than 78% for minute-by-minute data. It went further, to conduct an in-house robustness analysis using rolling three-month segments within the same time period, arriving at estimated correlation coefficients that were consistently between 90% to 99.2% for hourly data, and between 67.9% and 83.2% for minute-by-minute data.

Whether these correlations look high enough to you, they certainly bolstered the SEC’s newfound confidence in their regulatory significance. The SEC declared that a strong and persistent correlation between Bitcoin and Bitcoin futures prices would mean that any fraud or manipulation that could impact the price of Bitcoin “would likely impact” the price of Bitcoin futures, the latter of which having demonstrated a trading record on the well-regulated CME. Furthermore, since the CME and the exchanges share comprehensive surveillance agreements, the setup is as good as any other when it comes to facilitating the detection and deterrence of fraud and manipulation in the actual Bitcoin market, and therefore serving the purpose of risk regulation for the ETPs it backs.

So, there you have it. Our old friend gets a new job as a watcher of Bitcoin mischief, and with that anointment another chapter of an inspirational biography gets written. Even with a long and stellar career behind her, Correlation never ceases to reinvent herself and keeps contributing to the frontiers of scientific and economic progress as new opportunities arrive at her doorstep.

It is one matter to speculate whether correlation will reliably flag illicit Bitcoin market activities in the years to come. It is a different one to ask whether the logic at play here is a sound one. I, for one, am decidedly undecided. To regulate is to influence, an affirmative act that both requires and imparts causation. My hopelessly unimaginative mind could only construe a one-way street in which the price of Bitcoin drives the price of Bitcoin futures, with regulatory control travelling sensibly in the same direction. Then again, the Invisible Hand may well be more than a descriptive metaphor, being actually one of the natural laws reified by the market’s constant pursuit of rationality. If that is the case, who is to say that a bond between two financial objects is anything less sacred than gravity?

Interestingly, a small footnote in the SEC’s approval order reads: “Correlation should not be interpreted as an indicator of a causal relationship or whether one variable leads or lags the other,” though it does not say how it should be interpreted. We land again in the twilight zone between “what is” and “what is not,” another reminder of just how vast a gulf it can be.

1.  Gensler, G. (Jan 10, 2024), Statement on the Approval of Spot Bitcoin Exchange-Traded Products, https://www.sec.gov/news/statement/gensler-statement-spot-bitcoin-011023

2.  An obligatory disclaimer: I trust that you know better than to take financial advice from what I’m saying.

3.   Securities and Exchange Commission, Release No. 34-99306 (“approval order”).

4.   CME Group, Bitcoin Futures Liquidity Report, https://www.cmegroup.com/education/bitcoin/futures-liquidity-report.html

5.   Grayscale Investments, LLC v. SEC, 82 F.4th 1239 (D.C. Cir. 2023).