A Behavioral View of Cryptocurrencies - Part II

Millions of blind people and a very large elephant

photo from Quora

photo from Quora

In the continuing quest to follow the behavioral drivers in the cryptocurrency markets, one cannot ignore the effect of rampant ignorance, misinformation, and misperception on the behavior of participants. In the absence of complete and reliable information, perceptual biases become even more exaggerated, and behavior even less rational.

In addition to the obvious and pervasive effects of herding, fear of regret (or missing out), and lust for quick profit, behaviorists can also see that the current crypto markets are awash in factors such as availability bias and representativeness. A simple analogy can be found in the ancient parable from India about the blind men and the elephant, in which different participants, each exposed to incomplete information, view the creature in different ways. When encountering something new, humans are endowed with an exceptionally fast ability to search their existing knowledge base for something similar or representative and to use that as a reference point for evaluating the new discovery. Unfortunately, the process is so quick and powerful that its magic becomes a bias toward assuming similarity, even when such an assumption is inappropriate. People then act on these perceptions, which may not only deviate from reality, but which might be grossly misleading. To make matters worse, our impressions, however inaccurate, tend to stick with us and become overly relied upon, even in the face of new information to the contrary (belief perseverance).

When a juice company changes its name to include the word 'blockchain' and triples in price, we know we are in dotcom déjà vu -- a world in which people who missed out on the initial big winners are willing to grab anything they can at the early stages in an effort to 'catch up' or to jump on the next big winner. As the juice company exemplifies, it’s a buy first-ask questions later behavior.

The fear of missing out continues to drive many people into bitcoin on almost any dip in price, but there is a point at which the market determines that the early gains for bitcoin have been made and that the risk-return profile of newer alternatives is now more attractive, regardless of the lack of information on them. That point appears to have been reached when bitcoin approached a value of $20,000 USD in an almost vertical move and then dropped back about 30% and flattened out as sales of newer coins at far lower prices took off.

Unfortunately, the perception of risk vs. reward in this situation is frequently made on the basis of the price differential between bitcoin and its alternatives, with little regard for the merits or validity of those alternatives.

During the dotcom hysteria, we were at least dealing with equity investments in US-based entities with known corporate structures and a well-defined regulatory environment. We did not have protection against the investment going bankrupt, but we did have protection against the broker/dealer who held it for us going bankrupt. And despite the uncertainties of new business models, we could obtain basic financials on a company or a prospectus on an IPO, and we could at least be confident the founders were intending to create a legitimate business.

Cryptocurrencies are a very different animal. Their businesses and structures are much more ambiguous, totally unregulated, and far less likely to provide objective information for buyers or investors. Many are based outside the US where trusted information is all but impossible to obtain with any confidence. In addition, coins and tokens are highly misunderstood and are widely confused with, or assumed to represent equities, currencies, precious metals, and collectibles. Investors in these instruments are like the frontier pioneers in the American west -- some of which found the homestead of their dreams while others lost their scalp.

Suffice it to say that a large number of people with
little understanding of what most cryptos actually
represent are being drawn into markets where a
small number of insiders, professional traders, and
bad actors are awaiting their prey.

Along with the horribly inefficient process of buying and selling (like waiting nine days at Coinbase for a purchase of cryptos to clear when purchasing from your bank account), many new coins, wallets, exchanges and other crypto-related entities are popping out of nowhere with little basis upon which to assess true merit and virtually no protection against fraud or even just security that is weak enough to be hacked. In addition, the media continues to provide reports of market manipulation, ransoms, scams, frauds, and other nefarious activities in these markets, as well as to sprinkle such news with items placed for their own self-interests. As we all know, there is no watchdog anywhere to hold sources accountable, except for the few instances where a company flagrantly violated US securities laws.

A self-sustaining cycle of profit-chasing

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First came the gold miners, confident they could find limitless riches amidst the rocks in the ground. Next came the shopkeepers, confident they could find their riches from the gold miners. So it is with bitcoin as well. Various groups of players are entering the crypto markets with the idea that easy money can be made by purchasing cryptocurrencies. This in turn drives the behavior of other groups who look to make easy money from the first group.

Because so many people are so willing to purchase cryptos with so little information, new crypto-related services and new coin offerings proliferate – some legit, but many not.

All this activity, combined with huge market inefficiencies, has trading firms, hedge funds, dealers, brokers and other financial firms chomping at the bit to get a crack at trading and transaction profits. The pros give the market an appearance of acceptance and validation, but these entities are not validating the long-term potential or sustainability of cryptos -- they are simply attempting to exploit inefficiencies and high volume of transactions. They will make their money through market-making, scalping, markups and commissions, while hedging their overall positions with derivatives. Their risk is primarily in their operation costs -- not the ultimate value of bitcoin or any other cryptos. These players are in turn applying pressure on the US exchanges to trade derivatives, thus bringing the CME and CBOE into the fray.

With financial institutions and exchanges involved, the SEC, CFTC, IRS and other government or regulatory bodies are forced into adopting a policy for them. These policies will appear as further validation and will serve to bring more individual players into the markets. And so it goes.

The cycle can be illustrated as follows:

Cycle.jpg

Neither currency, nor equity, nor collectible, nor tulip

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The new concept now referred to as cryptocurrencies has elements of a number of familiar things to different people, but does not necessarily equate to any single one…at least not yet. It may yet evolve into a broadly used global currency or a store of value, but at present, it does not fit ideally into either of those definitions. As an everyday currency, it is clearly far too volatile to represent a meaningful, practical, reliable medium of exchange, except perhaps for certain very high-end niche markets where anonymity is more important than price volatility. Besides, as long as there is a dramatic uptrend in the value of a currency, no one will want to spend it.

At the same time, cryptos like bitcoin may ultimately come to be accepted as a gold alternative, but the lack of security, insurance, and other safeguards make that idea impractical for now as well. It may, however, become an alternate store of value -- a technologist's gold, or one preferred specifically for international transfers and purchases.

Or, it may never become any of these things. It may be replaced by something that is more quickly able to provide the key elements that the public wants or needs for practical acceptance. If you were a technology whiz with a solution to the transaction time and other operational issues with bitcoin, would you offer that solution to the bitcoin founders or simply try to create your own competing coin?

The point is that people see bitcoin and the cryptos through their own biased lens and their evaluations, perceptions, and actions are based on those biases. This, of course, makes for a very dynamic situation, and will continue to do so until the cryptos either become widely accepted for some particular purpose, fail completely, or transition to something that becomes a more stable long-term asset. Along the way, however, large segments of the current market will likely drop out as others enter. If you are a precious metals follower and you have taken a position in bitcoin to hedge your gold assets, you will likely abandon that strategy very quickly once it becomes apparent that bitcoin will not likely supplant gold.

The surviving digital currencies will likely morph to something not quite fiat but not quite bitcoin either. The world may want a digital currency, but it will not want to deal with the notion that it is facilitating terrorists, ransom hackers, drug dealers and organized crime. A compromise is likely that is still digital, but which addresses some of this issue.

Behavioral predictions for the crypto markets in 2018

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We couldn't resist the urge to throw out our projections for 2018 in the Crypto world:

1.       Options, futures, ETFs and hedge funds for bitcoin and other cryptos will proliferate. We also expect to see a Crypto Mutual Fund specializing in companies using blockchain technology or engaged in crypto businesses.

2.       The US government will issue a stance rather soon on how cryptos will be treated and taxed. If not securities, then property or some other designation. Some coin profits might even be considered gambling winnings.

3.       Other countries will follow the US, but may do so in different ways. Volume will gravitate to the easiest and least taxed & regulated countries.

4.       US media entities and financial sites will begin providing crypto information. The eyeballs are way too tempting to ignore.

5.       Bitcoin will rise further, though prices for the alt-cryptos will easily rise more than bitcoin as a percent.

6.       By mid-year, there will already be a major shakeout with a handful of winning cryptos and a slew of losers. We expect two or three to rival bitcoin in price. or at least close the gap to around two or three to one.

7.       US banks will form partnerships with coin dealers or offer their coin exchange services. At least one or two of the current coin exchanges will be bought by big institutions.

8.       High-profile hacks, thefts, and ransoms will continue. At least one crypto will be created that will allow owner identity to accompany transactions in an attempt to deal with this issue.

9.       An insurance company will offer to insure digital currencies for some outrageous price.

10.   President Trump will tweet that bitcoin is a creation of a foreign entity aiming to undermine our economy.

A Behavioral Finance View of Cryptocurrencies

[Initial post to the Bitcoin Behavior Blog]

We are in the grip of a social phenomenon like no other we’ve ever experienced. People are paying thousands of dollars for something that is essentially a reward for playing a computer game. It has no physical properties, questionable use, no regulation, and only exists when a sufficient number of other people’s computers say it does. It may already qualify as the greatest asset bubble in recorded history, yet may only just be getting started.