Reflexivity in the Crypto Market

The crypto market is still in its infancy, and as such, is subject to wild price swings that are disproportionally affected by FOMO and FUD cycles. Additionally, the concept that the entire crypto market is directly affected by the price of Bitcoin is another nod to the immaturity of the market as a whole.

There are some prevailing theories in traditional financial markets that we feel are not applicable to the crypto market in its current state. We believe that the tendency for the market to over-react positively or negatively to news and other sources of information can be explained by the concept of Market Reflexivity.

In this journal we will be outlining what Market Reflexivity is, the psychological factors that influence investor sentiment, and how these factors ultimately combine to affect the price and fundamentals of the market as a whole.

Disclaimer: NOT FINANCIAL NOR INVESTMENT ADVICE. Only you are responsible for any capital-related decisions you make and only you are accountable for the results.

What is Market Reflexivity?

Within the context of economics, reflexivity is the idea that market sentiment is a self-reinforcing phenomenon. For example, a rising market will attract buyers which leads to further appreciation in prices, which inspires further investment and so on. This is a positive feedback loop and is part of both herd behaviour within financial markets, and the tendency for people to believe what has previously happened is likely to continue happening in the future.

To explain the concept further it is important to define three key concepts:

  • Market Sentiment – the collective attitude of all participants towards the market which, through the action that participants take based on their attitude, influences the direction of the market. For example, a bull market or a bear market.
  • Herd Behaviour – investors follow what they see other investors doing rather than relying on their own research.
  • Positive Feedback Loop – where a subtle event causes an effect which in turn causes more of that event that leads to the amplification of the effect. For example, rising house prices causes buying, which leads to rising house prices causing further buying.

It’s important to note that the concept of market reflexivity goes against what is considered to be the norm when analysing markets and the way they move and function. The traditional theories state that markets are always seeking equilibrium and that all participants are rational and base their decisions on reality. Any fluctuations in the market such as boom and bust cycles, bubbles, or capitulation events are outliers and prices will soon return to the equilibrium. That equilibrium is determined by fundamentals which are not influenced in any way by price.

On the other hand, market reflexivity suggests that prices do affect the fundamentals of the market and that all participants base their decisions on their perception of reality. If price influences fundamentals, then it stands to reason that a change in price is a change in fundamentals, which in turn changes investor expectations which leads to a change in price as investors act on these new expectations – you can see where this is going. This positive feedback component of market reflexivity leads to boom or bust cycles, because the change in price is self-reinforcing through herd behaviour causing prices to become more and more detached from reality and in fact becomes the new reality, kind of like a self-fulfilling prophecy.

market reflexivity

George Soros is the primary proponent of market reflexivity theory. He believes that although prices should tend towards equilibrium, often the reflexivity of the market will cause prices to over or undershoot that equilibrium, and for extended periods of time. Prices only begin to reverse their current trend when market participants realise that their perception of the market has become detached from reality – often this occurs long after prices have passed above or below what anyone would consider to be rational.

The difficulty that investors have in determining true reality comes down to the fact that it is often difficult to separate fact from thought. It is impossible to deny the fact that if you throw a ball into the air, it will eventually come back to the ground. Before you’ve even thrown the ball you can reasonably predict the outcome of what will happen to it after it leaves your hand. Predicting the future in this case is not some magical power or psychic ability because we know and understand the fundamentals of gravity, which don’t change.

However, understanding the fundamentals of a market and being able to predict the future with 100% accuracy is pretty much impossible due to the number of inputs and the ever-changing dynamics. The movement of a market is just as much a social phenomenon as it is a simple case of supply and demand. An investor trying to make sense of a market attempts to do so as a detached observer, but it is impossible to fully overcome the fact that they are a part of the situation they are trying to make sense of.

For example, a bank is investigating the housing market to determine the rates they should be charging for mortgages. After concluding that the housing market is relatively safe and prices are stable, they set rates a bit lower than before. The subtle change in mortgage rates offered by the bank has changed the fundamentals of the entire housing market. The next bank to investigate the housing market will have a whole new set of facts, will see that bank number one has lower rates than before and could conclude that the housing prices are set to rise due to cheaper mortgages.

Nothing in the housing market has changed other than this one bank lowering mortgage rates, but this sort of subtle influence can echo through an entire market. This is just a hypothetical example and has been massively simplified, but the idea that markets can influence the events that they anticipate is undeniable. This is especially true in the crypto market.

Reflexivity in the Crypto Market

The momentum of the crypto market can often be explained by market reflexivity. For instance, if the price of Bitcoin jumps a significant amount in a short amount of time it is almost a given that the price will increase for a period after the initial move. The same is true in the other direction. The immaturity and low liquidity of the crypto market means that it is “easier” for price to move up and down by significant margins.

market reflexivity

“Bitcoin is a revolution” is a highly reflexive statement. Why? Because the statement is not a fact it is an opinion. However, if enough people believe this statement and do not sell their Bitcoin then prices will rise. Other people will begin to believe this statement and buy and HODL their Bitcoin, which causes further price increase. No-one knows the fundamental price of Bitcoin because it does not have a fundamental price. Of course, Bitcoin has fundamentals but cannot be priced using the same methods that are used when pricing other assets, such as a house or a car, for example.

The original narrative of Bitcoin was a peer-to-peer payment network has been abandoned for the new narrative as a store of value. When did this narrative switch? No-one knows. But narrative in the case of Bitcoin is 100% part of the fundamental value associated with the asset, especially with the outside influence of inflation fears. The narrative of Bitcoin as a store of value (SoV) leads to a positive feedback loop – investors witness Bitcoin outperforming other SoV assets and allocate a portion of their net worth to Bitcoin, which causes Bitcoin to outperform even more which leads to more investment etc.

The price of Bitcoin itself is a fundamental driver for the entire crypto market. In most cases when the price of Bitcoin rises or falls altcoins tend to follow it up or down – irrespective of their own fundamentals. There is no reason for altcoins to follow the price of Bitcoin other than the self-fulfilling prophecy that Bitcoin leads the market.

The problem arises when the positive feedback loop runs out of steam and unwinds. For instance, in May 2021 the crypto market had been on a historical bull run since mid-2020. The Chinese mining ban combined with Tesla’s change in policy on taking Bitcoin payments for their products led to a shift in sentiment that caused a significant price decrease.

These factors were by no means catastrophic – the Bitcoin network remained functional and there was no effect on any individual investor. However, the sharp price decreases caused panic which led to more selling which led to even more panic and more selling – all the way down from $60,000 to lows of $28-29,000. Further, even though most altcoins aren’t even mined and were never taken as payment by Tesla, they saw an even larger correction in price in a massive FUD cycle that wiped over $1 trillion off the value of the entire crypto market.

Therefore, it can be said that the crypto market is a highly reflexive market and price absolutely influences fundamentals. Decentralised finance assets are slowly changing the game by introducing productive assets with use cases that go beyond just storing or transferring value, thus offering an alternative method of measuring fundamentals that isn’t totally based on narrative and price. Ultimately, until the market moves away from the idea that Bitcoin is the index for the entire crypto market, it will always be reflexive in some way or another.

Sign up for our FREE mailing list

Join 12,590 others now and get actionable research and analysis sent directly to your inbox.

Post a Comment


Delivered daily, straight to your inbox.