21/1/20: Investor Fear and Uncertainty in Cryptocurrencies

Our paper on behavioral biases in cryptocurrencies trading is now published by the Journal of Behavioral and Experimental Finance volume 25, 2020:

We cover investor sentiment effects on pricing processes of 10 largest (by market capitalization) crypto-currencies, showing direct but non-linear impact of herding and anchoring biases in investor behavior. We also show that these biases are themselves anchored to the specific trends/direction of price movements. Our results provide direct links between investors' sentiment toward:

1. Overall risky assets investment markets,
2. Cryptocurrencies investment markets, and
3. Macroeconomic conditions,

and market price dynamics for crypto-assets. We also show direct evidence that both markets uncertainty and investor fear sentiment drive price processes for crypto-assets.

20/9/19: New paper on Cryptos pricing

Our paper "Fractal dynamics and wavelet analysis: Deep volatility and return properties of Bitcoin, Ethereum and Ripple" is now available in The Quarterly Review of Economics and Finance - early stage print version - here https://www.sciencedirect.com/science/article/abs/pii/S1062976919300730.

30/4/19: Journal of Financial Transformation paper on cryptocurrencies pricing

Our paper with O’Loughlin, Daniel and Chlebowski, Bartosz, titled "Behavioral Basis of Cryptocurrencies Markets: Examining Effects of Public Sentiment, Fear and Uncertainty on Price Formation" is out in the new edition of the Journal of Financial Transformation Volume 49, April 2019. Available at SSRN: https://ssrn.com/abstract=3328205 or https://www.capco.com/Capco-Institute/Journal-49-Alternative-Capital-Markets.

7/12/18: Seeking Alpha Market Outlook features a recent blogpost

My post on Bitcoin price dynamics and trading http://trueeconomics.blogspot.com/2018/12/51218-bitcoin-sell-off-is-structural.html has made it SeekingAlpha Market Outlook:

5/12/18: Bitcoin: Sell-off is a structural break to the downside of the already negative trend

Bitcoin has suffered a significant drop off in terms of its value against the USD in November. Despite trading within USD6,400-6,500 range through mid-November, on thin volumes, BTC dropped to a low of USD3,685 by November 24, before entering the ‘dead cat bounce’ period since. The Bitcoin community, however, remains largely of the view that any downside to Bitcoin is a temporary, irrationally-motivated, phenomena (see the range of forward forecasts for the crypto here: http://trueeconomics.blogspot.com/2018/11/201118-bitcoins-steady-loss-of.html).

Dynamically, Bitcoin has been trading down, on a persistent. albeit volatile trend since January this year. Based on monthly ranges (min-max for daily open-close prices), the chart below shows conclusively that as of mid-November, BTCUSD has entered a new regime - consistent with a new low for the crypto.

This regime switch is a relatively rare event in the last 11 months of trading, singling that the BTC lows are neither secure in the medium term, nor are likely to be replaced by an upward trend. While things are likely to remain volatile for BTCUSD, this volatility is unlikely to signal any reversal of the downward pressures on the crypto currency.

Consistent with this, we can think of two possible, albeit distinctly probable, scenarios:

1. Scenario 1 (the more likely one): BTCUSD will, in the medium term of 1-3 months, drop below USD3,000 levels, and
2. Scenario 2 (least likely one): BTCUSD will repeat its December 2017 - January 2018 ‘hockey stick’ dynamics.

Noting the above dynamics, the lack of any catalyst for the BTC upside, and the simple fact that since mid-November, larger volumes traded supported greater moves to the downside than to the upside, current trading range of USD3,900-4,100 is unlikely to last.

Scenario 2 supports going long BTC at prices around USD3,800, but it requires a major, highly unlikely and unforeseeable at this point in time, catalyst. A replay of the 2017 scenario needs a convincing story. Back then, in September-October 2017, a combination of the enthusiastic marketing of bitcoin as a 'solve all problems the world has ever known' technology, coupled with the novelty of the asset has triggered a massive influx of retail investors into the crypto markets. These investors are now utterly destroyed, financially and morally, having bought into BTC at prices >$4,000 and transaction costs of 20-25 percent (break-even prices of >$5,000). The supply of new suckers is now thin, as the newsflow has turned decidedly against cryptos, and price dynamics compound bear market analysis. Another factor that led BTC to a lightning fast rise in December 2017 was the promise of the 'inevitable' and 'scale-supported' arrival of institutional investors into the market. This not only failed to materialise over the duration of 2018, but we are now learning that the few institutional investors that made their forays into the markets have abandoned any plans for engaging in setting up trading and investment functions for their clients. In the end, today, the vast majority of the so-called  institutional investors are simply larger scale holders of BTC and other cryptos, unrelated to the traditional financial markets investment houses.

Scenario 1 implies you should cut your losses or book your gains, by selling BTC.

20/11/18: Bitcoin's Steady Loss of Fundamentals

Base rate fallacy is one of the key behavioral heuristics or biases in economics and finance, defined as a cognitive error whereby too little (or too much) weight is placed on the base (original) rate of possibility (e.g., the probability of A given B). In behavioral finance,

• Base rate neglect is the case of giving not enough weight to the prior/original fundamentals in analyzing a complex phenomena, focusing analyst's attention instead on more proximate/more recent trends. Put differently, analysts tend to assign greater weight to a rare category / outrun when tested with a single symptom whose objective diagnosticity was equal for all possible outruns; and 
• The inverse base rate fallacy is the case when too much weight is given to the complex priors / original fundamentals, downgrading newer information. In other words, people tended to give higher probability to a rare outrun when tested with a combination of conflicting priors or cues.

Some research has shown that the key effect of the base rates on judgement error is that base rate presence distorts our analysis by making more frequent outruns of uncertain events more important in our analysis. Thus, more common realizations of the uncertain gambles are magnified in perceived frequency, overriding either the original priors (neglect) or the changing nature of the priors (inverse neglect).

You really can't avoid stumbling on both of these manifestations of the fallacy in today's Bitcoin markets analysis.

Take for example this:

A 'guru' of Bitcoin investment world has been issuing absurd forecasts like a blind drunk armed with an AK47: fast, furious and vastly inaccurate.

The dude, armed with 'fundamentals' (unknown to anyone in the finance research universe, where predominant consensus is that Bitcoin has no defined price fundamentals), has predicted BTCUSD at $22,000-$25,000 for the end of 2018 some months ago (back in January). He upped the ante around March by 'forecasting' BTCUSD at $91,000 some time before the end of 2019, and scaled this back to $36,000 in May. He then re-iterated his $25,000 target in July, just around the same time another 'Hopium sniffing' 'analyst' - Julian Hosp - put a target of $60,000 for BTC in 2018. Four days ago, Lee scaled back his 'forecast' for the end of 2018 to $15,000. This comes on foot of the guru adding lots of mumbo-jumbo to qualify his optimism, saying in early November 2018 that he was "pleasantly surprised" by Bitcoin's stability around the newly found price floor close within the $6,400-$6,500 range.

Taking decreasing doses of the sell-side drug-of-choice, Mike Novogratz was a bit more 'reserved'. In November 2017, struck by the recency bias (the fallacy of not even bothering considering any information other than hyperbolic BTC price dynamics around the end of 2017), he 'forecast' Bitcoin to reach $45,000 by November 2018. This 'forecast' was trimmed back to $9,000 for the end of 2018, issued by Novogratz on October 2, 2018.

There were madder ravings still on offer this year. Mid-April 2018, Tim Draper and CNBC's Brian Kelly pushed out (separately) 'research' arguing that BTC will be hitting $250,000 by 2022. Lee's prediction for 2022 target was $125,000 per BTC mid-January 2018, and advised investors to follow his alleged strategy: "We expect bitcoin's major low to be $9,000, and we would be aggressive buyers around that level... We view this $9,000 as the biggest buying opportunity in 2018."

Note: this drivel has been reported by the likes of Bloomberg, CNBC, et al - the serious analysis folks, employing a bunch of CFAs. I mean, you wouldn't be conflicted if you employed institutional investors trading in Bitcoin as your analysts, would you? Of course, not! Next up: CNBC to hire Wells Fargo sitting executive to analyse Wells Fargo.

But returning to the behavioral anomalies, both base rate neglect and inverse base rate effect can (and do), of course, take place in the same analysts' decisions and calls. Framing - conditioning on surrounding attributes of the decision making - determines which type of the base rate fallacy holds for which 'analyst'. Hence, this:

Ever since the collapse of the parabolic trend, Bitcoin price dynamics can be seen as a series of down-trending sub-cycles, with only one slight deviation in the pattern since mid-September 2018 (the start of the 6th cycle). I wrote about this back in August, suggesting that we will see new lows for BTCUSD - the lows we are running through this week.

When you look at liquidity (trading volumes), you can see that the 'price floor' period from mid-September through the start of November has been associated with extremely low trading. This runs contrary to the 'fundamentals' stories told by the aforementioned 'analysts': the increasing efficiency of the cryptos networks and mining, the growing rates of cryptos adoption in the real economy, and the rising interest in cryptos from institutional investors.

Put more simply, the period of 'calm' (and it wasn't really a period of low volatility, just a period of lower volatility compared to the internecine levels of volatility that BTCUSD investors have been conditioned to accept in the past) was the period when the Bitcoin Whales (large miners) stuck to their mine-and-hold strategies, so that pump-and-dump scams were running wreckage across smaller investors portfolios. The events of the last two weeks seem to have broken that pattern, removing the supports from one of the only two fundamentals Bitcoin has: the fundamental factor of cross-collaterlization a myriad of junky ICOs with Bitcoin capital.  (see volume dynamics below)

As the ICOs crash, their collateral Bitcoins are being dumped into the markets to recover some sort of liquidity necessary for a shutdown or a run from the creditors and regulators, the only floor that BTCUSD has is the floor of the Whales still sitting on large BTC holdings accumulated from mining. Which is not the good news the BTC 'analysts' can hang onto with their 'forecasts'. Cost of mining is rising (as local energy utilities are jacking up electricity rates on large scale mining operations). Just as profit margins on mining are turning negative (at current prices). This means that in the short run, Whales are going to start dipping into their BTC reserves to sustain operations. In the longer run, two things can happen:

1. If the miners shut down their operations to cut on variable costs of mining, BTC might find a new temporary 'floor' until another regulatory assault on Bitcoin takes place and the downward momentum returns; or
2. If the miners decide to double-down in hope of price stabilization and continue to beef up their fiat cash reserves to pay for loss making mining, there will be a new sell-off coming soon.

Behaviorally, both mean that at some point in the future (no, I am not talking about end-of-2022 outlook, but something much sooner), the Whales will decide to cut losses and sell their holdings. As usual in such circumstances, first off, retail investors will step in to soak up some of the supply avalanche. The first sellers in this game will be the winners. The followers will be the relatively uninjured party. The hold-outs will end up with the proverbial bag in the end of the game. It is how all bubbles end up playing out in the end.

Now, go on, listen to the idiot squad of BTC 'analysts'. Everything will be fine. $15,000 --> $25,000 --> $36,000 --> $91,000 --> $125,000 --> $250,000 --> Takeover of the Universe. The Death Star is powering its lasers...

15/11/18: BIS on payments systems and cryptos / blockchain

On November 1, Agustín Carstens, General Manager, Bank for International Settlements delivered a pretty punchy speech on the topic of payments systems evolution in modern age of digital technologies. Punchy, in the sense that much of it is focused on, indirectly, enlisting the evidence as to the lack of the markets for the blockchain and cryptocurrencies deployment in the payments systems at the wholesale and retail levels.

Take the following:  "One of the most significant developments in the evolution of money has been its electronification and, more recently, digitalisation. ...Realtime gross settlement (RTGS) systems for interbank payments, ...emerged in the 1980s. ...RTGS systems allow banks and other financial institutions to send money to each other with immediate and final settlement. They are typically operated by central banks and process critical (read: high-value) payments to allow for the smooth functioning of the economy. Today, the top interbank payment systems in the G20 countries settle more than $17.5 trillion a day, which is over 50 times a working day’s global GDP. ...Given the technology cycle, many central banks are currently looking at next-generation RTGS systems to offer more robust operations and enhanced services."

What does this imply for the world of cryptos? In simple terms, there is no market for cryptos as platforms for interbank payments settlements - the market is already served and the speed of services, cost and security are underpinned by the Central Banks.

Next up: retail payments systems.

Starting with back office: "For retail payment systems, ...in Mexico consumer payments operate at the same speed as interbank payments... The beneficiary of a payment is credited money in near real time. That is, if I were to send you money from my Mexican bank account, you would see the funds in your Mexican bank account in 15 seconds or less. ...Based on a BIS analysis, fast payment systems are likely to become the dominant retail payment system by 2023."

Again, what's the market for blockchain systems to be deployed here? I am not convinced there is one, especially as payments latency and costs are, to-date, more prohibitive under blockchain systems than using traditional payments platforms.

Front office: Carstens notes the progress achieved in delivering what he describes as "payments ... made using bank account aliases" in Argentina that are instant in time, and the ongoing trend toward development of the front-end payments interfaces, based on "cashless systems – no cashiers, no lines, no cash, no physical payment devices. Amazon and others envision a future where you walk into a store, take what you want, and are automatically billed for the items using facial recognition and artificial intelligence. Though this approach may seem a bit scary, it is less so than having microchips implanted inside us, which some firms are also piloting! To be frank, though, neither of these options – facial recognition or microchip implants – are particularly appealing to me."

Carstens presents the evidence that shows current Advanced Economies already carrying more than 90 percent of wholesale payments via cheap, lightning fast and highly secure centralized RTGS systems, with 75 percent of payments via the same occurring in the Emerging Markets:

Given this rate of adoption, coupled with the evolving technology curve (that enables similar systems to be deployed in smaller settlements), one has to question the extent to which cryptocurrency solutions can be deployed in the payments systems.

Beyond the not-too-optimistic view of the market niche size, cryptos and blockchain are also facing some serious pressure points from already ongoing innovation in centralized clearance systems. "Although much attention has been focused on cryptocurrencies as the “it” innovation in payments, there’s much unheralded innovation going on" in the Central Banks and elsewhere (read: legacy providers of payments). "Central banks have been pushing the boundaries of what technology can achieve for operational robustness, including switching seamlessly between data centres at short notice and synchronising geographically dispersed data centres."

Carstens notes the potential for the distributed Ledger Tech (aka, blockchain based on private, enterprise-level blockchain) in this space, where innovation is also a domain of the centralized players, as opposed to decentralised crypto markets. "One interesting development in the central banking community is ongoing experimentation with distributed ledger technology (DLT) as a means to enhance operational robustness. People often use DLT and Bitcoin interchangeably, but they are not the same! ...DLT is simply a set of processes and technologies that enable multiple computers to maintain collectively a common database. DLT does not mean mining of coins, public ledgers and open networks. And no central bank that I’m aware of is contemplating these properties in its DLT experimentation."

There are some problems, however, for DLT enthusiasts:
1) "...a Bank of Canada study noting that a DLT-based payment system meeting central bank requirements would be similar to what we have today (ie private ledgers, closed networks and a central operator). The difference is that a network of computers would be used to settle a transaction instead of one computer." In other words, there is a case, yet to be proven, that DLT offers anything new to the payments systems to begin with.
2) "The second is an ECB and Bank of Japan study concluding that processing times would be three times longer using DLT versus current systems." In other words, DLT/blockchain cannot deliver, so far, on its main premise: higher processing efficiency than legacy systems.

Carstens sums it up: "My take is that current versions of DLT are not any better than what we already have today."

In other words: DLT/blockchain solutions appear to be:

• Not necessary: the technology is attempting to solve the problems that do not exist in the payments systems;
• Inefficient with respect to its core tenants/promises: the technology is inferior to existent solutions and the pipeline of ongoing improvements to the legacy systems.

Which begs two questions that the DLT/blockchain community needs to answer: What niche can blockchain occupy in payments systems going forward? and Is there a sustainable market within that niche that cannot be captured by alternative technologies?

But there is more. Carstens explains: "Cryptocurrencies, such as Bitcoin, Ether and Tether, do not serve the core functions of money. No cryptocurrency is a true unit of account or a payment instrument, and we have seen this year that they are a poor store of value. This then raises the question: what are they?" The answer should be a wake up call for anyone still long cryptos: "From my perspective, cryptocurrencies are, at best, an asset of some sort. Perhaps an asset comparable to a piece of art for those who appreciate cryptography. Buyers of cryptocurrencies are buying into nothing more than a software algorithm. Some firms are trying to back cryptocurrencies with an underlying asset, such as cash or securities. That sounds nice, but it’s the equivalent of making art from banknotes or stock certificates. The buyer is still buying an idea or a concept or, if you will, an asset that is the equivalent of art hanging on your wall. If people want the underlying asset, they might be better served just buying that."

Carstens previously (February 2018) claimed that the #cryptos are “combination of a bubble, a Ponzi scheme and an environmental disaster.”

Nice perspective. If you are an observer. For a holder of cryptos, this is a serious risk. Playing cards in a casino is fun, but it is not investing. Playing investing in the cryptos world is probably the same.


Note: for an even more 'in your face' assessment of the #Bitcoin and #Cryptos, there is ECB's Executive Board member, Benoit Coeure, who called #BTC the “evil spawn of the [2008] financial crisis, per Bloomberg report of November 15 (https://www.bloomberg.com/news/articles/2018-11-15/cryptocurrencies-are-evil-spawn-of-the-crisis-for-ecb-s-coeure).

The reality of #cryptos investments is that they are, empirically, a massively overvalued bet on the largely undeveloped and unproven (in real world applications) technologies that have only tangential relation to the coins currently traded in the markets. It is, in a way, a derivative bet on a future contract.