Talking about the Reflexivity of Blockchain: Industry Cycle and Market Risk Management

Why are the bull and bear markets in the currency circle changing so frequently? Why is the average life cycle of a blockchain project so short? What exactly is a death spiral? These problems may all be explained by Soros’s theory of reflexivity. This article will firstly introduce the theory of reflexivity and its application in the stock market cycle; secondly, analyze the reflexivity in the blockchain industry by comparing the stock market and the currency circle, and explain the reasons for the bull and bear market cycle in the currency circle; finally, use the reflexivity Theoretical comparison of the 1997 Thai baht’s abandonment of the fixed exchange rate event and the UST de-anchor event, to make certain recommendations for risk management.

reflexivity theory

Reflexivity is the mutual causal property of a leading to b, and b leading to a. When a is human cognition and b is an event in which humans participate, it becomes Soros’s theoretical philosophy of reflexivity. Rather than using a dichotomy to distinguish between thought and reality, reflexivity theory aims to state that human cognition is an integral part of constituting factual outcomes, and that real outcomes cannot be separated out for independent analysis.

Specifically, a reflexive unit consists of cognitive processes and engagement processes, and there is a two-way feedback loop between these two processes: the cognitive process is from (the last historical truth) the result to the (now to the future) Anticipation, and the process of participation is from (now to the future) expected to (future real) results, and the future real results become historical real results under the action of time, and this cycle repeats. Because of the asymmetry between ex ante and ex post, each process unit is not repeatable, since participants’ perspectives are likely to change at different times, even if all observable factors are the same.

Talking about the Reflexivity of Blockchain: Industry Cycle and Market Risk Management

In the above-mentioned cognitive process, since humans can never fully understand the real world, cognitive bias will occur, and this bias will directly affect the next real result through the participation process and thus affect the real world. When the direction of the cognitive bias is consistent with the direction of the true outcome, a self-reinforcing process occurs, leading to a continuous expansion of the bull market and a death spiral of the bear market.

Reflexivity in the stock market

In the stock market, the factual outcome is the stock price, and the stock price depends on two factors—the underlying trend and the prevailing bias. The underlying trend is not affected by investors’ expectations and is related to factors such as free cash flow and asset value; while prevailing bias is the deviation between the expectations of most participants in the market and the actual results. Fundamental trends affect participants’ perceptions through a cognitive process that simultaneously generates mainstream biases, both of which together affect stock prices through a participatory process (investment decision-making).

Fundamental trends and prevailing biases are in turn influenced by stock prices. Stock prices affect company fundamentals by affecting company status, credit ratings, consumer acceptance, mergers and acquisitions, etc.; and positive feedback on stock prices can increase mainstream bias.

In a typical sequence of market events, the three variables of fundamental trend, prevailing bias, and stock price first strengthen each other in one direction and then the other, alternating booms and busts.

Here’s an intuitive feel for a full stock market cycle (using EPS as the underlying trend, and the gap between stock price and EPS as the prevailing bias): At first, the identification of the underlying trend will lag somewhat, but the The trend has been strong enough to show in EPS (AB). After the basic trend is recognized by the market, it begins to be strengthened by rising expectations (BC); at this time, the market is still very cautious, and the trend sometimes weakens and sometimes strengthens. Such repetitions may be repeated many times, and only one is marked in the figure (CD). As a result, confidence begins to inflate, and a brief setback in earnings is not enough to shake the confidence (DE) of market participants. Expectations are overly inflated and far from reality, and the market cannot continue this trend (EF). Bias is fully recognized and expectations begin to decline (FG). The stock price loses its last support and the plunge begins (G). Finally, the excessive pessimism was corrected and the market stabilized (HI).

Talking about the Reflexivity of Blockchain: Industry Cycle and Market Risk Management

Reflexivity in the Blockchain Industry

In the blockchain industry, Token price is determined by supply and demand. Under the premise of certain supply, demand can be roughly divided into use demand, investment demand and speculative demand. Similar to the stock market, currency prices are also affected by fundamental trends and prevailing biases. The basic trend consists of capital flows brought about by usage demand and investment demand, which are not affected by subjective expectations of currency prices; while the mainstream bias is reflected in capital flows brought about by speculative demand: speculative capital is a rising rate of return (usually In DeFi projects) and rising currency prices, the role of currency prices is far greater than the yield, because as long as the currency value drops slightly, the total revenue may become negative. Therefore, the expectation of future currency price changes constitutes the main motivation for speculative trading.

There are two major differences between the stock market and the blockchain market in the process of reflexivity. The first is that the impact of the underlying trend on the price is different. The stock price is greatly affected by the basic trend (this is why the theory of value investing is evergreen in the stock market); however, due to the large proportion of capital flows brought about by the current speculative demand in the blockchain market, the basic trend has a great impact on the currency price. impact is small. The second difference is how much price affects the underlying trend. The impact of the stock price on the fundamentals of the company is indirect and relatively small; in the blockchain market, due to the native nature of Token, the price of the token directly affects the income of miners/verifiers, employee income, community activity, and new users. The attractiveness of the project and other factors will affect the basic trend, so the impact of the currency price on the basic trend of the project is very important.

After understanding these two major differences, let’s look at the reasons for a complete currency circle cycle: first, assuming that the basic factors remain unchanged, but the market expects the currency price to rise, so the mainstream bias is strengthening, which will lead to an increase in the real currency price. The rise of the currency price will improve the fundamentals of the project by incentivizing more verification nodes, community activity and the number of new users; at the same time, the mainstream bias will self-reinforce and continue to expect the currency price to rise, and the fundamentals and mainstream bias will further drive the rise Currency prices rose. Once a trend is established, it maintains and develops itself until a turning point occurs. This trend reverses when speculative capital inflows fail to compensate for capital outflows from reduced usage demand, investment capital outflows from changes in the macro/legal environment, and rising interest/debt outstanding. Thereafter, a self-reinforcing process is initiated in the opposite direction. The expected decline will bring about the strengthening of the mainstream bias, which will lead to the decline of the currency price; the falling currency price will affect the enthusiasm of miners and nodes, the enthusiasm of the project party and the number of new users, which will make the basic factors worse and bring about the decline of the currency price. It fell further into a death spiral.

Talking about the Reflexivity of Blockchain: Industry Cycle and Market Risk Management

Since the currency price change is a purely reflexive process, it also brings the following general characteristics to the blockchain industry:

  • The bull and bear cycle will always accompany the blockchain market, and the conversion speed is faster than other financial markets.
  • A good project in a bear market must be a good bull market, because the overall currency price rise will promote the fundamentals, and the positive feedback will continue to increase.
  • The project party can add some negative feedback factors to the currency price to slow down the reflexive process, but it cannot stop this trend.
  • DeFi projects develop best in the bull market and suffer the worst decline in the bear market, because the fundamentals of defi projects are almost supported by currency prices, so the fundamentals of currency price rises have improved and skyrocketed; currency prices fell and the fundamentals became worse Death spiral.
  • Non-financial projects/projects with high real use demand are relatively stable in the bear market, but because of the project’s currency issuance, the fundamentals will still be affected by the reflexivity of the bull and bear market.
  • Regarding the question of whether the currency circle is suitable for value investment: Although fundamentals are greatly affected by price, fundamental factors that are good in a bull market may become unfavorable factors in a bear market; but in the same market environment, a relative analysis of fundamentals is definitely needed. Of course in the blockchain industry, data analysis has become more important.

Reflexivity in UST detachment events

The de-anchoring event of UST has many similarities with the Thai baht’s forced abandonment of the fixed exchange rate during the Asian financial crisis in 1997. Soros, who believes in reflexivity, judges that the turning point of the cycle is approaching, and the sudden sell-off caused market panic by hoarding the Thai baht, forcing Thailand to finally give up. The fixed exchange rate is in a currency crisis. The following will use the theory of reflexivity to analyze the UST de-anchoring event from the two dimensions before and during the event, hoping to give you some reference for risk management before and during the event.

1. Factor analysis before the crisis (short-selling timing)

Before the Thai baht was shorted, the fundamental factors deteriorated (excessive interest rates, long-term current account deficit, the economic cycle entered a trough), the fundamental factors became more affected by the exchange rate (the economy was fully opened to the outside world, the level of external debt was too high), and mainstream biases The phenomenon of aggravated and suspicious emotions is also some harbingers of the inflection point of the reflexive cycle. Based on this, we compare and analyze the situation before the UST de-anchoring:

  • The fundamental factors have deteriorated: the rate of return exceeds the market, and the real income on the chain has been searched. Anchor’s underlying real revenue sources are POS and loan revenue. If the real revenue is < Anchor Rate (about 20%), it will be supplemented by the on-chain revenue reserve (bAsset reward & collateral liquidation fees). Since February this year, Anchor’s reserve Losses of more than 300 million US dollars.
  • The basic factors are greatly affected by the currency price: Luna, as a chain currency, is related to the survival of the entire chain ecology. As the counterparty of UST, the price fluctuations of UST will be transmitted to Luna, so the anchoring of UST directly determines the development and income of the entire chain. With on-chain earnings being continuously subsidized to depositors, on-chain fundamentals depend almost entirely on currency prices.
  • Mainstream prejudice intensifies and skepticism emerges: Mainstream prejudice is mainly due to the expectation that the project is too big to fail (high degree of centralization), the illusion of over-collateralization based on the current luna price, and LFG’s move to buy BTC; Emergence is due to worsening insight into fundamentals, fears of a bear market (market sentiment itself is fragile), and concerns that reserve assets/stabilization structures cannot withstand a massive stampede. The price anchoring has basically completely relied on the confidence of the market. It can be seen that once the market panic has a huge impact on the de-anchoring.

Ex-ante risk management inspiration:

  • The ex post result is one of the possibilities of all ex ante expectations, so when we learn ex ante cognition from the ex post result, we should not only pay attention to the interpretability of the ex post result, but also pay attention to the difference between the ex post result and the various ex ante expectations. I personally think that the role of doing more post-mortem analysis is only to give people an intuition of trends.
  • Deteriorating fundamentals, more price-influenced fundamentals, increased mainstream bias, and skepticism, these early warning factors may last for a long time, or may immediately usher in an inflection point. As a market participant, setting a few warning lines to do ex-ante risk management can protect against large-scale losses.

2. Analysis of the death spiral process (short-selling method)

When the Thai baht is shorted, the attacker first borrows the Thai baht through various channels, then throws it in the market to depreciate the Thai baht, and then buys the Thai baht in foreign currencies such as US dollars to return it. Since the attack weapon is a forward contract (with leverage), it is more powerful. Initially, in the face of the attack, the Bank of Thailand kept reclaiming the baht thrown out of the market with foreign exchange such as US dollars and kept the price stable. However, the Thai market is highly open and the foreign exchange is very useful, so it cannot be consumed too much on the attackers. . Therefore, the Bank of Thailand launched two major measures. The first measure is to raise the overnight interbank offered rate to 1,000% to increase the cost of overnight funds. The second measure is to cut off the channel for the Thai baht to flow to foreign attackers, and require banks to submit real transaction certificates when transferring the Thai baht abroad. However, the attackers had sufficient ammunition and continued to increase market panic. In the end, the Bank of Thailand was forced to announce that it would change the fixed exchange rate system to a floating exchange rate system. The exchange rate quickly fell from 25:1 to 30:1, or even lower.

According to nansen’s on-chain data analysis, the UST de-anchoring event was mainly due to the market panic caused by the withdrawal of some giant whales. Some giant whales have already started to withdraw UST from Anchor in April, cross-chain to Ether through Wormhole and deposit into Curve, and then exchange it for other stablecoins through UST-3pool. As early as May 7, LFG has started to buy a lot of UST on Curve to fight against the whales. Until May 9th, the decoupling of UST due to the huge amount of selling (hundreds of millions of dollars in a row) caused panic; LFG sold $1.4 billion of BTC to take over the order, and the whole market fell into greater panic because of fear of BTC falling. On the morning of May 10th, Jump Trading and LFG stopped selling their Bitcoin reserves, letting the situation worsen. On May 12, LUNA was delisted from all major exchanges, and the price fell from over $60 to less than a tenth of a cent.

Inspiration for risk management in the event:

Both the baht and the UST were shorted with a battle between the market and the centralized organization. Due to the large number of retail investors in the currency circle, the response is slow, so there will be a certain time for the participants to react from the beginning to the end of the competition. In general, when the competition starts, it is basically the signal of the turning point of the cycle. No matter what the outcome is, the trend of continuous self-reinforcing will definitely be detrimental.

Crypto assets should be the most reflexive of all assets, which also means that currency prices contain the most human emotions and are the most unpredictable. In other words, the impact of human perception (in line with or against the facts) on real results is the largest in the blockchain industry. Of course, if perfect cognition can be achieved, there will be no room for imagination. After all, to a certain extent, the world we live in is what we imagine.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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