Cryptomarkets and the Standing Waves of Reflexivity

The power of crypto-powered platforms remains game changing. While much of the speculation frenzy in secondary markets bears little relationship to the challenge of migrating the global economy to Web3 principles, it has provided crypto with the attention of investors all over the world, and that situation will remain the case for the time being and way beyond the current sell off. But high secondary market prices do ensure that big investments come in to the primary market. This is basic reflexivity in action:

high secondary market prices -> high valuations for pre-sales -> more funds raised by projects -> more ambitious projects + money to hire world class teams -> better chance of success -> higher valuations

In other words, market price impacts fundamentals, which then impacts price. However, often with reflexivity the down cycle is the same in reverse: debt / funding becomes a problem, key staff leave, projects get cancelled (market price weakens fundamentals). However, crypto has some good characteristics that protect it on the downside. Firstly, projects raise large pools of capital up front. While this can create unhealthy levels of overspending, it does mean that a well-managed project can mostly ignore the secondary markets. They don’t have a debt burden or need to convince VCs to fund B and C rounds in poor market conditions. In addition, as the teams will usually own meaningful amounts of tokens, they are incentivised to keep their heads down, work hard and get through to any downturn. Once they can keep delivering on the roadmap, the fundamentals remain unaltered. So while a severe downturn (and I mean way worse that the last seven days) will likely see primary sales dry up, the funded projects will be safe. And we now have enough well funded projects, across a broad range of the required infrastructure, to start to believe that the Web3 vision is still on track.

But maybe this weeks sell off has increased the chances of success for the crypto ecosystem. Maybe it gets us closer to the soft landing we need. Let me try to explain a recent concern about some reflexivity effects and why a soft landing will help things. All of which ties into a major trend for 2018: the professionalisation of token investing.

So we know standard reflexivity causes non-linear instabilities as markets rise, and often pairs these with equal over-reactions on the way down. But sometimes in markets two different effects cancel out. So I want to explore what I term standing wave reflexivity, where two reflexive forces are cancelled like standing waves on the way up, but could potentially be self-reinforcing on the way down. I will also explore how these effects could lead to market cycles.

Firstly, let’s start with a quick review of platform business models and the connection between crypto and platforms. There exist difficult to overcome chicken-and-egg problems when building platforms (aka two-sided or multi-sided networks). A two-sided network, e.g. Airbnb, brings together supply and demand. It only works when you have both sides on the platform at the same time. For Airbnb, too few customers and property owners lose faith, too little property and travellers won’t come back to the site. Get the balance right and both sides becomes evangelists. There are hundreds of tricks and hacks to match supply and demand. But you need to do it per property type, per demographic segment / price bracket, per geography etc. It’s a massive (in fact, near-zero probability) challenge to scale a platform. When it comes to platforms, crypto is the best chicken-and-egg solving hack ever. Crypto can seed your platform with highly-incentivised enthusiasts (token owners) who can seed the market at the start, buying time until the early majority to join in.

So the theory goes anyway…

But what if those enthusiasts are too busy checking the prices of the fifty tokens they own (like every five minutes!)? How much time are they spending on making sure your platform is a success? What if it’s more productive for them to be reading white papers and learning about trading signals, than on coding up plug-ins for your new platform?

When we choose to launch a new consulting brand for crypto, the term “reflexivity” jumped out at me. Many years ago, I stumbled across the philosophy of Karl Popper, who in turn lead me to a modern-day Popper fan: the legendary financier and philanthropist, George Soros. Soros, through his Open Society Foundations, was trying to deliver practical implementations of open societies based on Popper’s work. In one of his books (“Open Society: Reforming Global Capitalism”), Soros introduced (to me anyway) the concept of reflexivity. Whereas the models used by most economists assume market price and asset fundamentals as independent, reflexivity posits that sometimes there is a closed loop feedback mechanism introduced between the market price of an asset and the fundamentals of those assets. This reflexivity can cause extreme instability. The idea that a change in market sentiment can alter the real world valuation of an asset may, at first, seem strange. But let’s look at a basic scenario: positive market sentiment drives up a company’s valuation, which causes the company to make an acquisition using company stock. Now maybe the company has a new growth engine it wouldn’t have had if the share price had remained low. Or another example might be where market sentiment (through corporate bond pricing) makes the cost of raising debt funding very attractive for the firm, so they borrow tens of millions to expand. This is where we start to see the flip side of reflexivity. When the market turns, the company now starts to look like a weaker proposition, due to the additional debt burden. The company may then cut back on spending to improve debt coverage ratios. This cut in spending impacts R&D, which potentially reduces future earnings, and thus valuation. Soros showed that reflexivity makes market dynamics unstable and therefore highly unpredictable.

Which leads us onto reflexivity in crypto. When I first looked at crypto platforms, the insight that players in the market (users as token owners) had immense power to influence the token price of the asset. This was reflexivity on steroids. By merging the investor base with the customer base, decentralised value networks created a feedback loop like no other. In crypto the investors were not just the customers. They were the network. They were the developers who would build the network, the apps and the integrations. They were the marketing department that would amplify your social media campaigns. They were an ready-made, global, on-the-ground sales force like no other, attending every conference and evangelizing the platform. With rising sentiment, came rising prices, came even more reasons to be excited. Extreme reflexivity.

But… then along came another problem that would be very familiar to platform strategists: multi-homing. Just ask Uber what happens when a competitor like Lyft comes along. Now your customers have options, your drivers have options and your market is divided. While some platforms tend to wards a monopoly, others (like ride-hailing) have characteristics that make it hard to maintain dominance. The same thing is happening in crypto. The investor who made 50x on one coin, is now off looking for the next coin for better returns. As long as your coin is still gaining value, they might help out now and then. But their incentives are skewed towards building up new platforms. And eventually, when they have thousands of coins to choose from, these investors become full-time speculators, looking for the next 100x coin. They stop developing code and leave it too others to evangelize their favourite platform. They continue travelling around the world but no longer talk about your platform. They evangelize speculation.

Note that the reflexivity still exists, it just gets watered down. There are still newcomers championing the latest and greatest platforms. A subset of the crowd remain committed to evolving the ecosystem, writing code, documenting and providing support to others. But most of the platform evangelism gets drowned out in the noise. And many of the best and brightest get drawn into feeding the speculation.

And this is the standing wave. As prices rise we should see a feedback model that builds momentum for a token, bringing in new supporters. But instead the multi-homing of speculation dampens or maybe even cancels it out. When we get down cycles, then maybe everyone stops checking prices every five minutes and gets back to contributing to the ecosystem, improving fundamentals as the ecosystem is better prepared to take on more newcomers (better docs, cleaner APIs, more tooling etc.). But then another rally and the focus shifts back to speculation.

It’s actually not a bad thing. Unstable feedback loops of reflexivity and dangerous. So anything that dampens their impact can be good in the long term. Unfortunately, this is just the start of the reflexivity problem…

The second effect is something I noticed when I exchanged emails on treasury policy with Mona ElIsa for the report we wrote on Melonport, late last year. I wondered what happened to the Ether they raised in their token sale in February of last year, given that the price of Ether has appreciated significantly. It turned out, that in their determination to deliver on their promises, Melonport had converted the Ether to Swiss Francs to secure the funding for their project. A very wise and prudent policy that any top-notch CFO would support. Of course, we all know what happened next: the value of Ether has continued to appreciate much faster than Swiss Francs. But it’s not all bad news, luckily for them the value of Melon tokens continues to appreciate nicely, and so their funding needs are more than adequately covered. So Melonport don’t have a reflexivity problem.

But plenty of token-backed networks do. In the hyper-deflationary world of cryptoland it becomes very hard to spend crypto. The projects that hold their funds in Ether or Bitcoin have had some real hard choices to make. They can hire a developer today, or wait a month or so and hire four! The more frenzied the markets, the more rational it becomes to delay spending. Now this is good and bad. A conservative spending plan for a project that has raised a lot of money is no bad thing. But the flip side is that it may encourage crypto-hodling treasury policies. And that means that when the market turns, they are exposed: their currency reserves take a serious hit, they cancel / delay projects, may need to lay off developers and may even end up putting the project at risk.

Entrepreneurship is another area where I think the speculative hype has also created reflexive standing waves. On the one hand, the high valuations have created a surge of new projects launching token sales. Again we have more investing, more innovation, higher chance that the overall ecosystem succeeds. So better fundamentals for all players from higher prices. Good work reflexivity.

But is there a dampening effect here too? Are the smartest entrepreneurs leading these efforts? They may not be.

The probability of success in any start-up is very low. Add a great team, a great idea, a great market opportunity and things look better. But when an early investment in Ether outperforms seed rounds in leading Silicon Valley startups, then isn’t the smart money investing rather than creating? And it’s not just entrepreneurs. Developers who may never have started their own business may also be making more money from investing than they would from writing code.

So let’s look at a typical startup founder. They’ve put aside a little money to support themselves as they get the company off the ground. Maybe then can support themselves with no income for 2–3 years, and maybe enough to pay one or two developers to get to a seed round. If they are in the crypto space in 2017 they would be crazy to proceed. Going for it when tokens are seeing 10x, 50x, 100x is just plain irrational. You are betting that you can do better with your own idea, talents and a little funding. Any sensible attempt to work out the expected value of your returns will tell you not to do it. So now, assuming the wannabe entrepreneur is investing in the secondary market (not funding new projects), we have market price negatively effecting ecosystem fundamentals, as less high-quality projects are launching. And yet, this is happening at a time where Wall Street is intent on joining the party. So what happens next? More money, less quality… before we do there, let’s first look at where the house money goes when Wall Street enters the casino.

House money refers to the early investors who made their money on Bitcoin, Ethereum, Ripple etc. They “diversified” their gains into new tokens and made even more money. They are likely to buy in to pre-sale / public sales, so they are directly funding these projects. Could it be that 2018 is the year that many of these house money investors find they can no longer get decent returns? Firstly, it’s worth noting that the best of the house money investors have already moved over to advise / start hedge funds. These hedge funds and other institutional investors will take over the primary market. Those offerings that do come to up for public sales now come to market at valuations where the returns for retail investors will be significantly weaker than before.

And now we see the cycle reverse…

The expected returns for entrepreneurs improve vs. secondary market speculation. At the same time that the professional funds / professional angels take over the primary market, the professional traders also take over the secondary market. So at the same time we see the supply of quality startups increase, the demand for startups is also increasing. The house money wants to keep investing, so they either (a) professionalise, (b) shift their gains into hedge funds or (c) they start their own companies. Either way they reinforce the effects. Gaining an edge in the secondary market becomes much harder, as does getting access to deal flow in the primary market. This is the power law of venture capital: the most respected VCs get in on the best deals, get the best returns / best portfolios, best networks and the virtuous cycle continues. A new generation of funds / angels will build the great crypto investing brands of tomorrow. The reflexivity standing wave looks as follows:

market valuations rise -> entrepreneurs postpone their new startup and speculate -> less quality startups -> weaker ecosystem fundamental -> deepens trough of disillusionment when it comes -> lower market valuations

Then we get a positively reinforced reflexive wave as markets professionalise:

markets stabilize -> harder to profit -> professionals money managers take over -> even harder to profit -> entrepreneurs shift winnings to fund businesses -> more startups -> stronger ecosystem / better fundamentals -> higher chance of success -> better valuations

Then the cycle begins again: prices increase, the next wave of wannabe entrepreneurs get drawn into speculation…

Crypto will reinvent the global economy. We are so far away from the top of the market that the word bubble is meaningless. These cycles will be irrelevant when we look back in five years. But understanding how they work will help investors decide when to enter the market. If you are looking to invest in a public sale now, bear in mind that we could be about to see a surge of high quality startups as the best entrepreneurs get back to building.

Brendan Dillon is CEO at Reflexivity. We provide consulting and advisory services to token-backed decentralised value networks.

Please contact us at info@reflexivity.network.

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