There is widespread concern about Crypto contagion which far exceeds the market capitalization of the crypto world. The crypto market has been a bellwether for much larger markets and economic trends. And the weather has not been good, as skyrocketing interest rates and bear markets in equities show. Crypto contagion is so broadly relevant because it is a fundamental indicator of trust in markets.
The Terra collapse has been widely underestimated. It collapsed in price and began a collapse in trust in crypto which is still happening. Two months ago, I noted that Terra set off a crypto contagion. It is a slow-moving iceberg of chaos. It is still not over.
The crypto winter is a winter of confidence where the bottom is not a matter of calculation. Many participants use a form of technical analysis to forecast prices. While technical analysis is an old workhorse in finance, it does not address the issues which the crypto market is now seeing. But confidence is an element in another workhorse of financial modeling—herding.
Herding is a fundamental human behavior. People like to live in groups and engage in group activities. It seems natural that herding would be applied to financial modeling and early on it was. That is until it fell out of favor and was replaced by formal mathematical models. For a while, the role of herding in securities pricing was downplayed. It seems intuitive that a fundamental human behavior like herding would be important, but it was long rejected in favor of the impersonal Efficient Market Hypothesis. The Efficient Market Hypothesis says markets continuously and objectively price all relevant information in a formal risk-adjusted fashion.
Herding is especially important in crypto pricing where many of the quantitative elements of securities valuation are missing. Herding relies on the important idea that an individual buyer lacks the information of a group or of a collection of experts. This is a good description of the Hold on for Dear Life (HODL) mentality of many individuals in the market. The constant jabber of the cryptocurrency believers should be enough to show us the herding forces at work in the market. Empirical studies of crypto investor herding broadly support the casual observations of herding among investors. Herding is observed in daily, weekly, and monthly behavior to different degrees.
But, as one may expect, herding is as complex as the human traders and jabbering it reflects. Pricing with herding behavior is sensitive to the price behaviors of other markets around crypto.
Empirical data supporting herding behavior begs a fundamental question. If a contagion destroys trust in the market, and the herd goes away, what will the price of crypto be? That number is probably a very low number. The prospect of all the retail herd deserting crypto may seem small but it is not impossible as crypto institutions file for bankruptcy and founders disappear.
Are institutions herders?
Even if retail investors largely disappear, there are plenty of institutional players left in cryptocurrency. How will these institutions price crypto?
Institutional investors are in no sense immune from herding behavior. Herding behavior from institutions is a complex fact situation since any kind of collusion is legally suspect. Nevertheless, there is a large body of empirical work supporting institutional herding. In fact, research in this area has been growing.
There are many institutions now investing in cryptocurrencies and there is no reason to expect that crypto markets would be exempt from herding behavior. But herding by individuals and institutions may not lead to the same result in terms of pricing. Institutions, for example, may not respect individual buying trends as smart money moves. Institutions may trade against individual trends. Retail herding behavior may induce anti-herding trading by institutions. This is an empirical question to be answered.
One thing we would expect in an institutionally dominated market is that there would not be a HODL class supporting a particular demand level. Other things being equal, prices may well be lower with an institutional market than in a retail one. In a retail market, crypto prices may get a source of demand from HODLs supporting prices. In a mixed market with both retail and institutional investors, the institutions may well be the hot money leaving the market with less support.
The slow-moving iceberg of mistrust in cryptocurrencies threatens the pricing mechanism of crypto. Crypto pricing is strongly motivated by herding which in turn demands trust in information and markets. The destruction of trust may well change the fundamental pricing structure in cryptocurrencies. No more rallying the troops, i.e., the HODLs, to end a crypto winter. As the winter ends prices may not shoot up to satisfy a sudden surge in demand but just slog along seeking to identify intrinsic value.
1. The crypto pricing processes can change fundamentally if the contagion of trust destruction now moving through the market impairs the herding process. The crypto winter may just lead to a big melt, not price recoveries.
2. Investors should be cautious about calling a low in the crypto market based on technical.
3. If enough misfeasance is found in the market, pricing structures may finally shift out of the HODL patterns of cyclicality.
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