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Decoding The Allure of Crypto

Written by Siya Goyal and Data Visualisation by Mia Zhou
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Cryptocurrencies, once seen as a beacon of financial innovation, now seem to be sinking deeper and deeper. With the narrative shifting from optimism to caution, major crypto currencies such as Bitcoin have lost over one-third of their value as compared to 2022 and the overall crypto market cap following a similar trend. The unravelling story begs the question: How did the so-called ‘future of money’ get rebranded as an ‘outright scam’.


How this mystical currency took centre stage


Cryptocurrencies were first created in 2009, but took the global economy by storm during the Covid-19 pandemic. Bitcoin skyrocketed from a market cap of $250 billion in 2020 to a staggering $3 trillion by the end of 2021 ( see Figure 1). In the tumultuous pandemic-stricken world, as faith in government and central entities wavered, consumers were drawn to crypto as a safer haven for wealth, since the currencies are independent from traditional institutions utilising blockchain technology infrastructure.

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But what is blockchain technology? It is essentially a ‘virtual spreadsheet’ of transaction histories which is arranged in blocks ordered in a giant chain. Every cryptocurrency transaction is individually recorded onto the blockchain by a huge network of volunteers verifying its authenticity computationally. The information is accessible to everyone and is not stored on a singular device or computer.


Many other factors also exacerbated its explosive growth, for example, the volatility of cryptocurrencies intrigued traders, as huge price-swings have the opportunity to generate unparalleled returns. Even the average consumer began investing, in the hopes of indulging in a profitable piece of the crypto pie. Further, given that blockchain technology promised enhanced security, transparency, data privacy and efficiency, the trajectory of crypto positioned it as a front-runner in shaping the future. 


These advantages combined to fuel widespread optimism and popularity for cryptocurrency, but also perpetuated positive feedback loops that accelerated its growth further. However, such forces created speculative bubbles causing the prices of cryptocurrencies to soar unjustifiably higher than their original value. And we are all well aware that the fate of a bubble bursting is inevitable. 


The expected unexpected fall of crypto 


Realistically, we knew crypto was a ticking time bomb to begin with. After all, its key promises hinged on complete decentralisation, with no government intervention or regulation and extreme price instability. Shown in Figure 2, in 2021 alone, Bitcoin's value swung wildly between $28,000 and $65,000, boasting an annualised volatility rate of 80.27% and a daily rate of 4.2%.

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These rates are significant as compared to traditional stocks such as the S&P 500 that demonstrate an annualised volatility of 18.71%. This perfect storm not only fosters an environment ripe for scandals and abuse of power but also exposes consumers to significant financial risk, making the entire crypto landscape a precarious realm where substantial losses loom large and accountability remains elusive. 

Consequently, when listening to the story of the lifetime imprisonment awaiting the ‘King of Crypto’ Sam Bankman-Fried on the FT podcast a few weeks ago, I was not taken by surprise. Neither did the alarming headlines that plastered the resignation of Binance's CEO, Changpeng Zhao, as he pleaded guilty to U.S. criminal charges with the company being fined $4.3 billion.


Scandals such as these are not a recent phenomena, and have repeatedly occurred in a triad of money laundering, pyramid and Ponzi schemes (deceptive investment systems sustained by a constant influx of new individuals/investors to pay the returns to those before them). Consider the case of the 'Crypto Queen,' Ruja Ignatova, whose 2016 exploitation of OneCoin defrauded individuals of over $4 billion, leading to her 2017 disappearance as the truth unravelled. In 2018, Bitconnect faced exposure as a suspected Ponzi scheme, triggering a catastrophic 92% price crash in currency value. The PlusToken scam of 2020, following a similar script, met its demise when Chinese authorities seized £3 billion. Astonishingly, these revelations unfolded prior to the crypto boom of 2020, raising the question: why did they not dissuade consumers from venturing into cryptocurrencies?


If the drawbacks are therefore so stark, why did crypto still explode in popularity?


Interestingly, economic theory helps us pinpoint many key factors that incentivised consumers to partake in the crypto craze. 


The first was the pursuit of competitive advantage whereby being an early adopter of new technologies or practices can lead to huge economic profits, known as first mover advantage. In the case of crypto, those who first dared to venture into the uncharted waters of digital money made unimaginable monetary returns.


Take Erik Finman, better known as the “Bitcoin Teenage Millionaire” invested a sum of $1,000 dollars from his grandma when Bitcoin was only worth $12 to see a 9900% return in just two years. Not bad for a 12 year old! An even more remarkable tale unfolds with Kristoffer Koch, an electrical engineer from Norway, who knew virtually nothing about crypto, even forgetting about his $22 investment in 2009, discovered his fortune had grown to an astonishing $886,000 by 2013. Cooper Turley, who only entered the crypto space in 2017 –  when Bitcoin was already going for over $2,000, made phenomenal returns by investment in Ether (an emerging cryptocurrency at the time), gracing him with a 7-figure net worth.


Aside from first-mover advantage, bounded rationality stands as a key characteristic of the crypto market and hence, a lens to understand consumer behaviour. First introduced by Nobel laureate Herbert A. Simon, it refers to the idea that decision-makers often operate with limited cognitive resources and incomplete information, leading to suboptimal decisions. The context of crypto investments seems to embody this concept as official reports in 2021 (peak crypto), outline that over 85% of crypto investors did not “fully understand” the value and potential of cryptocurrencies and over one-third reported zero knowledge about the space or would call their level of understanding as ‘emerging’. Even our Norwegian engineer stated he had no clue of the extreme benefits he would reap. Bounded rationality is amplified by the market's inherent volatility. Even in a scenario with perfect information, the unpredictable fluctuations in prices defy straightforward explanations anyway. This meant that consumers, despite fully knowing their own gaps in knowledge, bought into the hype. 


Another behavioural economic phenomena that may explain the desire to purchase crypto is herd behaviour. Empirical evidence underscores this argument as herd investing was the driving force contributing to the Dutch Tulip Mania of the 1630s, the 2007 housing market crisis and the ‘dot com bubble’ of the early 2000s. We see substantial reasoning to link crypto to such dynamics as these markets were characterised by asymmetric information and bounded rationality – the exact same properties that underpin the crypto market. Furthermore, it is critical to note that cryptocurrencies itself are just currencies with no fundamental value and unlike traditional investment paths such as investing in stocks and shares of a company, crypto’s only values are dictated by how much a consumer is willing to pay (i.e demand). Consequently, herd behaviour solely dictates the value.


The convergence of bounded rationality, herd behaviour, and the allure of competitive advantage shed light on why consumers still plunged into the volatile world of cryptocurrencies. The recognition of these factors does not, however, serve as justification for such risk-taking behaviour. Instead, it underscores the complex interplay of psychological and market dynamics that propelled individuals to navigate a landscape marked by uncertainty and speculation. 


Intriguingly, these very intricacies persist as the core reason to why there seems to be rumours of a potential re-emergence in the crypto sphere. Recent trends show a gradual ascent in the prices of diverse cryptocurrencies, propelling the overall crypto market cap to an astonishing $1.6 trillion from the beginning of this year's $828 billion. The looming question now lingers: can these dynamic forces muster enough strength to reignite another crypto craze?

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