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Cryptocurrency has become the hottest of hot fads and where fads pop up, so does the herd effect.
Even with recent market fluctuations (Bitcoin has cooled to $7,000 per coin, down from its December 2017 peak value of nearly $20,000 per coin), the crypto craze continues to be of great interest to investors and speculators across the globe.
In the last week of May alone, over $10 billion dollars of market appreciation occurred.
In the last 18 months, Bitcoin and Ethereum (and Ripple, and Litecoin) have become household names and the source of much watercooler talk.
Along with a primer on the basics about cryptocurrency and its underlying technology, blockchain, this article breaks down how the herd effect is shaping cryptocurrency market dynamics.
What is it, anyway? Cryptocurrency is a digital, encrypted currency (hence “coins”) built on a type of technology called blockchain.
Approaching its tenth birthday this year, blockchain (previously “block chain”) is just what it sounds like, a series of blocks. Together, these blocks are connected in a series, or chain, to function as a bread crumb trails between transactional records and with certain bits of information encoded.
Managing these chains relies on a peer-to-peer network in most cases and is built from the ground-up to be secure against external threats, including hacking. Ironically, these distributed blocks comprise a system, it’s been argued, that is more efficient for recording transactions than centralized record-processing.
Blockchain technology can be used in a variety of applications. Voting is an alternative application it may be useful for as a decentralized but verifiable system for logging transactional information. Cryptocurrency is just another application of blockchain.
Cryptocurrency such as Bitcoin is the compilation of blocks, or units of currency, strung together in a blockchain. These blocks are distributed all across the world. Other ways this model of spread-out assets and record-logging is frequently described is as a “distributed ledger” or a “decentralized” system.
If this doesn’t sound like a traditional bank operation, that’s because it is as opposite to that way of functioning as you can get. And some customers of maligned traditional banking institutions (see: Wells Fargo) view that very favorably.
Cryptocurrency to these folks may represent more than the potential to build massive wealth in a sort of twenty-first century digital gold rush. It’s also an opportunity to shake up the financial industry status quo as a means of democratizing assets.
Examples of cryptocurrency companies include Bitcoin, Ethereum, Ripple, Tron, Litecoin, and thousands of cryptocurrency startups you’ve never heard of.
That includes one that recently buried company assets on Mount Everest as a terribly remiss PR gimmick. (A local mountain guide died in a tragic accident in the attention-seeking climb. File under “Atrocious Business Behavior.”)
What Is The Herd Effect?
Human Herd Behavior
Interestingly, herding behavior is a phenomenon consistently observed in humans, not just cows and birds and other animals.
Originally observed in the 1970s by an evolutionary biologist as a human activity, the herd effect is understood best today through interdisciplinary studies given its complex social, psychological, and biological underpinnings.
Fields engaged in the study of herd behavior include, but are not limited to, cognitive neuroscience, social psychology, sociology, and economics.
By way of definition, the herd effect refers to the collective behavior of a group, such as physical movement through a space or uncoordinated action such as congregating in the kitchen at a party.
As an alternative example, in a crowded space where a group of individuals may feel threatened, people tend to move toward one in an unplanned and uncoordinated means of seeking safety at the individual level. Groups can be large or small; they’re also leaderless.
A few other examples of the herd effect:
- selling a stock when everyone else does
- buying a powerball ticket when everyone in the office is
- visiting the “hot” vacation spot for the year where everyone else will be
- driving the speed of traffic
→ In these contexts, herd mentality is not a good thing.
As a contrast to the herd effect, social proof helps us shortcut to the conclusion that another person’s behavior is appropriate or correct.
The difference is social proof is an evaluation (if a somewhat lazy one) of how to behave whereas the herd effect is comparatively mindless and unquestioning.
I caught myself using this social proof shortcut last weekend during a music festival while parking on a street that is normally reserved for bikers. Briefly, I wondered if the standard signs would be enforced. I scouted out the area.
Several other cars had parked on the side of the street where I was. There weren’t any official signs up from the city, nor the police department, suggesting traffic would be in that area.
Given there probably wouldn’t be bikers in the area the day of the music festival given its grounds layout, it seemed like I would probably be fine.
Seeing that other people were doing the same thing, I assumed, “Hey, a bunch of people are doing that, so it is probably okay.” I decided to take the risk of getting a ticket, confident in the parking solidarity I had with half a dozen other cars.
4 Ways The Herd Effect Is Shaping Cryptocurrency
While we’d all like to think we make rational decisions when it comes to money, the reality is that most of our decision-making involves shortcuts like the one I just described. Our decision making is also frequently influenced by our emotional inner dialogue, our personal histories, and certainly social expectations.
That last point, social expectations, is what herd behavior is about. It’s also about those other two things, though, because we probably have experienced feeling safe in groups before. It’s the decision-making trifecta!
Because herd behavior doesn’t so much engage us to think about joining a group and questioning our role with in it, this tricky situation can cause problems when it occurs in the context of economic choices. Let’s look at three ways herd behavior is shaping cryptocurrency.
Problem #1 – Like Wolves to Sheep, Herds Have Attracted Thieves and Scammers
Since the beginning of 2017, $1.2 billion of cryptocurrency assets have been stolen. Off the top of my head, I can recall at least three multi-million dollar heists in the last six months alone. Outright asset theft is just one type of security-related issue, however.
In addition to the household names like Bitcoin and Ethereum, hundreds of smaller cryptocurrency alternative coins (“alt coins”) are a prime vehicle for a scam. Think of these like penny stocks in the public stock exchange.
They’re relatively unknown players, but picking the right one could, in theory, make someone rich. Not surprisingly, bad guys exploit this dream.
Using new cryptocurrency brands, Initial Coin Offerings (ICOs) are launched, funds are collected fraudulently, and the bad guys are gone with investors’ money faster than you can say blockchain.
The sheer volume of the herd means there will be members vulnerable to the desperate dream of getting rich fast. Truth be told, the headcount of crypto investors who joined for that reason is not exactly inconsequential.
Physical Asset Theft
Another theft consideration to look at with respect to theft is heists of physical property. Remember the PR stunt on Mount Everest above? They buried a physical asset on the mountain; that was the whole schtick. Someone could have stolen that from them
Identity Exposure (And Theft?)
Anonymity is considered a defining benefit of cryptocurrency. Transactions are recorded and available publicly, but only as an electronic address.
But, although it is anonymous in theory, the MIT technology review publication shared a story in 2017 featuring cyber security experts who claim e-commerce companies frequently leak data from purchases made using cryptocurrency.
Those leaks may mean it’s easier to link cryptocurrency users with their identifiable, personal data far more easily than originally thought. Consequently, this means identity exposure is a valid concern.
To that point, the cyber security professionals who commented in the in MIT publication referred to cryptocurrencies characteristics as pseudo anonymous, analogous to using a pen name as an author of a book instead of your legal given name.
In other words, as long as no one knows who owns the pen-name, you remain effectively anonymous. But, how hard is it to figure that out? And, if they can figure that out, would it be a huge leap to commit identity theft leveraging information encrypted in someone’s transactions?
→ Incidentally, anonymity is a double-edged sword. On one hand, anonymity in digital transactions with money allows for a level of transaction privacy. On the other hand, there is an open door for shady transactions to stay, well, in the shadows. This creates a wormhole of challenges for regulating market manipulation and criminal transactions under government purview.
Problem #2 – Market Manipulators Exploit Herd Responsiveness
The value of crypto is known to wildly, if suspiciously, fluctuate. It isn’t unheard of to see several coins change 40% in a single day in a way you wouldn’t necessarily expect. It follows logically that there are major concerns about the suspected role of market manipulation in those intraday and between-day ups and downs.
In fact, the US Department of Justice launched an investigation regarding market manipulation in late May. Spoofing is the major issue being investigated, according to early reports.
This occurs when investment orders are made, but reneged before being complete. By placing trade orders which suggest a bright or negative outlook on futures for a particular crypto, they can manipulate the herd of investors into responding to large orders suggesting someone knows something they don’t.
Spoofing isn’t the only market manipulation going on, either. Per the Business Insider, “A Business Insider investigation last year found that “pump and dump” scams were rife in cryptocurrency markets.
In those scams, people bid up the price of a certain crypto before selling once unsuspecting traders have been lured into the market by those inflating the price.”
The depression part is that experts in digital currency seem resigned to the fact that market manipulation may be an unavoidable characteristic of the markets. Woof.
Problem #3 – Pressure for Regulation Will Accelerate as the Herd Grows
As proof that the United States federal government plans to set the rules of the game for cryptocurrency domestically, I submit the IRS laws issued in 2017 for your consideration.
Another clue arrived this February when a former FDIC official was quoted in an interview with CNBC: “I worry that people are getting into this because they’re seeing the skyrocketing returns and the tremendous increase in value without really understanding what it is.”
As an authority on the topic of currency regulation, the FDIC former Chair quoted above favors managing (read: regulating by law) rather than squashing (read: banning it) cryptocurrencies.
There are safeguards and warnings, by comparison, from FINRA, SIPC, and the FDIC regarding other types of financial products you might buy or invest in within the US, such as stocks on the New York Stock Exchange (NYSE).
Her quote points toward the herd effect; she effectively said she is concerned people are following one another into this market. In other words, regulators worry consumers may not know enough about the potential costs and consequences of these investments.
Although United States government is not regulating cryptocurrency yet, the growing body of investors (estimates show less than 1 in 10 Americans are in crypto; 8% of the general public), there is increasing pressure on federal agencies and representatives such as senators to consider how to best communicate warnings to the public.
Because cryptocurrency is decentralized by design, regulation could be a thicket of weeds without a clear path forward for the foreseeable future.
Predicted Problem #4 – GDPR Will Spook the Herd, Triggering a Major Cryptocurrency Event
One of the hallmark benefits cryptocurrency fanatics rave about is its anonymity. On its face, this seems as though it would be in lock-step with GDPR guidelines in the European Union.
These rules set stringent requirements for companies servicing residents of member countries to provide improved data privacy, clearer opt-out options, and the ability for their data to be permanently deleted.
That last one is the problem.
A fundamental design element of cryptocurrency is its “immutable” (permanent, cannot be changed) dispersed ledger structure.
That would appear to not be GDPR compliant as it means transaction records could not be deleted. Especially given “GDPR will… inadvertently aid cybercrimianls,” it’s possible European investors will adapt their investing behavior by leaving the pack abruptly.
Or, perhaps their feelings about blockchain will change more subtly over time as they come to expect data deletion rights as a given.
“Blockchain” and “cryptocurrency” are probably words you’ve heard thrown around a lot since 2017. If your life is anything like mine, you hear people talking about it at work (and at home). Its rocketing ascension into pop culture hasn’t come without complications, however.
To recap, these three points covered the question “How the herd effect is shaping cryptocurrency” today and a prediction about something that may be coming down the pipe:
- The frenzy of investments in cryptocurrencies has attracted predators to the herd. Specifically, scammers and thieves have stolen well over a billion dollars in documented heists since the beginning of 2017, and that number is growing. Identity theft is a very real concern as well because the anonymity of cryptocurrency purchases may not be as absolute as crypto companies would like investors to believe.
- Just as the size of the market has attracted scam artists, it has also piqued the interest of skilled market manipulators. Some speculate the currencies are manipulating pricing themselves; others think Wall Street may be implicated. Either way, if cryptocurrency investors will behave predictably (spoiler alert, they will: human behavior is 93% predictable), then manipulation is not only possible, but highly probable, to continue, according to experts. The US Department of Justice just launched an investigation into spoofing, a type of market manipulation that’s illegal.
- Pressure is mounting for domestic financial regulations by a government entity such as the SIPC. As investors have followed the herd, they may very well have not understood the volatility and other risks involved with the cryptocurrencies in which they invested. More often than not, technology is developed faster than our laws are made in the USA. Cryptocurrency is not an exception to that rule and, consequently, a bevy of risks have yet to be addressed in these innovative but volatile markets.
- (Prediction) Global changes to laws regarding data safeguards are likely to spook investors as they become more aware of how their data is used, tracked, sold, stored, and exploited. In other words, the GDPR laws may result in a major market event. In other words, the herd effect could also have yet unseen consequences for European investors if GDPR take root culturally and drives a wedge between the currencies and investors’ perceived risk-taking. Opinions on what may happen in the months which follow the implementation of GDPR are mixed, but raise valid questions about the seemingly fundamentally incompatibility of immutability and data deletion rights
Warren Buffet has been an outspoken critic of cryptocurrency, calling it “speculation,” “gambling,” and “rat poison.” He probably wouldn’t recommend trying to time the market to turn your last $50 into enough to get back on your feet.
But, maybe he’s onto something with the observation that human behavior seems to be driving the cryptocurrency markets more than any sort of value-add production, from which traditional investments gain market value.
Instead of traditional ways of creating value, the prices of cryptocurrency are strongly influenced by the herd effect. This psycho-behavioral phenomena refers to the way people tend to move mindlessly in groups, in unplanned and uncoordinated ways. Cattle are also known to move in herds, thus the namesake inspiration.
Buffet has never followed the pack (he’s famously bet against actively managed investments versus index funds – and everyone thought he was nuts because of it), so perhaps he’s less concerned about safety in numbers.
What do you think, frugalers?
Have you found yourself discussing cryptocurrency over lunch? Do you think GDPR will have a big impact on how investors think about crypto moving forward, or in the distant future?
Are you worried it might all come crashing down, like the dot com fad or due to an unforeseeable disaster driven by the herd effect? Tell us what you think in the comments!