Information Cascades in Cryptocurrency Bubbles
Source: https://arxiv.org/pdf/1806.11348.pdf
(Herding behavior in cryptocurrency markets by Obryan Poyser)
This academic paper discusses the boom in value experienced by cryptocurrencies, attributing this growth to a speculative bubble in the market due to social “follow-me” investing behaviors. Cryptocurrencies are virtual currencies that are produced, tracked, and shared in a decentralized fashion. These cryptocurrency markets are largely unregulated, and the values for cryptocurrencies fluctuate wildly. While some proponents of cryptocurrencies attribute the skyrocketing values (at the time of publishing) to the potential of cryptocurrencies as an alternative currency, the author explains that the source of the valuation boom is actually rooted in social dynamics (“herd behavior”), rather than some sort of inherent value of the cryptocurrencies themselves. The paper draws a comparison between the speculative nature of cryptocurrency markets and the speculative financial bubble of the tulip bulb trade in the mid 1800s, where the price of tulips grew to an unsustainable level, all due to perceived valuations based on social pressures and chain reactions of collective decision-making. The author makes a case for how herding behavior, a model for speculative decision-making, has ballooned up the price of cryptocurrencies in a similar fashion. Essentially, this herding behavior leads to a situation where collective decisions are based on the decisions of others in a group, regardless of whether these decisions are rooted in realistic valuations. As the paper outlines, there comes a time at which rational decision making is overcome by the social and financial incentive to just go along with what everyone else is doing, which ultimately underpins the ascension of most cryptocurrency valuations.
The paper connects perfectly to the concept of information cascades we learned about in class. The core concept of the paper, that speculative decision-making has artificially driven up the values of cryptocurrencies, can be thought of as a very large information cascade. Cryptocurrencies have been around for years, but the prices have only ballooned to such a degree once the “critical mass” of adoption was reached. Just like how we talked about the example of people going to a party once they get information that enough other people will also be at the party, so too did cryptocurrency investing become mainstream only when enough people were on board. This is a particularly interesting situation, because most of the late adopters of cryptocurrencies based their decisions entirely on the information from others in their social groups. In other words, the information cascade was so powerful in the case of cryptocurrencies, that there were people investing literally thousands of dollars not because they believed or understood the purpose of the technology, but purely because aligning their decision with the decisions of others brought so much perceived upside that it overrode common sense. Ultimately, what we’ve learned about information cascades serves as a great basis for understanding the wave of hyper associated with the rapid ascension of cryptocurrency valuations. Also, I think it’s interesting to note that this paper was published in May, and we’re able to reflect on it now (in November). In the time between, the values of many cryptocurrencies have in fact crashed, just as the proposed model of speculative bubbles predicted. The paper’s message, and the underlying factors of information cascades have in fact shown themselves to be reliable explanations for what happened. It’s very cool to apply what we’ve learned in class to real world situations!