Tanzeel Akhtar is an independent British journalist whose work has been published in the Wall Street Journal, CNBC, FT Alphaville, Investing.com, Forbes, Euromoney and Citywire.
Recent news that George Soros' $26 billion family office is entering the cryptocurrency market has many investors speculating about the likely impact.
But one of the billionaire's most famous ideas might be even more important to understanding how the market functions, with or without his participation.
For those unfamiliar with this powerful palindrome: In the world of economics and finance, Soros is feared and known as "the man who broke the Bank of England" when he made $1 billion in one day, September 16th, 1992 (known as Black Wednesday). This is one institutional player with the ability to go large and make or break a currency ... even a digital one.
Soros has attributed his success in part to his understanding of what he calls reflexivity. In simple terms, this theory states that investors base their decisions not on reality but on their "perception" of reality.
According to reflexivity theory, there are two realities: the objective and subjective. Soros explains that the subjective aspect covers what takes place in the mind and the objective aspect is what takes place in external reality.
Reflexivity connects any two or more aspects of reality, setting up two-way feedback loops between them. In this way, actions resulting from each reality, the objective and the subjective, will affect investors' perceptions, and therefore prices. Soros has cited the global financial crisis of 2008 as an illustration of the theory.
Markets, he reckons, are in a constant state of divergence from reality and far from accurately reflecting all the available knowledge, instead representing almost a distorted view of reality.
"The degree of distortion may vary from time to time," Soros once wrote, adding:
"Sometimes it's quite insignificant, at other times it is quite pronounced. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend."
He goes onto explain that when positive feedback develops between the trend and the misconception, "a boom-bust process is set in motion." This is tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.
So, how does his theory apply to the crypto market? For starters, we do see these feedback loops.
The more people form a positive view on bitcoin, the more the price will soar, and vice versa. This is what happened late last year: when the price of bitcoin jumped, it attracted more users, which further juiced the price, which brought in more people.
Crypto markets are just as prone to the phenomena of irrational exuberance, bias or opinionated actors as any other market, said Omri Ross, assistant professor at the University of Copenhagen and CEO of Firmo Network, a smart-contract startup.
Further, the community's famous cultishness amplifies these effects, he said.
"The reflexivity of economic actors is confirmed by the proliferation of subcultures and fan groups emerging around various projects," Ross said. "In the young and volatile crypto markets, near-religious beliefs about price appreciation with references to various intrinsic valuation models can be observed daily."
Another area where reflexivity applied, for a time, is in the initial coin offering (ICO) sector, where momentum drove up prices, said Shane Brett, co-founder and CEO of GECKO Governance, a regtech startup. But it lasted only so long.
"Recently, however, discussions around compliance, not to mention fraudulent ICOs, have caused some investors to retreat," Brett said. "Conversely, institutional investors are keen to invest in the market, but in the absence of compliance, are remaining on the sidelines, contradicting this theory."
Nobody really knows what the long-term effect will be of Soros' entry into the crypto markets, only months after he joined other elites at Davos in calling bitcoin a bubble. Things are about to get more interesting.
But we can learn from his insights about the circular relationship between cause and effect, and the role of cognitive function in a new, developing and volatile market.
George Soros image via Shutterstock.