As I write this, the price of Ethereum has just dropped below $200, which is about 20$ lower than it was a year ago. Its gains against fiat and Bitcoin have–for the time being–been wiped out. Clearly, the wild rise in Ethereum (reaching a peak of over \$1400 just nine months ago) and the crypto markets as a whole was, as many predicted, a speculative bubble.

If history is any indication, this will not be the last bubble for cryptoassets. A cursory glance at the total cryptoasset market cap over time (or just Bitcoin’s) shows a fractal of increasingly larger bubbles1.

Given the reasonable expectation of future bubbles, I want to better understand the nature of these bubbles and the psychology of its participants.

## Narratives and bubbles

Jeff Tong recently shared a paper with me called “Cracking the enigma of asset bubbles with narratives” that argues that “periods of intense market speculation are driven by narratives and narrative thought.”

They authors define narratives as:

a cohesive story or account of events, experiences, or phenomena, whether true or fictitious

The most salient excerpt is this, outlining the three central reasons why narratives drive asset bubbles:

First, asset bubbles typically form during periods of profound innovation, product introduction, and market liberalization, all circumstances in which investors have less, or at least less reliable or relevant, historical data on which to base their decisions. Hence, bereft of sufficient historical data, decision makers have no choice but to rely on narratives, which are widely recognized as our primary sense-making currency in ambiguous situations (Abolafia, 2010b; Boje, 1991; Weick, 1995), to guide their decision making. Such a feature of asset bubbles is well documented in events such as the dotcom bubble referred to above and the Southeast Asian crisis in the late 1990s.

Second, asset bubbles also tend to arise during euphoric periods of easy credit and loose regulations, conditions that attract a surge in retail investors and copycat organizations. As these market players make significantly less use of detailed or long-term analysis of market data and trends, narratives also function as a dominant form of communication—as a sense-giving currency. The rapid and wild spread of innovations in credit derivatives circa 2002 demonstrated just how destructive such copycat behavior can be (Tett, 2009).

Finally, today’s internationalized, high-speed investment environment provides investors with seemingly endless investment opportunities but limited time in which to make decisions. Under such conditions, narratives, which through their elegance and cohesiveness are able to attract our attention and are more easily learned than raw data (Shaw et al., 1998; Smith and Anderson, 2004), are highly influential.

In sum, an environment where narratives fuel speculative bubbles have the following three properties:

1. Lack of reliable or relevant historical data to form valuations
2. Conditions that attract retail investors, oftentimes poor regulation
3. Relative strength of narratives to grab attention in an opportunity rich investment environment.

This maps neatly with what we’ve observed in crypto. Because we lack a proven valuation model for cryptoassets, narratives drive investment decisions. The global and 24/7 nature of the cryptomarkets and poorly defined regulations increase the onboarding and engagement of retail investors.

If you asked passionate new crypto investors late last year why they decided to invest, you’d likely here one of a few popular memes like, “permissionless world computer,” “unseizable money,” or “new banking infrastructure.”

And in each preceding speculative mania, you’d have heard the same thing with slightly different narratives.

Will things change in future bubbles? Probably not. We will still lack reliable or relevant historical data to generate useful valuations of cryptoassets and the markets will continue to be global and 24/7. Additional regulations may come to pass, but there will always be ways to participate in underregulated environments.

Given these properties, cryptomarkets are likely to continue to be driven by narratives.

## Mass movements

I previously explained the in-fighting within the crypto industry with the psychology of mass movements.

The ripe population in a mass movement isn’t only ripe for a particular religious or financial or other forms of mass movement, they’re more ripe than average for any mass movement, including directly competitive movements. It’s more likely that a radical group will be able to recruit from a competing radical group than from an apathetic group.

“A Saul turning into Paul is neither a rarity nor a miracle. In our day, each proselytizing mass movement seems to regard the zealous adherents of its antagonist as its own potential converts.”

This explains the fierce competition between crypto projects that seem unrelated aside from their choice of technology. While they may not compete from a business perspective, they compete directly for a population of true believers: “the gain of one [movement] in adherents is the loss of all the others.”

The constant conflict between crypto mass movements is a battle for adherents. Members of one movement evanagelize their own, promoting dogmas that promise spectacular and sudden change, while demonizing the beliefs of other movements.

This conflict is particularly visible at the tail end of a speculative bubble, as the true believers of a movement stick around as asset prices fall to try and build the foundation for the next wave of possible adherents.

To apply the language of the markets, true believers are building a community of “holders of last resort” and refining their narratives to best attract the next wave of retail investors.

## The Narrative Bubble Loop

Narratives and the psychology of mass movements fuel cryptomarket boom and bust cycles. Thus, bear markets are a time for true believers to A/B test narratives in preparation for the next speculative bubble.

The Narrative Bubble Loop

This is how I imagine it.

• A speculative bubble forms in an environment described by the paper: (1) lack of reliable historical data, (2) conditions that attract retail investors, and (3) relative strength of narratives
• Narratives formed by early believers of some form of mass movement spread. The most compelling narratives start to be assumed as true
• The winning narratives fuel a speculative bubble around the assets supported by the narratives
• The bubble crests as asset prices rise to a point where there are fewer marginal buyers than sellers
• Mass movements compete for adherents, along the way experimenting with new narratives and strengthening old ones
• A new speculative bubble forms

We’re somewhere on the right side of that loop. I can’t say whether we’re nearing the end of the correction or whether we’ll be here for some time, but the properties of cryptomarkets suggest that we will, at some point, see the formation of another narrative fueled speculative bubble.

The narrative fueled bubble doesn’t usually loop in other asset classes. Take the internet for example. A massive speculative bubble fueled by narratives formed in the late-90s, pushing valuations way higher than its fundamentals. Then, a subsequent crash far below the fundamentals. And eventually, the environment changed. Better valuation methods and regulation decreased reliance on narratives, leading to the more efficient market we’ve seen since the dot-com bubble.

In contrast, I suspect the trend of repeated bubbles continue in crypto for the foreseeable future, hence the loop. Until well-accepted valuation methods and clear regulations are adopted, the environment around cryptomarkets will continue to be ripe for narrative fueled speculative bubbles. The big questions are when, around which assets, and driven by which narratives.

1. Of course, this time could be different, but for the sake of this piece, let’s assume there will be one.