The emergence of cryptocurrency brings a new era of behavior in financial markets: from institutional-driven to retail, influencer, and traffic-driven

Written by: Ashwath Balakrishnan, researcher at cryptocurrency research firm Delphi Digital
Compiled by: Li Ke, Chain News

We know that financial markets are institutionally driven, with any large financial company, from insurance underwriters to long-short hedge funds, being an institution. From a broad perspective, the behavioral patterns of institutions are quite similar. They are large in scale, have strict trading management and risk control mechanisms, need to be accountable to LPs (unless fully funded internally), and meet certain custodial investment metrics (most of which are similar).

In short, the financial markets have experienced similar cycles for at least the past 50 years because the institutions that control these markets have similar behavioral tendencies. However, this does not mean that they all make the same investments and trades; rather, their ways of participating in the market are similar.

I believe we are at the cusp of a new era: institutions are no longer the only force determining the direction of the market. If this is indeed the case, it will have a significant impact on market structure.

Cryptocurrency Assets: Making Early Investment Opportunities Fairer

Traditional Early Investment Opportunities Closed to Retail Investors

Before we delve into the behavior of the crypto market, let’s first look at why cryptocurrencies are game changers for early investment opportunities.

Imagine you want to raise funds for a traditional industry or a Web 2.0 business or idea. In this case, you are largely limited to obtaining funds from investment funds or accredited investors. Some jurisdictions have not established rules for identifying accredited investors, so theoretically anyone can invest in startups, but there’s a problem: most startups will not accept angel investments below $5,000, and most retail investors cannot invest that much across multiple startups (as angel investments must diversify risk).

For the few retail investors who can do this, investments have no liquidity until the company is acquired or goes public. Even if you know that the company you invested in is performing well now, it could ultimately collapse, and there’s nothing you can do about it—because your entire early investment lacks liquidity. Similarly, even if you think a small startup might become a unicorn, you have no chance to participate in its growth before it goes public. As of 2019, it took an average of 6 years for a company to go from its first round of financing to an IPO.

Time from First Round Financing to IPO Source: Ian Hathaway

Cryptocurrency Markets Allow Retail Participation in Early Investments

The crypto market has more or less solved this problem. Investors can achieve liquidity faster without waiting 6 years. The current general process is that startup projects obtain seed funding from funds and well-known angel investors. They then use this money to build an MVP, launch their native governance token (with liquidity open to everyone), and gradually decentralize. In this case, even if you are not an investment fund or an angel investor, you have the opportunity to buy in early. Thus, retail investors can purchase governance tokens of crypto startups for $500.

Interestingly, some crypto projects completely skip the seed round and execute what is called a "fair launch." Governance tokens are directly distributed to users over time, without a private placement round. This model facilitates rapid decentralization and instant liquidity, but it is not suitable for every project, as some still need funding to build an MVP.

Imagine if Twitter had released its first widely used version early and "went public" a few weeks later at a mid-single-digit valuation; this is the opportunity that crypto provides. Of course, crypto is an emerging industry, which means it carries risks and is absolutely not for the faint-hearted. However, for retail investors seeking asymmetric upside opportunities and who can bear some risk, they now have choices.

Tokenization of Equity Could Sweep Across All Businesses

It is worth noting that given the current position of the industry and the black box of securities law, this decentralized ownership model and broad liquidity only benefit purely digital, crypto-native projects. This is precisely why DeFi protocols (like fintech companies owned by users) are so popular under this model. Over time, I am optimistic that ownership tokenization will become an opportunity that any business can leverage, but there is still a long way to go.

In short: cryptocurrencies have greatly increased the opportunity for the public to participate in early investments. Like anything, it has its pros and cons.

The Impact of Cryptocurrencies and Meme Stocks on the Market

Retail Investors Begin to Rise

The public market segment is driven by retail investors, but overall, institutions still dominate. However, in recent months and years, the proportion of U.S. household net worth allocated to stock investments has significantly increased. A report from Barclays Bank in September 2020 highlighted that the sudden emergence of retail investors is a driving force in the stock market.

Proportion of Stocks in U.S. Household Net Worth Source: FRED

The Era of Retail FOMO Driven by Traffic, Institutional Fundamental Analysis Fails

Markets are essentially driven by behavior. We believe that everything we consider "fundamentals" is caused by liquidity, i.e., buying and selling assets. Stocks do not spontaneously rise from $20 to $35 because valuation models predict higher earnings in the next three quarters. They rise because investors trust that model, believe the stock is undervalued relative to its worth, and buy the stock.

This does not mean that fundamentals are unimportant; they are certainly important. Fundamentals or growth factors drive the narrativity of the story, attracting investors to buy in. Fundamentals are the logic behind the buying flow. However, if retail investors continue to pour capital into liquidity markets, the rigid mindset (looking at fundamentals) followed by most well-known institutional investors will quickly lose control over the market.

The simultaneous rise of cryptocurrencies and meme stocks this year has played a significant role in amplifying this point (traffic is king). Essentially, people see their neighbors or cousins making a fortune in cryptocurrencies or Gamestop stocks, and they decide to start investing as well. With the market seemingly having no upper limit, even passive cryptocurrency investors are seen as the next Warren Buffett. This has sparked an intrinsic interest in investing, and "investing as entertainment" has begun to gain popularity.

Comparison of Retail and Institutional Bitcoin Trading Source: Coindesk

The Influence of Retail Investors is Growing

Several experts believe that the global pandemic lockdown, combined with low interest rate policies (which make venture capital appear more attractive), is another catalyst for the increasing participation of retail investors in secondary market trading.

As retail investors begin to occupy a larger share in many markets, their behavioral patterns must be considered when analyzing these markets. For example, if a buyer's valuation model tells a group of hedge funds that a stock trading at $25 is worth $45, they will start buying. But if retail investors do not believe that valuation model and the story it tells, they will not buy. This behavioral difference can impact stock prices. Institutions have become a minority, so their predictions have less impact on market prices.

Retail Investment Leads to Volatility

If you think about it, this is also the best explanation for the extreme volatility of cryptocurrencies. Retail investors generally do not have the same conviction as institutional investors, and their emotions tend to be erratic, which can lead to extreme instability in market prices. When crypto assets fall, they can drop significantly—because those buying and selling them are more susceptible to short-term price fluctuations. The same goes for price increases. The crypto market often exaggerates during upward trends and experiences cliff-like drops during downturns. From now on, you may see more of this in the stock market, although it is rare.

I am too lazy to look up the exact data, but I have reason to believe that if you compare the historical data of large-cap stocks like Amazon and Google with retail-dominated stocks like AMC and Tilray, the latter's volatility will far exceed the former's. Asset classes dominated by institutions will not be affected by the increased penetration of retail investors. However, I believe we will see new market dynamics beginning to sweep certain assets. Mainly because their stories attract a new generation of investors (like those from the 90s and Gen Z).

Keep in mind: all these predictions are based on the assumption that the proportion of retail investors will continue to grow at the same pace. If it does not continue to grow, we will revert to 2020, but if it continues to grow—then be prepared for a new era of market behavior!

Many people say that the crypto market and its volatility resemble what it would look like if startup equity could be freely traded. While this is true, I believe it more shows us what the market looks like when retail investors become dominant. Soon, everything will become an investable asset, from your friend's startup to your favorite artists and musicians. And I bet retail investors will also become the main investors in these fields.

Key Takeaways

1. As early investment opportunities that were previously closed to retail investors open up and gain liquidity, the market will have more opportunities and risks.
2. As retail investors dominate specific markets, the structure (trends) of these markets will undergo significant changes.

Thanks to Jeremy Ong, Darren Lau, and Shreyas for their feedback.