- Apr 3, 2024
- 4 min read
Updated: Apr 8
"This is the nature of capitalism, get over it." - Kevin O'Leary
Even after spending nearly two decades being in finance, I don't think I appreciate how capital markets really work. It's not about the math behind how stocks are being valued but rather the behavioural science (or art) behind how they are priced.
The housing market crash and financial bailouts in 2008 gave way to a crisis of confidence in the global financial system. A few banks had gone under and jobs were lost, but what followed shortly was also a re-configured mindset towards greed and risk taking.
The printing of money to arrest economic decline made a lot of people lose faith in traditional financial markets. As a result, cryptocurrencies such as bitcoin became increasingly popular as investors started to look for an alternative store of wealth. Cryptocurrency and digital assets were meant to be a good thing as they were meant to be digitally secure and essentially "un-fraudable".
But human nature would eventually catch up.
Bet on anything
In 2022, a series of unfortunate events led to the downfall of SBF, which had been the poster boy for advocating cryptocurrency. FTX, once touted as one of the world's largest crypto exchange used to be valued at more than the NASDAQ. The firm's bankruptcy was a rude wake up call for crytocurrency enthusiast and investors.
Look, I'm not dismissing the credibility of crypto assets and bitcoin. But think about it: All the digital tokens that changed hands on the platform had to start from somewhere--cold hard cash from the existing fiat system.
Those who trade cryptocurrency ultimately believe that at some point of time in the future, those tokens can be exchanged for cash, ideally at a higher value. This is not very different from trading of stocks, listed options and contracts for difference. This is a secondary market trade.
Money in a secondary market trade doesn't flow to the company for expanding its business, innovation or research. It just circulates among investors, punters and speculators, creating a lot of liquidity for those who make money from this flow.
Anyone can make a bet on anything and the secondary market is the world's largest legalised gambling den. It is far easier to sit on the sidelines and make bets on which is the winning horse than to build a something real.
You can make a bet on the possibility of a business milestones, profit targets, the release of a new product--basically almost any event trigger. And people further make bets on those bets through structuring warrants, put and call options, CFDs, products that don't require people to come up with capital, just enough cash to buffer any unexpected losses. It's just comes down to finding enough buyers and sellers on both ends of the trade, effectively making the market.
As long as those in the game keep the ball rolling and no one gets hurt, prices will continue to hold up. All market crashes are primarily due to a crisis of confidence and a whole lot of people just wanting to get out of the trade.
Telling stories
"Entrepreneurs must be powerful storytellers to win early stage support"
A paper written by IESE in 2023 talks about the dark side of entrepreneurship whereby both founders and their investors inadvertently drum up the value of their business even with the best intentions of fundraising and getting a business going. The pressure can sometimes lead to well-meaning people falling victim to an unhealthy culture of hype and overpromising.
Assume that a company receives a huge order from an important customer which potentially leads to a significant increase in its revenue. It doesn't have sufficient manufacturing capacity so it raises money from investors in which the proceeds are used to buy or build a new factory, thereby solving for production capacity. Investors do the cost-benefit analysis and math behind this story and decide how much to put in. With this new factory in place, the business is now able to solve for its revenue backlog, translating to more profits for all stakeholders which consequently increases the value of the business.
This story, if told properly can be sensationalized into positioning the company as a winner in the market and everybody likes winners. Bankers sell lofty dreams about the future of the business in order to further drive the company's perceived value. Product deliveries and execution start taking the backseat.
This is how modern-day capital markets management looks like for many companies. Share prices driven by narratives rather than fundamentals. More people are telling stories than building businesses. And if everyone is telling stories then who is telling the truth?
Cryptocurrency and financial derivatives do not build products.
Aside from contributing to liquidity in the markets (which once again, benefits mostly the intermediaries), there is no value created in the real economy. There aren't enough merchants around the world today that would accept bitcoins or tokens in exchange for goods and services, and cryptocurrency isn't backed by an underlying business. Many bank accounts still do not support wallets that you can transact virtual assets on a day-to-day basis. You can't even take out a loan using cryptocurrency as collateral. And so regulators around the world are still wrapping their heads around how they should deal with this asset class.
Call it an "educated guess" or decorate it with probabilistic calculations backed by detailed analysis. The truth is in today's market, the movement of share prices are no longer driven simply by fundamentals. Buying a stock or crypto is effectively a speculative trade.
There will always be winners, losers on both sides, and people in the middle profiting from it. As long as there is sufficient regulation and no one creates an economic hole too big that it swallows the entire house, the show will go on. People will continue to gamble, this is the nature of capitalism.
No one calls fraud when things are smooth sailing and the pie is large enough to be shared. It just takes one bad egg, one wilful misstep, to screw everything up.
