How Prospect Theory (Partially) Explains the Growing ICO Market

Guest Author: Bhaargav Kosuri | July 5, 2018

When the bumpy ride began for Bitcoin in January, it was hard to see the ICO funding landscape continue its momentum from 2017. But here we are in June 2018 with capital inflows continuing to grow month over month despite the bear market. So what gives?

 

The Conundrum

While the dominant cryptocurrencies, BTC and ETH have been slipping, ICO funding has in fact gone up. One might expect mega sales like Telegram and EOS to have skewed this data, but the $10B raised so far in 2018 is almost twice as last year. This seems counter intuitive as one would expect a bull run like 2017 to supplement ICO funding, and not a bear run like 2018. However, Prospect Theory does provide an explanation for this unusual occurrence.

 

Prospect Theory: Loss-Aversion

Prospect Theory is a behavioral economic theory developed by Nobel winner Daniel Kahneman and Amos Tversky. The theory analyzes human decision making under risk and uncertainty. The general concept is that losses cause a greater emotional impact on an individual than an equivalent amount of gain. Basically, the dissatisfaction of losing $1,000 is more than the satisfaction of winning $1,000.

At the turn of the year, BTC was trading at an all-time high, and this substantially shifted everyone’s Reference Point. In the case of Bitcoin, this means that if someone purchased 1 BTC at $9,000 in November 2017 and were at a net gain of $1,000 when BTC was trading at $10,000 in February 2018, there was still a tendency to perceive this as a loss. This is due to the fact that when BTC hit it’s all-time high in January 2018, the Reference Pointhad shifted from $9,000 to $21,000. This is applicable to anyone who had bought BTC before February 2018.

Also, the above scenario is analogous to the other dominant cryptocurrency, ETH, as it has been following a similar trajectory to BTC.

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Risk-Seeking Behavior

One of the ideas arising from Prospect Theory is that people become risk-seeking when faced with a high probability of a loss. This attitude is a consequence of their attempt to recoup these losses and get even.

Here, getting even means arriving at the most recent Reference Point which in the above case of BTC is $21,000. So when people holding BTC or ETH in early 2018 saw their assets plummet in value, the uncertainty cloaking the crypto space provided them 4 options.

1. Cash out their BTC or ETH at a ‘certain’ or perceived loss before it got worse (and it has gotten worse indeed)
2. Trade their devalued BTC and ETH for other existing coins and tokens
3. Use their devalued BTC and ETH to buy new coins or tokens issued at upcoming ICOs
4. HODL

 

Decision Making Under Uncertainty

It is important to note that none of the 4 Options presented a ‘certain’ gain. Among these, Option 1 was a ‘certain’ or perceived loss. The crypto market’s dependence on BTC and ETH meant all other coins and tokens were hit as well, making Option 2 a probable loss as well. Though Option 4 has always been the prevailing wisdom it was still far from a ‘certain’ gain. Therefore, the risk-seeking attitude outlined by Prospect Theory made more people opt for Option 3.

New coins or tokens issued at ICOs were the only digital assets (or any asset class) with even a slight probability of a 200%-500% return in the short term. Despite the high risk and uncertainty involved (considering the failure rates of ICOs), these investments provided people a remote possibility of getting back to their Reference Point. Hence, this is an argument explaining why the ICO funding landscape has thrived despite a crypto market bear run in 2018.

 

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Despite all the algorithms, humans will always be at play. Hence, incorporating behavioral concepts in crypto-economics or tokenomics is going to be critical. This will help us not only understand crypto markets better but also design truly powerful Blockchains.

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Guest Author: Bhaargav Kosuri

I currently work with Beast, a New York based venture studio, bringing together entrepreneurs, innovators, and investors from across the globe.