Blog: Exploring the curious psychologies of crypto – City A.M.

Exploring the curious psychologies of crypto

Why do regulators seem to be at cross purposes with the crypto community?  We want them to be as excited about crypto as we are: the technical advances, the chance to change society, being our own bank, being paid for our efforts in Web3, the people, the money. 

Financial regulators have a different perspective. Their role is to protect consumers and keep the markets under control. Not much of that involves being intrigued by whether we’ve found new ways to send information or create a utopian future.

Equally important, different people see the world in different ways. Amos Tversky and Daniel Kahneman, two Israeli psychologists working in the 1960s and 70s, reinvented psychology. They were interested in how people make decisions and, in what the psychologists identified as systematic biases in human decision-making.  Applied to decision-making in relation to financial transactions they discovered what we know as loss aversion and prospect theory.

Loss aversion is no longer a technical term and needs no explanation. It isn’t difficult to have sympathy for the position of a regulator who seems crypto-unfriendly.  Consumers might lose money, and the regulator rightly wants to stop them from doing so. Commentary on the FCA’s 2021 Note ‘Cryptoasset consumer research’, reported with concern that around 10% of UK crypto-holders thought that their crypto investments had some form of protection from loss. But it would be equally correct to say that almost 90% of UK holders of cryptoassets know that they are not protected (and some of the 10% may not be mistaken: they may, for example, have in-app insurance for their deposits).

If a regulator says ‘if you invest in crypto you will lose all your money’ people will think they know of people who have made a lot of money. If a regulator says, crypto is only for rich or sophisticated investors, people will think why shouldn’t I access investments that rich people like?  The difficulty is that if investors don’t take you literally, they may also not take you seriously.

Prospect theory relates to decision making under risk. Simply put, it says that investors don’t think about losses and gains in the same way. They are motivated more by potential gains than potential losses. A poll by Interactive Investor found that almost half of 18-26-year-olds chose cryptocurrencies as their first investment. The FCA says that cryptoassets are “very high risk, speculative investments”. But prospect theory says that this may not dissuade people. 

How else could regulators and policymakers help? To use a deliberately controversial analogy: there is a difference between “don’t do drugs” and “don’t do drugs, but if you do, here is what you can expect, plus advice, support, and further resources”.

So why do people buy crypto? To learn about it (and learn about finance and technology), for investment (or to gamble), for social status, for entertainment, to hedge other positions – or because they believe they have inside information. Only the first of these is pertinent to a financial regulator (there is a strong argument that the last one should be too, but unregulated investments are not subject to the market abuse rules).  If you think that crypto is only an investment you probably also think that people meet their friends in branches of Lloyds Bank in the evenings.  We can’t wish away or ignore the non-financial aspects of this world, but there are good reasons why this is difficult for regulators. They aren’t supposed to be psychologists or sociologists and it isn’t their job to know why people do things.

Psychologists do, however, know all about crypto. This is because of what crypto people refer to as its democratisating tendency. In its aspirational sense they mean that crypto can give people control of their financial lives. More prosaically, it is true because a lot of people now hold crypto, and they hold it for a range of reasons. So, what can psychologists tell us?

Psychologists can tell the regulator to beware of confirmation bias. Confirmation bias would say that, if you have worked in the financial system for your entire career, it will be difficult to see an alternative system as feasible. All your experience tells you that the current system works.

Psychologists can tell the consumer to beware of optimism bias (which leads people to overestimate the probability of success of a venture) and the hot-hand fallacy (a tendency to believe that being on the right side of trades is a steady state, ignoring reversion to the mean).

The problem is that regulation must develop to take account of the psychologies of crypto and of the non-financial aspects that are involved in the crypto worlds.  F Scott Fitzgerald famously said that smart people can hold two conflicting ideas at the same time.  In crypto you need to be able to hold more than two.

Charles Kerrigan, a crypto and fintech partner with law firm CMS.

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