Today I’ll be doing a quick write up of an idea my buddy Patrick Gorrell shared with me. I found the concept super compelling and thought other people might enjoy the content as well. Be sure to subscribe if you enjoy the read!
Reflexive Market Making
How some people are using sociological signals to stimulate reflexive market conditions and drive narrative of prophetic market trade strategies.
Intro
One of the most captivating aspects of projects deployed onto the Ethereum Mainnet is that every action is permanently logged onto the Ethereum Virtual Machine and can be easily referenced at any point in time. By taking those transactions and understanding that they are a reflection of someone’s decision-making, we can start to build out a social graph of activity. Since the success of a project is largely driven by the population engaging with their smart contracts, comparing price action between projects and social signals amplified by the masses (or the few) means we can dig a little deeper into “Self-Fulfilling Prophecies” or Reflexive Markets.
Social Proof & Amplification
With the rapid growth of social media platforms throughout the last decade, it is becoming much harder to avoid how impactful reflexivity is in the market. This is becoming more apparent in markets like those in crypto where movements of money can be directly measured and correlated to the dissemination of thoughts on social media platforms. In the past decade, this concept was hard to test and measure; however, large-scale social analytics tied with transparent markets now allows us to look deeper into the correlation between price and social signals/responses.
Reflexivity
When giving thought to a new investment or opportunity, the source of this information usually comes from less than worthy sources. It is more common to hear an opportunity from peers or social media than it is a successful advisor. This is typically true because those sources are not in your direct sphere of influence or because you are not subscribed to their information. Since the source of opportunities lies on public platforms such as Twitter, those who consume their information from those sources are always acting reactively rather than proactively. In addition, most of the reputable Influencers in the market are operating off of an internal bias- they are looking to share the investment decisions they’ve made since sharing the investment decision has a higher likelihood of being adopted by their followers and increasing profitability. In essence, an influencer has the opportunity to:
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Share their new found investment.
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Consciously sway their followers to consider the opportunity.
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Have their investment increase in value do to the influx of new money.
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Sell their profitable position.
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Publicize their successes- further reinforcing their position of status in the market.
As you meditate on the workings of reflexivity, take this quote from George Soros as a supplement to the concept.
“I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants’ view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. For instance, treating drug addicts as criminals creates criminal behavior. It misconstrues the problem and interferes with the proper treatment of addicts. As another example, declaring that the government is bad tends to make for bad government.” - George Soros
Incentivized Performance
Since on-chain data is so easily accessible, most performant traders don’t need a huge social following to amplify their success. Though reflexive markets do allow for performant traders to become even higher performers, it is not mutually exclusive. For this reason, it is also more difficult for Influencers of low performance to blindly sway their audience to invest in the projects they publicize. These shills, as they’re commonly known in the space, are far less effective and are ignored if the on-chain data does not exist to back their comments.
Network Multiplier
Since on-chain data is so accessible, it is common for trading strategies as well as performant wallets to become popular in ways similar to viral content on social platforms. Since the information is amplified by the network, these strategies tend to become more watered down and less effective; however, those who find the information first tend to have the advantage in the market. As the on-chain information is discussed more frequently the information typically travels from Analysts → Professional Traders → Retail Traders → Newcomers. By the time the information is made public to the broader market audience, the strategies are typically watered down to the point that they are no longer profitable or effective.
Creating Influential DeFi Strategies
Creating influential strategies in Decentralized Finance is more complex and more competitive than its traditional counterpart. For a decentralized strategy to influence the market it must have an influential figure behind it as well as the on-chain data supporting it’s success. Conveniently, a strategy created by an influential figure that has a public group participating in it will grow much more rapid than a strategy missing one or the other. The overall benefit of this is that queries that measure value or show performant strategies can be made public and the masses can more easily look into and adapt these strategies.
On-Chain Methodology
When observing transactions on the Ethereum Mainnet there is a bit of filling in the blanks required to get the full idea of the intent behind a specific transaction. The given variables that must be considered are the sending wallet, receiving wallet, transaction/token type. With the ability to transparently track those factors you can group them and graph their interactions to get a better understanding of their relationship to each other as well as what their intent is.
Relationships
Imagine a wallet as a single home on the country and every transaction as a trip to a new location. Every time a transaction is made it would carve a new path that could be traced back to the original wallet. These paths may lead to all sorts of points of interest. Using the paths leading to and from those points of interest would allow you to pull together wallets of similar activity and categorize them. Some Mainnet examples of this could be exchanges, mixers, or even scams. Wallets often interacting with these points of interest can be clustered together for more analysis.
Intent
Measuring intent is a bit more difficult than relationships between wallets. Whenever a wallet interacts with another wallet or smart-contract the intent is often obfuscated by technology. On the bright side, most smart contracts have specific actions written as code that are directly copied from another working product on the network. This allows us to group smart contracts together based on what they do or how they work since wallets are interacting with them the same way as other contracts.
In the above example we can see a wallet using the deposit function to add funds into a liquidity pool. By grouping wallets using similar actions we can group them into liquidity providers and sort them based on value or size of liquidity. If this wallet consistently makes this move, it is likely that they are primarily liquidity providers; however, some wallet’s can be placed into multiple categories.
Personification
If a wallet has a significant amount of transactions it is possible to create labels and descriptions to forecast their recent/future activity. An example of this would be something along the following:
Origins
Determining the origin of the wallet is mostly tied to its primary exchange and their specific KYC/AML requirements. If there are no KYC/AML requirements, it is pretty difficult to find the origins of a wallet; however, if the wallet has interacted with a specific exchange, it is likely that there is some information tied to the account. By locating the primary exchange, you can typically deduce the wallet’s general geographic location as well as regulatory constraints they must abide by. These wallet origins can also be categorized like the following:
Since Binance USA is a regulated exchange. The wallet above must have submitted the KYC information needed to properly identify the owner.
Sophistication
Depending on the interactions a wallet has with a smart contract, it is possible to gauge the level of sophistication behind the end user. For example, a wallet with one to five wallet to wallet transfers is likely a burner wallet, a new user, or a party looking to gather and hold tokens while a wallet that interacts with lending protocols, liquidity pools, or conducts arbitrage through flash loans may have a much higher level of sophistication. There is often positive correlation with product value and having highly sophisticated traders using the product.
Timeliness
When you take a look at the timeliness behind projects or a performant wallet’s actions, there are usually some implications that can be made about the potential or success of the source. By looking at the full spectrum of adoption we can typically gauge the health of a project as well as find supporting evidence to other factors that may show project growth/decay.
Financial Considerations
There are a few ways to gauge a project’s standing by tracking its inbound/outbound transactions. If a wallet’s treasury is growing rapidly by small amounts from many wallets, it is likely that it is being adopted by a broader audience. If it is growing by large amounts from few wallets that are high performant, it is likely that they are early adopters hoping to gain higher multiples and may even know something the greater audience does not. If the inward flow of capital is increasing at a faster rate than the expenses of the project, it is likely scaling financially, but it is not always indicative of the growth in respect to product development since some teams fail to employ capital to properly build products. It is rarely the only indicator needed to predict a projects’ success.
Obfuscation / Noise Reductions
It is not uncommon for a project to use multiple wallets with obscure or little to no transaction history to make their project appear to be growing at a rate above what it is truly growing at. For that reason it is important to filter out these noisy wallet’s to gauge whether the project’s value is aligned with what appears on the blockchain. A project with extreme numbers of these strange wallets may be a solid indicator of a rug-pull, cash grab, or other potentially fraudulent activity.
Off-Chain Methodology
One of the key ways to gather project insights on product/service, expertise, and project performance is through public information. This can be done through a variety of online sources published by the team or outside parties. It is the quality and frequency of information (or lack thereof) that can be indicative of a projects overall health.
Team
It is not uncommon for teams building on blockchain technologies to desire being anonymous. This anonymity typically leads to distrust since interested parties may be skeptical of the intent of the founders. When a team is anonymous(undoxxed), their current efforts and execution is the only real gauge of the teams capacity.
If the team is doxxed then digging into the individual members’ previous experience through social profiles such as LinkedIn or publications may lead to strong indicators of what they can do. It is important to note that some teams do not have experience in the field of blockchain. That is not always a poor indicator, but often the team needs at least a single member who is familiar with the space and it’s rapid development.
If the team has open forms of communication through outlets such as twitter, facebook, discord, or any other possible mediums it is often an easy way to gauge of development. This tends to lead to higher adoption rates than silent operations but is not a stand-alone indicator.
Github
If the team has a Github repository, it is usually easier to measure the amount of progress they are making by the frequency and quality of their iterations. If many people seek to clone the project as a baseplate for their own projects, it is usually a healthy sign. If the team is inactive on Github, it is likely that they work on their own environments or tend to move more slowly.
Investors
It is usually worth taking a look at who is financially backing the projects. Investors typically are diligent in their research and if they have a proven track record it is typically worth noting as an indicator for the projects’ potential.
Capital Raises
By using third party subscriptions it is possible to look into the capital raised to date. If a project has more than one successful round of funding is usually a good measure for how credit-worthy the project is. It is not to be used as a sole indicator for blockchain based projects since oftentimes project founders will reach out to their own developing community for funding.
Projects that have launched token sales in the form of ICOs(initial coin offerings) are usually a red flag since there are usually some pretty high legal risks associated with early(often private) token sales. Apart from the legal risks the projects might be subject to, tokens are often far more volatile to market changes and are typically high risk investments as a whole.
Revenue
Any project who is able to disclose revenue and has a history proving that it can grow or stay afloat without the capital of investors is worth taking a look at. It is not uncommon for a project to have poor revenue projections despite having raised capital from investors. In the case that the company’s projections can be found through on-chain methods, it is important to note that the volume can be faked by wallets owned by the company. If that can be disputed through further research, then the profits of on-chain transactions become irrefutable.
Token Activity
Token activity is typically a hard metric to use to gauge the potential or success of a project. Since tokens are all typically volatile(including stable-coins) and typically correlated to Bitcoin/Ethereum, a project with a token must be observed with more caution. There have been many projects that seem to have lots of volume or value through their token, yet flip like a switch at the slightest sign of a turning market. For this reason, project’s must have strong tokenomics (a topic I’ll eventually discuss at a later time).
Price / Performance
Finding true token value for a newer project is particularly difficult, but a trusted method has been Volume Weighted Average Pricing.
Network Growth
Market Capitalization
Volatility Annualized
Sharpe Ratio / Market Performance
An Era of Transparent & Decentralized Finance
If you as an investor were given the opportunity to invest into a privatized traditional market product (such as one provided by Goldman Sachs or Vanguard) or invest into an open market product such as an on-chain strategy assuming they had identical yields, it is more likely that you would invest into the public product. We are moving into that reality. As financial products continue to grow with the advent of decentralized finance, we are finding more investors open to DeFi products as a means for investing. Not only is the information publicly accessible, but the investments are also no longer custodial meaning you can pull out and move your investments as you wish.
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