Reflexivity
George Soros introduced his theory of reflexivity in “The Alchemy of Finance”. The primary takeaway for most readers was that market prices are influenced by the participant’s biases, as shown below.
While true, this is a far too simplistic conclusion to justify the excesses seen by certain markets when a reflexive process takes hold.
A deeper understanding of Soros’ message is that a boom/bust process occurs only when market prices find a way to influence the underlying fundamentals that are supposed to be reflected in market prices.
Soros uses a few examples in the book:
The conglomerate boom - conglomerates used their overvalued shares as currency to buy earnings which, in turn, served to justify the overvaluation.
The international lending boom - banks used debt ratios to measure borrowing capacity of debtor countries, such as the ratio of the debt outstanding to the Gross national Product or the ratio of debt service to exports. Banks considered these objective measures, but in fact they were influenced by their own activities, i.e. when they stopped lending, the Gross National Product deteriorated.
These examples demonstrate the short-circuit between fundamentals and the valuation placed on them. When this happens, it sets in motion a process that initially may be self-reinforcing, but eventually peaks and becomes self-defeating.
The primary error that precipitates these boom/bust cycles is a failure to recognize that a so-called fundamental value is not really independent of the act of valuation. This was the case in the conglomerate boom, where per-share earnings growth could be manufactured by acquisitions, and in the international lending boom where the lending activities of the banks helped improve the debt ratios that banks used to guide them in their lending activity.
Soros defines the key stages of these boom/bust cycles:
AB - Usually the process starts with a trend that is not yet recognized.
BC - When it becomes recognized, the recognition tends to reinforce it. In this initial phase, the prevailing trend and the prevailing bias work to reinforce each other. At this stage, we cannot yet speak of far-from equilibrium conditions. That happens only as the process evolves.
CD, DE - The trend becomes increasingly dependent on the bias and the bias becomes increasingly exaggerated. During this period, both the bias and the trend may be repeatedly tested by external shocks. If they survive the tests, they emerge strengthened until they become seemingly unshakable.
EF - What follows is a period of acceleration.
F - A point comes when the divergence between belief and reality becomes so great that the participants' bias comes to be recognized as such. We may call this the moment of truth.
FG - The trend may be sustained by inertia, but ceases to be reinforced by belief so that it flattens out-let us call this the twilight period or the period of stagnation.
G - Eventually, the loss of belief is bound to cause a reversal in the trend that had become dependent on an ever stronger bias; this trend reversal is the crossover point.
GH - The opposite trend engenders a bias in the opposite direction, causing a catastrophic acceleration that qualifies as a crash.
The above graph closely mirrors the boom/bust cycles Ethereum has gone through since inception.
Ethereum Reflexivity (pre-merge)
As discussed above, the deeper interpretation of Soros’s book is that these boom/bust cycles occur only when prices find a way to influence the underlying fundamentals that are supposed to be reflected in market prices. Let’s walk through these dynamics for ETH.
The below graph shows the Google search trends for “Ethereum” and the price of ETH. The correlation between these two data series is r = 0.77. Conceptually, this makes sense. Interest in the Ethereum network rises and falls with the price of its native token – and as the price rises, more people hear about ETH and want to buy in and use the network, driving the price up further.
(credit: Arthur Hayes)
Taking the above graph into account, let’s summarize the ETH pre-merge reflexive process:
The price of ETH increases
Potential users search Ethereum and learn about the ecosystem
These potential users convert to actual users, increasing the number of wallets on chain and engagement with ETH DApps
Developers who are deciding what Layer 1 to build on choose Ethereum, as it has the most users
New DApps are built on Ethereum, causing more users to join the chain over alternative Layer 1s
These new DApps attract new users, who need ETH to participate in the ecosystem
These new users buy ETH, the price increases, and the process repeats
EIP-1559 and ETH PoS
Looking forward, with EIP-1559 and Ethereum’s shift from PoW to PoS, these reflexive dynamics are greatly enhanced, as the below ETH burn mechanism comes into play:
Through the ETH burn mechanism, ETH becomes deflationary, and the amount by which ETH supply is deflated depends on the amount of gas fees that are burnt.
The amount of gas fees burnt is dependent on the amount the network is used.
The amount the network is used is dependent on the number of users and quality of applications.
The amount of users and quality of applications both have a reflexive relationship with the price of ETH.
Therefore, the magnitude of deflation and the price of ETH have a reflexive relationship.
Ethereum Reflexivity Enhanced (post-merge)
Tying together the ETH pre-merge reflexive dynamics with the ETH-post merge burn mechanics, we get the following:
The price of ETH increases
Potential users search Ethereum and learn about the ecosystem
These potential users convert to actual users, increasing the number of wallets on chain and engagement with ETH DApps
Developers who are deciding what Layer 1 to build on choose Ethereum, as it has the most users
New DApps are built on Ethereum, causing more users to join the chain over alternative Layer 1s
This increase in collective Ethereum activity causes more ETH gas to be burnt
The increase burnt ETH deflates the ETH supply
Deflating ETH supply increases the price of all ETH in circulation
The price increases, and the process repeats
Deviations from Soros’ Examples
Like the above examples relating to the conglomerate boom and international lending boom, these Ethereum fundamentals are directly influenced by the price of the asset. Unlike the above examples, however, I would argue that Ethereum reflexivity has a much higher bound than either the conglomerate or international lending booms. Given the range of possible Ethereum use cases and the number of DApps that can be built on this decentralized “world computer”, the reflexive process for Ethereum could extend far beyond either example provided by Soros.
Additionally, unlike the conglomerate or international lending booms, the Ethereum reflexive process will likely repeat until price achieves some semblance of stability. In “The Alchemy of Finance”, Soros is careful to note that after the catastrophic collapse in the examples he covers, the process is complete and neither the trend nor the bias remains the same. He states that the process does not repeat itself and that there is a regime change. I think ETH will follow a different path. Ethereum has gone through multiple cycles since inception, and will continue to progress through boom/bust cycles until both the ecosystem and price achieve homeostasis.
