“In a matter of just a few months, the Asian economies went from being the darlings of the investment community to being virtual pariahs. There was a touch of the absurd in the unfolding drama, as international money managers harshly castigated the very same Asian governments they were praising just months before but, as often happens in financial markets, euphoria turned to panic without missing a beat.”
— Jeffery Sachs on the Asian financial crisis
One thing I learned from my time in TradFi is that people who run huge sums of money are not any better at making decisions than people who run small sums of money — investment decisions included.
They sometimes have better information than the rest of us, but that edge is outweighed by the universal foibles of behavioral finance: They, too, suffer from the fear of missing out, recency bias, loss aversion, etc.
Most notably, their investments are based primarily on narratives.
As evidence, consider the 1997 Asian financial crisis, which I’d argue was largely caused by narrative-based investing.
Many billions flowed into Southeast Asia based on a narrative that the “Asian Tigers” were experiencing an “economic miracle.”
The investment managers directing those billions would have explained their investment decisions with statistics on demographics and whatnot.
But really they were just buying into a narrative, same as we all do. Because the only way to operate in a complicated world is to simplify things.
This is why the sell-side analysts and strategists I used to work with were perpetually on the road seeing customers: Investment managers don’t want to read research reports. They want to hear a story.
The fat reports we used to print out didn’t get read much — they were just evidence the analyst had done a bunch of work.
The problem with narrative-based investing is that it’s low conviction: The foreign investors that were pouring money into Southeast Asia in the mid-1990s did not know those countries very well.
So, when the popular narrative changed, the flows changed, too: Inflows to the region of $56 billion in 1996 turned into outflows of $27 billion in 1997.
Those low-conviction flows may or may not have done some good on the way in, but, on the way out, they crashed exchange rates and exploded budget deficits.
Not much had changed in Southeast Asia between 1996 and 1997: The outflows were mostly due to external factors — a product of the risks and incentives faced by international fund managers.
The crisis demonstrated investment inflows rendering recipient countries vulnerable to external financial shocks: When a country imports capital from foreign investors, it imports exposure to their risks as well.
The same can be said for asset classes: When new types of investors bring their capital to an asset class, that asset class is exposed to new types of risk.
Every buyer is a potential seller — so it’s important to understand what risks those potential sellers are exposed to.
Too Much of a Good Thing?
That is what came to mind when I saw the news that Fidelity would make bitcoin available to its 401(k) customers.
We all celebrate new sources of demand for crypto, be it 401(k)s, ETFs, El Salvador, corporate treasuries or DeFi collateral funds.
But keeping the Asian financial crisis in mind, when new money arrives, we should ask ourselves, “How easily could these new buyers be turned into sellers?”
In the case of 401(k) money, the risk is, like fund managers rushing into Southeast Asia, the buyers don’t really know what they’re buying.
Retail money tends to be stickier than institutional money, but if the crypto narrative changes, 401(k) inflows could quickly turn into 401(k) outflows.
Other new categories of buyers have a fuller understanding of what they’re getting into, but may nonetheless pose an even higher risk of capital flight.
Countries: President Bukele’s bitcoin bonds flopped and El Salvador’s conventional bonds reflect rising risk of default. Could the country be forced to sell its bitcoin as part of a rescue? Bukele has brought new capital into bitcoin, which is great — but bitcoin now has exposure to El Salvador’s risk of default.
Corporate treasuries: Michael Saylor has done great work as an evangelist for bitcoin, but a lot of MicroStrategies’ bitcoin was financed with debt. Which means that if MicroStrategy ever gets itself in trouble, bitcoin could be in trouble, too.
DeFi: Do Kwon has made DeFi a new source of demand for bitcoin. But he’s also exported some of UST’s peg-risk to bitcoin, too.
In each case, new sources of demand bring not just new capital into bitcoin, but new liabilities, as well.
We’re already feeling the effects: Bitcoin’s recent high correlation to the sell-off in tech stocks is at least in part due to all the macro funds that have bought into crypto over the past year or so.
Those funds brought new capital into bitcoin, but also new risks: When macro funds sell tech stocks, they now sell bitcoin, too.
This was the lesson learned in the Asian financial crisis: Investment inflows are not always and only a good thing.
Asian governments welcomed the huge inflows of investment capital, but those investments made their economies vulnerable to external financial shock.