Conversation with Bitwise Investment Manager: Liquidity is the foundation of the encryption market, and investors need to manage their emotions well

Guests: Jeff Park, Bitwise Alpha Strategy Investment Manager; David Kalk, Reflexive Capital CIO

Host: Jason Yanowitz, Founder of Blockworks; Santiago R Santos, Investor;

Podcast Source: Empire

Original Title: Mastering the Psychology of Crypto Cycles | David Kalk & Jeff Park

Air Date: August 8, 2024

Summary of Key Points

In this episode, David Kalk from Reflexive Capital and Jeff Park from Bitwise discuss the critical role of psychology in encryption trading. They believe that controlling one’s emotions and biases is key to standing out in the highly fluctuating and reflexive encryption market. They reveal the limitations of traditional venture capital approaches, the potential of liquidity strategies, and why psychological resilience may be the most valuable advantage in today’s cryptocurrency field. They share their insights on managing trading psychology, adapting to market institutions, and the future of institutional encryption investments.

Introduction of David and Jeff

• David Kalk is the founder and Chief Investment Officer of Reflexive Capital, while Jeff Park is the Head of Alpha Strategies and Portfolio Manager at Bitwise. Both guests have unique backgrounds, especially David’s extensive experience in the macroeconomic field.
• David began his career in 2008 at Goldman Sachs’ Interest Rate Derivatives department, focusing on market structure. His collaboration with Peter Tier taught him the importance of independent thinking and risk management in the macro market. In 2020, he left Goldman Sachs and co-founded Commonwealth Asset Management, where he identified cryptocurrency as a macro asset. David also mentioned that he established some customized products to enter the encryption market in 2021 and decided to focus on the encryption business after observing the policy changes of the Federal Reserve, ultimately founding Reflexive Capital.

Low-efficiency market with low Liquidity of Crypto Assets

Liquidity and Efficiency in the encryption Market

• David pointed out that the Cryptocurrency market is a high liquidity but inefficient market. Typically, a liquid market will be more efficient, while the encryption market is a notable exception. Although the encryption market has some Liquidity, its efficiency is low, mainly due to the composition of market participants, lack of professional trading experience, and more retail investor and Newbie investors.
• David believes that there is a clear lack of portfolio adjustment in the market, especially during the significant Fluctuation in the encryption cycle, many investors fail to adjust their strategies in a timely manner. He compares the current encryption market to the macro market of the 1990s, pointing out that if you can correctly grasp the large-scale market rotation, you will gain huge profits.

Investor Psychology and Trading Strategies

• David further analyzed the psychological factors of investors in the encryption market, believing that the skills of trading and Risk Management are crucial in this market. He pointed out that successful traders are usually able to adapt flexibly to market changes, which contrasts with the long-term thinking of risk investors. Risk investors often react slowly to market price changes and may miss the best trading opportunities.
• Jeff added that as the head of Alpha strategies at Bitwise, his team is dedicated to seeking unique investment returns through a framework of multiple strategies and managers. He emphasized that the inherent volatility of the encryption market is one of its characteristics, and this volatility provides opportunities for professional investors.

Market Structure and Future Outlook

• David discussed the structural changes in the encryption market, believing that historical experience may be misleading. With the influx of venture capital, the initial token price of the market is affected, leading to higher entry costs for liquidity investors. He believes that many investors currently lack sufficient funds to make effective investments when facing market fluctuations.
• Yano mentioned that many funds fully allocate their funds in the bull market, leading to ineffective response during market downturns.
• David believes that investors need to re-evaluate their investment portfolios to cope with different market cycles and recommends adopting flexible strategies to seize new investment opportunities.
• Jeff also pointed out that investors are often influenced by traditional venture capital thinking when choosing managers, and overlook the unique value capture mechanism of the encryption market. He believes that the encryption market relies not only on the investment of financial capital, but also the contribution of social capital and human capital, providing investors with new perspectives and opportunities.

Liquidity Provider’s Focus

Investors’ High Return Expectations

• Santi mentioned that when selling to Liquidity Providers (LPs), investors usually expect extremely high returns, such as 30x returns. They are not concerned about the specific investment strategy or governance participation, but hope to obtain returns that match the historical returns. This mentality makes it challenging for many managers to sell to LPs because they need to prove that their strategies can achieve these expected returns.

The Relationship Between Returns and Volatility

• David further pointed out that Liquidity Providers are more focused on following returns within the range of volatility, rather than pursuing maximized returns. The current capital allocation process is often limited to managers who align with investor thinking, leading to a lack of effective return models in the market. Many investors hope to keep most of their funds in cash and then invest a small amount in encryption, but such a strategy needs to be packaged in a suitable manner, otherwise it will be deemed unfeasible.

Clarity of Investment Strategy

• Santi emphasizes the need for managers to clearly distinguish whether their investment strategy comes from Hedging funds or venture capital, especially when pitching to LPs. If the strategy is seen as “liquid venture capital,” investors may feel confused and choose to give up. Therefore, managers need to clearly convey the nature and objectives of their investment strategy.

Psychological Factors and Risk Management

• David points out that psychological factors play an important role in trading. Successful trading relies not only on market knowledge but also on a profound understanding of Risk Management. He mentioned that many managers from the TradFi industry may not possess the necessary trading skills, which makes them face challenges in the encryption market. Effective Risk Management can be an advantage, and trading itself is a psychological game that requires flexible responses.

Structural issues with investment vehicles

• Jeff mentioned that the structure of investment vehicles is crucial to the appeal to investors. Open-end structures have different incentive mechanisms from closed-end funds, which may have advantages in Risk Management. However, structural issues in the current market, such as annual expense burdens, can cause investors to feel disappointed after experiencing significant Fluctuation. Therefore, managers need to consider how to design investment vehicles to better meet the needs of investors.

Comparison between the liquid market and the private sale market

New Trading Mentality and Financialization

• Jeff mentioned that with the development of the encryption market, new trading mentality and financialization trends are emerging. For example, the launch of BTCETF may bring more derivatives trading, such as Options. The integration of these TradFi trading tools with the encryption market will gradually increase, providing more pathways for Risk Management trading solutions. He believes that choosing the right investment vehicles structure to align with Liquidity Providers (LP) is a key issue that may not have received sufficient attention in the past but is expected to be improved in the future.

Lack of trading skills and data points

• David emphasized that successful trading requires special skills. He mentioned that although some people may have rich experience in TradFi fields such as oil trading, it does not mean that they can successfully carry out encryption trading. He pointed out that the lack of appropriate data points makes it difficult to evaluate the ability of traders. In addition, trading is not only a combination of technology and strategy, but also involves understanding emotional management and cognitive biases. He expressed doubts about those who can effectively manage their emotions and formulate trading plans.

Emotional Management and Trading Plan

• David further discussed the importance of emotional management in trading. He believes that only a few traders have enough discipline and emotional self-awareness to effectively use their cognitive biases to formulate trading plans.

The importance of psychological advantage

Psychological Factors in Trading

• Santi mentioned that in conversations with other traders, the most commonly discussed questions are “What am I not seeing right now? What biases do I have?” This introspective way of thinking is crucial in trading, especially in complex markets. Managing emotions and cognitive biases are considered key to successful trading, and this psychological advantage is particularly prominent in the encryption market.

Cognitive Biases and Market Behavior

• David emphasizes that psychological advantage is the most significant advantage in the encryption market. He mentioned that many traders are easily influenced by cognitive biases when experiencing market Fluctuation. For example, investors may choose not to sell assets again because of previous losses, leading to continued holding of losing assets when the market falls. Such behavior reflects people’s emotional response to losses, often leading to irrational decisions.

Reflection and Market Response

• David further discussed the market’s reaction mechanism, emphasizing the reflexivity of the market. The feedback loop between price changes and fundamentals will affect investors’ decisions. For example, when the BTC price pumps, market sentiment becomes optimistic, leading to more investors entering the market, further driving up prices. This phenomenon is particularly evident in a bull market, and may lead to reverse emotions and decisions in a bear market.

Capital Protection and Risk Management

• Santi pointed out that many managers are often hesitant to inform Liquidity Providers (LPs) about their holdings of cash or major assets when faced with uncertainty. They worry that this will affect their relationship with LPs, but in reality, managers sometimes need to adopt a conservative strategy to protect capital in uncertain markets. Effective Risk Management and psychological advantage can help managers stay calm and make more rational decisions in market fluctuations.

Coping with Market Conditions

Changes in the investment environment

• Santi proposed how to adjust the psychological model to achieve market-beating performance in the past three to six months of challenging investment environment. Jeff responded that the importance of the multi-strategy investment approach was demonstrated in the past six months, especially in the current market conditions.

Advantages of Multi-Strategy Investment

• Jeff emphasized that using a multi-manager investment strategy can better cope with market fluctuations. He mentioned that different trading strategies, such as macro trading, trend strategies, and high-frequency trading, perform well in different time periods as the market changes. For example, with the launch of BTC ETF, macro trading and trend strategies driven by computers can capture market opportunities. At the same time, innovations in the Decentralized Finance field, such as Pendle and Athena, have also become the focus of investors’ attention.

Understanding Market Liquidity

• David mentioned that understanding the change in market Liquidity is key to successful investment. He pointed out that there is a significant difference in fund flow between the first and second quarters, which is particularly evident in the Liquidity indicators of BTC ETF and stablecoins. In addition, he emphasized that the market may experience technical selling pressure in certain situations, and investors need to carefully assess the risks.

Dynamic of old coins and new coins

• Santi discussed the performance of old coins, pointing out that some old coins are healthy in terms of circulation supply, while others have performed poorly in the unlocking process. He believes that the market has realized the impact of unlocking, and many investors tend to choose assets that have already been unlocked and have fundamental support when choosing assets.

Reflection and Future Outlook

• David mentioned that although many old coins have performed well in the past cycles, the future market may not attract investors as it did before. He believes that new investment opportunities will come from new projects and innovations, rather than just relying on past hot assets.

How to manage emotions in the market

Emotions and Market Reactions

• Santi proposed that quantifying the rise in the market is an important issue. Jeff explained their research method, mainly following two indicators: the ratio of Total Locked Value (TLV) to the Market Cap, and the weekly rise and engagement of users. These indicators can help investors identify assets that may face the risk of depreciation.

Reflexivity and Emotional Management

• David emphasizes that the reflexivity of the market means that certain factors, such as new Wallet creation and user rise, can significantly affect market sentiment and asset prices. When these factors change in the same direction, investors need to adjust their strategies in a timely manner. He mentioned that emotions play an important role in trading decisions, especially in market Fluctuation.

Identify Market Changes

• Santi believes that the key to understanding market changes is to recognize that he is not smarter than the market. He mentioned that many investors are prone to overconfidence when facing market changes, which can lead to decision-making errors. Instead, recognizing the complexity and uncertainty of the market can help investors better cope with challenges.

The Impact of Emotions on Decision Making

• When the market sentiment changes, investors often face the dilemma of whether to continue holding their positions. David believes that emotional management is the key to successful trading. He mentioned that investors need to devise a plan to deal with the fluctuation of market sentiment, rather than simply relying on intuition. Emotional fluctuation may lead to investors making wrong decisions, so identifying and managing these emotions is crucial.

Emotional Management in Practice

• Santi shared his experience in this cycle, emphasizing the importance of gradually increasing the position. He mentioned that although he sometimes missed the best time to get on board, by gradually increasing his position, he was able to get better returns when the market rebounded. This strategy helped him overcome the emotional pressure of not getting on board at the lowest point.

Is Cryptocurrency worth investing in?

The Importance of Liquidity

• Santi emphasizes that Liquidity is crucial in the cryptocurrency market, as it can disappear rapidly and also recover rapidly. He mentioned that in the current market environment, excessive trading may lead to losses, so he prefers to wait for the opportunity of Liquidity recovery.

Investment Strategies and Psychological Factors

• David believes that many investors do not actually crave Liquidity, as it means they need to trade frequently. He mentioned that many investors feel at a loss when faced with market Fluctuation, so they tend to avoid making decisions. In contrast, the risk tolerance in the TradFi market may be higher, as investors can usually wait for a longer time to see results.

Adapt to market changes

• Santi suggests that investors should learn to embrace Fluctuation instead of avoiding it. He advises that when faced with a market downturn, investors should view it as a buying opportunity and maintain cash flow to capitalize on these opportunities. At the same time, he emphasizes the need for investors to have a clear plan and adjust it based on market information.

Long-term Investment Perspective

• Jeff mentioned that despite the fierce competition in the encryption market, it still provides unique opportunities. He believes that Liquidity and volatility are factors that must be considered when investing in Crypto Assets. With the right strategy, investors can find profitable opportunities in the market. He also mentioned that good investment returns are often related to Liquidity risk, so it is very important to look for suitable investment opportunities in the encryption field.

Emotional Management and Decision-Making

• Santi mentioned that one of the challenges investors face in the encryption market is emotional management. He believes that understanding one’s emotions and learning to control them is key to successful investment. Many investors may become overly cautious after experiencing significant losses, so establishing good psychological resilience and investment habits is essential.