Can a Nobel Prize winner help banks navigate the bitcoin craze?

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The ability to forecast the future accurately is obviously very important for success in banking — but it’s not very easy to do.

There were not many who predicted the financial crisis, yet there were outsize rewards for those who did. And predicting the financial future is becoming even more difficult as new technology continues to disrupt the economic landscape.

Cryptocurrencies are the current challenge of the day. The ability to predict their future and that of other technologies is likely to be an important factor for success in banking and trading over the next decade. Accurate predictions can lead to good strategy and business success — and an effective analytical framework for forecasting is critical.

The psychologist Daniel Kahneman, one of the founders of behavioral economics, wrote in 2011 about how he stumbled across an analytical framework for prediction after working on a project to develop a high school textbook for the Israel Ministry of Education.

The team, looking at its own set of activities and the planned scope of work, concluded that it would take just over two years to complete the project. This was the “inside view” prediction.

As a gut check, Kahneman asked a curriculum expert about similar projects and how long they had taken. He was told that 40% failed to be completed altogether and the average length of time for completion — among those that finished the work — was seven years. This was the “outside view” that provided an external basis for prediction.

Kahneman writes that the team completed the project in eight years. The inside view proved an inadequate frame of reference for the question; the outside view was a more accurate predictor.

This model could prove to be a useful indicator, for example, when assessing the duration of major IT programs. How many banks, when entering the implementation phase of a major program, put out a timeline to key stakeholders before they have taken a proper look at the outside view? In my experience, it is invariably the case that banks and their project managers take an inside view, without carefully benchmarking against the duration of similar projects.

When it comes to cryptocurrencies, it is not clear if investors are properly assessing these risks to arrive at an assessment of the true long-term future of digital currencies. Using this same framework, the outside view should be used to assess the future of cryptocurrencies as a whole to develop a position on the risk versus reward of such trades.

The outside view should consider all the issues that will impact the future of cryptocurrencies as a whole. This might include their utility, their ability to store value, their rapid propagation, concerns regarding their use for money laundering and their high level of volatility. The class as a whole has pluses and minuses that will most likely affect every new cryptocurrency. The outside view allows those evaluating the trend to look at a set of similar opportunities or products to identify a future prognosis for the specific case that considers historical precedent.

This is far from easy, however.

Would it be fair to compare a new cryptocurrency to bitcoin, for example? Given that bitcoin is still hardly a mature product, that is probably not sufficient. While it gives fair warning of the volatility ahead, bitcoin itself is still evolving. Could sovereign currencies be a precedent? This seems unlikely to be the case as they are guaranteed by a central bank, have an everyday utility, do not exhibit the same level of volatility and can be easily accessed and exchanged. Could precious metals like gold and silver be used as a comparison set? Again, there are superficial comparisons, but their proven ability to hold value is probably not a fair comparison.

What of the internet investment bubble of the late 90s? While many internet companies shone brightly for a short time, companies like Amazon and eBay have proven that there was value there for the long-term. If the internet bubble is a good comparison, the outside view would suggest that some type of investment in cryptocurrencies would be of long-term value to investors and so developing expertise in trading them would makes sense over the long-term. The inside view then would attack the details to determine what specific product or approach — some type of hedging strategy, for instance — would make sense to secure long-term value in a new cryptocurrency product.

It’s worth noting that I don’t intend the discussion above to be a recommendation for or against an investment in digital currencies. Instead, it’s an illustration for how this framework can be useful to bankers in setting business strategy. Much of the chatter around bitcoin and other cryptocurrencies appears to come from two opposing viewpoints: the first seems overly optimistic and naive, while the second appears overly skeptical and pessimistic. A sober analysis is needed from the finest analysts that considers both the potential positive benefits of this new product as well as the potential downsides.

Change is occurring more quickly than ever, and the financial crisis — especially for those banks that held on too long to those subprime mortgage assets — illustrated the costs of getting it wrong and following the trends without stopping to think through the true value of the products being sold.

The lesson for those in banking: Be sure to take the inside view only after you understand the outside view.

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