Black Swan Event: How Does It Apply to the Crypto Market?

If you're interested in crypto or investing, there's a chance that you've heard someone talking about "black swan events." Though this term might sound like it's describing cute animals, the reality is a lot grimmer. Black swan events are certain types of catastrophic occurrences that come with disastrous consequences. If you want to protect your assets, it's essential to understand what a black swan event is and why it happens.

Key Takeaways:

• A black swan event is an unforeseen and extremely rare event that has severe consequences for the economy.
• There are three defining prerequisites for a black swan event: it’s statistically unlikely, has an extreme impact and is easy to rationalize.

What Is a Black Swan Event?

A black swan event is an unforeseen and extremely rare event that has severe consequences. It often causes significant economic damage and can be difficult to avoid. Though it's almost impossible to predict, in hindsight the consequences of a black swan event often appear obvious or inevitable.

How Does a Black Swan Event Work?

Black swan events come in all shapes and sizes, ranging from the 2008 real estate crash to World War I. What do these unexpected events have in common? There are three defining characteristics that all need to occur in order for a black swan event to happen:

• Statistically unlikely: A black swan event is always a statistical oddity. The probability of it occurring is low, and there may have been countless times in the past in which similar conditions failed to precipitate such events.
• Has an extreme impact: When a black swan event does occur, it has a tremendous impact on the world around it. This impact can be positive, but in most cases it’s catastrophic.
• Easy to rationalize: Despite the shocking surprise of a black swan event, people can look at such improbable incidents in hindsight and realize they could have been predicted. Instead of being due to completely random bad luck, in retrospect black swan events occur as part of a logical chain of events.

Black swan events tend to exist due to a combination of several different logical fallacies. First of all, humans have such a strong sense of pattern recognition that they often see them even when there are none. Observers may pick a few similar events in the past, and build up a narrative that these occurrences are somehow connected.

Due to the phenomenon of confirmation bias, people have a tendency to ignore data that doesn't fit their preconceived theories, instead paying close attention to data that does confirm their ideas. Furthermore, many make the mistake of assuming the past is always a reliable way to predict the future. They may assume such events will keep happening just because they've happened before — or they might assume other events are impossible, just because their opposite has previously occurred.

Why Is It Called a Black Swan Event?

This term gets its name from a very influential book by options trader Nassim Nicholas Taleb. Titled The Black Swan: The Impact of the Highly Improbable, this 2007 work explores statistical outliers and their effects on the economy.

Taleb explains that for hundreds of years, people assumed all swans were white. Therefore, black swans were seen as a sign of the improbable or impossible. However, this assumption was turned upside down when Europeans first visited Australia and were shocked to find black swans floating on their lakes.

This real-world lesson aptly illustrates the principle that has come to be called the black swan theory. There was no proof that black swans were impossible, yet people's experiences and biases led them to make false assumptions about how the world worked. In much the same way, investors can use faulty reasoning to successfully make a profit for decades, and yet unpredictable events can suddenly take place, proving their strategy was flawed and causing them severe consequences.

Past Black Swan Events in the Crypto Market

To better understand how the black swan theory affects the cryptocurrency market, it's helpful to take a look at some real-world examples. Following are five black swans that notably affected crypto investors.

FTX Goes Bankrupt

One of the most notable black swans of 2022 was the bankruptcy of FTX. In a complex series of events, this crypto exchange faced legal troubles, internal instability and an SEC investigation. Markets everywhere crashed as panicked users tried to liquidate their funds from the exchange, and many FTX users were unable to recover all of their money before the exchange closed.

Currently, industry experts predict that FTX still owes money to millions of users, despite recovering more than $7.3 billion in assets.

Move-to-Earn Games Soar in Popularity

Not all unexpected events are automatically disastrous. Every now and then, a black swan event actually has positive consequences. The move-to-earn black swan event started with STEPN, an app that lets people earn crypto by exercising. Thanks to the influence of such improbable events as the COVID-19 pandemic, move-to-earn went from an amusing footnote in the crypto world to a major player, its industry currently involving billions of dollars.

Yuga Labs Causes Record-High ETH Gas Fees

For an example of how a small black swan event can have a major impact on certain investors, take a look at the record-high ETH gas fees of May 2022. In March of that year Yuga Labs, the parent company of Bored Ape Yacht Club, announced a new project called Otherside. This project generated so much hype that when it went public, trading volume skyrocketed. Gas fees for Ethereum reached record highs of up to $7,000. Ultimately, investors wasted $175 million in gas fees for investments worth a total of only $100 million.

LUNA, USTC and BTC Simultaneously Plummet

Due to the ways in which certain cryptos are connected, unpredictable events can cause multiple coins to crash at once. In May 2022, a single Terra user with an enormous amount of UST (now known as USTC) sold off all their coins. This caused the capital pool for UST to collapse, and users began a run on the stablecoin. 

Unfortunately, as users redeemed their tokens for LUNA, they increased LUNA supplies, dropping its overall value. Furthermore, reserve funds for LUNA were held in BTC, so as Terra rushed to stabilize, massive BTC sell-offs led to further drops. Ultimately, Terra collapsed, and $45 billion worth of market capitalization was lost in a week.

Crypto’s Black Thursday

Of course, no list of notable black swan events is complete without a look at the COVID-19 pandemic. In March 2020, crypto markets everywhere crashed amid general panic about the new virus. Just one day after the World Health Organization officially recognized the pandemic, BTC’S value dropped by almost 50%. 

Other cryptos soon followed suit, and market caps decreased by 40% in a single day. For some investors, this spelled financial ruin. However, others were able to purchase valuable crypto at very low prices, resulting in major profits later on.

Can You Prepare for a Black Swan Event?

As you can see, black swan events are often disastrous for investors. Thousands of investors lose profits, and some even end up dealing with copious amounts of debt. If you don't want to be in this position, what can you do? Of course, by definition, you can’t predict a specific black swan situation before it occurs. However, a smart investor can create a strategy that helps them weather any number of unforeseen events.

Preparing for a black swan event is mostly about not relying too much on any given investment. Even if a crypto like Bitcoin seems too big to fail, there is inevitably some black swan event that could cause the unthinkable to occur. Therefore, it's essential to mitigate risk by diversifying your portfolio. Keep in mind that just buying several similar cryptos isn't enough to protect you from a financial crisis. There's always the chance of a new government regulation that affects all prices simultaneously. Therefore, having other styles of investments, such as NFTs and options, is wise.

Another thing to consider are the potential problems that could cause an investment to fail. For example, if a crypto's value is almost entirely backed by a single nation, problems in that nation alone could cause prices to plummet to irrecoverable lows. Ideally, select cryptos that are supported in multiple locations, tradable through multiple exchanges and not tied to any single asset or organization. You want to try to make sure that a single thing that goes wrong won't be enough to completely tank your investment.

The final way you can prepare for a black swan is simply to follow this basic investment advice: "Don't invest money you can’t afford to lose." While there is some truth to the idea of needing to spend money to make money, never overextend yourself. The best investors always keep some funds in reserve, so a single financial crisis doesn't entirely destroy their finances.

And as always, it’s essential to do your own research.

The Bottom Line

While every investor can benefit from thorough research and careful planning, the reality is that there’s always some inherent unpredictability that no one can account for. Even the most cautious investors can’t always prepare for random events that may impact their portfolios. However, smart moves like diversifying your portfolio and maintaining some liquid assets can help you avoid the most catastrophic consequences of a black swan event.

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