Crypto’s Incentive Misalignment Problem

From sergiogallardo9 by Sergio Gallardo

Thanks to  Jordi Alexander ,  0xngmi ,  Proph3t  and  Hildobby  for reviewing the article and providing feedback, with special thanks to  Robin Davids  for the brainstorming over the past months.

1. Introduction

In traditional Web2 businesses, significant returns are typically linked to a company's long-term success. Founders and early investors are incentivized to build sustainable businesses because their ability to profit is closely tied to the company's performance over time. In contrast, Web3 often allows some market participants to secure large returns relatively quickly, without requiring the project to achieve PMF or demonstrate real utility, as access to liquidity is much easier. TGEs can occur at any time and do not require the project to meet specific milestones, unlike IPOs in TradFi.

The weak success-exit link in Web3 causes a significant incentive misalignment. Many market participants optimize for short-term returns that do not require a product to be successful in the long term. The lack of transparency and regulation in crypto allows value-extractive behaviors to be profitable and often go unpunished. If this issue is not addressed, it could pose a risk to the growth and adoption of our industry, as value-extractive behaviors will continue to be incentivized and rewarded over long-term, sustainable efforts.

There is no doubt there are plenty of well intentioned people in the space, this article aims to address the issue caused by those who are not.

2. Describing the Incentive Misalignment Problem

Prisoner's Dilemma Leading to the Tragedy of the Commons

In crypto, market participants often face a dilemma similar to the Prisoner's Dilemma when deciding how to act in various situations.

Examples include a KOL deciding whether to disclose a promotion, a CEX setting criteria for listing a token or determining its launch valuation, a memecoin insider dumping tokens early, or a founder exiting OTC shortly after TGE and abandoning their project. Many opt to extract value for short-term gains, even though this may reduce their potential for long-term returns if the industry grows.

As the Prisoner’s Dilemma keeps happening, it often leads to the Tragedy of the Commons, a theory explaining how individuals acting in self-interest can deplete shared resources, resulting in worse outcomes for everyone. In crypto, these value-extractive actions can misallocate capital and other resources, discourage sustainable projects, and harm the industry’s credibility.

The Logarithmic Utility of Wealth 

As wealth increases, the marginal utility of additional wealth decreases non-linearly: initial gains significantly improve well-being, but further gains offer diminishing satisfaction. This concept is particularly relevant to crypto market participants when evaluating their incentives.

In many cases, extracting short-term value can lead to significant financial improvement. However, the additional benefits of staying long-term aligned may be less impactful, further incentivizing participants to prioritize short-term gains.

Example: A founder’s token allocation is worth $10 million shortly after TGE but locked for 3 years. Exiting early through OTC at a 60% discount could still generate enough to retire. On the other hand, staying long-term and seeking PMF carries a high risk that the allocation might be worth less than $4 million in 3 years. Even if the project succeeds, providing the chance to exit for much more than $4 million, the founder may still prefer the guaranteed $4 million, as the risk/reward of waiting for higher returns is often not attractive.

“The more successful a project is, the weaker the incentive for insiders to make it even more successful. This explains why we have so many projects that make it from 0 to 1 and then slowly fade.”  – Proph3t from MetaDAO

Source: Fixing crypto’s incentives, for fun and for profit - Proph3t

Who Benefits and Who Suffers?

Beneficiaries of Misaligned Incentives

It’s worth noting that generally, those in more privileged positions have the most opportunities to benefit from these incentive misalignments, but this doesn’t necessarily mean that everyone in these groups acts maliciously. There is a spectrum from very well to very bad intentioned participants in each of these groups.

In most cases, participants in these groups are incentivized to maximize returns, as they are running businesses. It is therefore reasonable to expect them to act in ways that optimize their profits.

Those Who Suffer

Is the incentive misalignment slowing down the industry progress?

While this is a subjective view, I believe the misalignment of incentives is slowing down the progress of the industry and putting its future at risk. If key market participants adopted a longer-term focus, prioritized sustainable projects, and found it harder to extract value in the short term, the industry would benefit greatly. This topic has been  widely researched  in industries outside of crypto.

3. The Path Toward Incentive Alignment

Possible Approaches

a) Regulatory Intervention: 

The implementation of laws and guidelines to enforce better behavior and ensure transparency would benefit the industry. However, since crypto operates globally and isn’t governed by a single jurisdiction, enforcing effective global regulations is nearly impossible. 

Additionally, regulations are beyond our direct control. While we can advocate for them, there’s no guarantee they will be implemented, and they may not favor the industry. Therefore, although the right regulations would be helpful, we cannot rely solely on them to address incentive misalignment, especially in the short to medium term.

b) Doing Nothing and Waiting for Market Self-Correction: 

New markets tend to self-correct over time by addressing inefficiencies. However, in crypto, the absence of regulation, transparency, and accountability makes self-correction more challenging. Many participants may not even be aware of the value extraction occurring.

While self-correction plays a role, improvements such as better valuation frameworks are needed. However, without greater transparency, there is a real risk that self-correction may not occur or that it will waste significant time and resources.  

c) Encouraging Self-Regulation: 

Though self-regulation is difficult to implement and imperfect, it is likely the most practical solution in the short to medium term. It requires the community to advocate for greater transparency, hold participants accountable by exposing bad actors, and foster a culture of ethical behavior. Better self-regulation will likely accelerate the process of market self-correction.

4. Encouraging Self-Regulation: Transparency and Accountability

The Role of Transparency

More transparency is essential to reduce information asymmetry, enable greater accountability against bad actors, and allow the market to self-correct some of its current issues effectively.

Areas Needing Greater Transparency

Holding Participants Accountable

It's worth noting that in some cases, the anonymous identity of some participants can also make accountability more difficult.

5. Improving token vesting designs

Token vesting designs play a key role in shaping market participants’ incentives. The common designs we see today do not address the incentive misalignment problem and, in many cases, facilitate value extraction.

Key design requirements:

Example: Token vesting for a Team’s allocation in an Ethereum L2 

This is just an illustrative example, intended to provide general guidance rather than a precise framework.

Benefits:

Challenges:

There hasn’t been much testing of goal-based unlocks in our industry so far. Some of the most relevant ones have been:

While these experiments were interesting, none made goal-based unlocks a core part of their vesting design from the beginning, or only allocated a small portion to it.  MetaDAO appears to have embraced this concept at its core , and hopefully more teams will experiment with similar approaches.

Is this also applicable to early investor token vestings?

Early investors also need to be aligned with long-term goals but have much less control over achieving specific milestones. A mixed approach might be more suitable for them (e.g., 50-50% linear vs goal-based, rather than 20-80% for the team)

6. Conclusion: A Call to Action 

Since we cannot rely entirely on regulations, especially with their uncertain timeline, the community cannot afford to wait for the market to self-correct. While it’s possible that, over time, more projects will achieve PMF, better valuation frameworks will emerge, and respected key participants will lead by example, encouraging others to follow, there are steps we can take now to address the incentive misalignment problem:

Improvements in these areas will increase the likelihood that more sustainable projects are built and that our industry grows over time.

Finally, it is worth mentioning that I would have liked to conduct a more quantitative analysis of the value extraction in our industry. However, the lack of transparency made accessing much of the relevant data impossible, which reinforces the issues highlighted in this article.