Unlocking means dumping the market? An in-depth analysis of the incentive misalignment in the crypto industry

Original title: "Crypto's Incentive Misalignment Problem"
Original author: Sergio Gallardo
Original translation: zhouzhou, BlockBeats

Editor's note:This article discusses the incentive misalignment problem in the cryptocurrency industry, pointing out that many market participants ignore the long-term success of projects for short-term gains, resulting in improper allocation of capital and resources and weakening the credibility of the industry. To solve this problem, the article recommends increasing transparency, strengthening self-regulation, optimizing token attribution design, and promoting sustainable development of the industry by setting clear project goals and incentive mechanisms.

The following is the original content (the original content has been reorganized for easier reading and understanding):

1. Introduction

In traditional Web2 companies, significant returns are often closely linked to the long-term success of the company. Founders and early investors are incentivized to build sustainable businesses because their profitability is closely linked to the company's long-term performance. However, in contrast, Web3 allows some market participants to earn high returns relatively quickly without requiring projects to achieve product-market fit (PMF) or demonstrate actual utility, as liquidity is much easier to acquire.

Unlike initial public offerings (IPOs) in traditional finance, Token Generation Events (TGEs) in Web3 can occur at any time, without requiring projects to reach specific milestones. This weak correlation between success and exits in Web3 has led to significant incentive misalignment issues, with many market participants pursuing short-term returns without long-term success. The lack of transparency and regulation in the cryptocurrency space has made it possible for “predatory” behavior to not only be profitable, but often go unpunished.

If this issue is not addressed, the growth and adoption of the industry will be threatened, as predatory behavior will be more incentivized and rewarded than long-term sustainable development. While there are many well-intentioned people in the industry, this article aims to explore the problems caused by those who are motivated by short-term gains without considering the long-term.

2. Description of the incentive misalignment problem

The "tragedy of the commons" caused by the prisoner's dilemma

In the crypto space, the decisions of market participants in different situations are often similar to the prisoner's dilemma.

For example, the choice of KOLs when deciding whether to disclose promotional activities, the considerations of centralized exchanges when setting token listing standards or determining token listing valuations, some Meme coin insiders selling a large number of tokens in the early stage, or project founders quickly cashing out and abandoning projects through over-the-counter (OTC) transactions after the token generation event (TGE). Many participants tend to extract value through short-term gains, even though their long-term return potential will be reduced if the industry develops.

As the Prisoner's Dilemma continues to emerge, it often leads to the "tragedy of the commons" phenomenon. This theory explains how individuals can deplete shared resources when pursuing their own interests, ultimately causing losses to everyone. In the crypto space, this type of predatory behavior can lead to the misallocation of capital and other resources, hinder the development of sustainable projects, and damage the industry's credibility.

Logarithmic Utility of Wealth

As wealth increases, the marginal utility of additional wealth decreases nonlinearly: initial gains can significantly improve the quality of life, but further gains bring diminishing returns. This concept is particularly important for crypto market participants as they evaluate their incentives.

In many cases, pursuing short-term value can significantly improve financial conditions. However, the additional benefits of choosing to align with the long-term interests of the project may have limited impact, which further encourages participants to prioritize short-term gains.

For example:Suppose the tokens held by the founder are worth $10 million shortly after the Token Generation Event (TGE), but are locked up for 3 years. If the founder chooses to cash out early at a 60% discount over-the-counter (OTC), he or she will still have enough money to retire. However, the long-term return of holding on and waiting for product-market fit (PMF) is riskier: these tokens may be less than $4 million in 3 years. Even if the project is successful, the founder may choose the certainty of $4 million because the risk/reward of waiting for a higher return is not attractive enough.

"The more successful the project, the weaker the incentive for insiders to further promote its development. This explains why many projects gradually decline after going from 0 to 1." - Proph3t of MetaDAO

Who benefits and who suffers?

Beneficiaries of Incentive Misalignment

It is important to note that some people, often in a more advantageous position, have the opportunity to profit from incentive misalignment, although this does not mean that they all have malicious intent. Within these groups, the various actors range from good intentions to malicious motivations.

1. Teams and founders:They have control over project design, token economics, and strategy, so they can choose to exit early without necessarily ensuring the long-term sustainability of the project.

2. Venture Capital Institutions:Early capital allocation is critical. If investing in unsustainable short-term projects and exiting early can bring higher returns, many VCs will also tend to choose this approach.

3. Centralized Exchanges:While their incentives should be aligned with their users, we often see CEXs extract value against their users’ interests by listing tokens at overvalued valuations, charging high listing fees, or listing low-quality assets.

4. Market Makers:Some market makers may use their advantageous position and the team’s reliance on their services to negotiate extremely favorable terms.

5. KOLs:We often see undisclosed promotions, misleading information, and “pump and dump” designed to harvest short-term value from their audience.

In most cases, participants in these groups are incentivized to maximize returns because they are essentially for-profit. Therefore, it is reasonable to expect that they will act in a way that optimizes their own profits.

Victims

Retail investors:They often lack sufficient experience and information to serve as “exit liquidity” for more sophisticated participants. Lack of transparency coupled with predatory behavior by some groups makes it harder for retail investors to participate in liquid markets.

Long-term participants:Developers, community members, and investors committed to sustainable growth may be frustrated by the prevalence of short-term behavior. This can lead to a loss of talent and a lack of innovation in the industry.

Is incentive misalignment slowing down industry progress?

This is a subjective opinion, but I think incentive misalignment is indeed slowing down the industry and putting its future at risk. The industry would benefit greatly if key market participants could focus on long-term goals, prioritize supporting sustainable projects, and make it easier to extract value in the short term, a topic that has also been widely studied outside the cryptocurrency industry.

3. The Path Towards Incentive Alignment

Possible Solutions

a. Regulatory Intervention:
The establishment of laws and guidelines to regulate behavior and ensure transparency can help the industry develop healthily. However, since cryptocurrencies are global and not subject to a single jurisdiction, effective global regulation is almost impossible. In addition, regulation is beyond our direct control, and even if we can promote it, implementation is still uncertain and may be detrimental to the industry. Therefore, while appropriate regulation may help address the problem of incentive misalignment, we cannot rely solely on regulation in the short to medium term.

b. Do nothing and wait for the market to self-correct:
Emerging markets typically self-correct over time to address inefficiencies. However, in the crypto industry, the lack of regulation, transparency, and accountability makes self-correction more difficult. Many participants may not even be aware of the value extraction that is taking place. While self-correction has its role, improvements are needed, such as better valuation frameworks. Without greater transparency, market self-correction may be delayed, wasting a lot of time and resources.

c. Encourage self-regulation:
Although self-regulation is difficult and imperfect to implement, it may be the most practical solution in the short to medium term. It requires the community to advocate for greater transparency, improve accountability by exposing bad actors, and promote a culture of ethical behavior. Better self-regulation will help accelerate the process of market self-correction.

4. Encouraging Self-Regulation: Transparency and Accountability

The Role of Transparency

Enhancing transparency is critical to reducing information asymmetry, increasing accountability for bad actors, and allowing markets to more effectively self-correct current problems.

Areas where more transparency is needed

Founders/VCs:

 · Increase transparency of internal address holdings

 · Disclose over-the-counter (OTC) sales or hedging strategies

 · Disclose team commitments, roadmaps, and progress

Centralized Exchanges (CEXs):

 · Disclose token listing criteria, including listing fees and any related terms

 · Disclose any conflicts of interest

 · Provide transparency about upcoming token listings

Market Makers:

 · Disclose market making agreements and related terms

 · Disclose incentive structures and potential conflicts of interest

 ·Publish activity reports, including possible market impact

KOLs:

 Disclose financial relationship with the project

 State token holdings or recent purchases when relevant

 Disclose paid promotion information

Hold participants accountable

Community monitoring:Encourage public discussion and criticism of unethical behavior.

 ·Example:Publicly denounce key market participants who lack transparency or engage in predatory behavior on community platforms.

Support groups that provide transparency:Key market participants and independent researchers who make the industry more transparent should be rewarded and incentivized to encourage them to continue to provide transparent information.

 ·Example:Provide resources and funding programs for independent researchers to recognize their contributions to industry transparency and ensure they remain motivated.

Reputation system:Build a public platform where market participants can obtain information and understand the ethical behavior of key market participants. This will ensure accountability and prevent predatory behavior from going undetected.

 · Example: Establish a neutral institution to provide public reputation scores for key market participants.

It is worth noting that in some cases, the anonymity of participants can also make it more difficult to hold them accountable.

5. Improve token vesting design

Token vesting design plays a key role in shaping the incentives of market participants. Current common vesting designs fail to address the problem of misaligned incentives and even encourage value extraction in many cases.

Key design requirements:

· Avoid low circulation during a token generation event (TGE): A reasonable proportion of token supply should be unlocked as early as possible, mainly for non-insiders, while also including a small portion of internally held tokens.

· Get rid of the fixed token supply model:Most projects can benefit from a flexible and uncapped token supply to mint more tokens as needed or continuously. The fixed supply model originated from BTC, but most projects have very different characteristics.

· Design convex revenue distribution for insiders:Tie token unlocking to project success to incentivize long-term behavior, similar to the incentive structure of traditional finance and IPOs.

·Introduce a goal-based unlocking mechanism:Not all token unlocking needs to be time-based. Milestone-based insider unlocking is more conducive to incentivizing consistency, but it is necessary to be wary of certain indicators that can be manipulated. This approach has not been fully explored and is worth trying.

Example: Token vesting design allocated by the Ethereum L2 project team

This is an example intended to provide general guidance rather than a precise design framework.

·20% linear vesting over 4 years:Allows the team to sell some tokens when necessary, which is particularly beneficial for founding teams whose net assets are 99% locked tokens. Partial cashing out can provide significant financial buffers and help the team focus on long-term development.

·80% Goal-based allocation:

30% Valuation-based:1% unlocks for every $1 billion increase in fully diluted valuation (FDV) between $1 billion and $10 billion; 2% unlocks for every $1 billion above $10 billion, based on a long-term moving average.

20% Delivery-based:e.g. product launch (completion of Phase 2, decentralized sequencer).

20% Performance-based:e.g. sustained uptime, throughput, and other long-term operational metrics.

10% Key Metric-based:e.g. long-term value locked (TVL), revenue, or number of successful ecosystem applications.

·Continuous distribution: linear + goal-driven:

 Linear distribution:2% of tokens per year to incentivize the team.

 Goal-driven:For every FDV exceeding $20 billion, an additional 3% will be distributed.

Advantages

·Success is more closely linked to exit:Founding teams that are interested in building high-quality projects are incentivized, and token unlocking is tied to product development and project success.

·It is more difficult to exit early through over-the-counter transactions (OTC):If the team plans to exit through OTC and abandon the project, it will be more difficult to achieve the goal, which may lead to larger discounts, thereby reducing the willingness to exit early.

· Clear goals: Transparent, quantifiable milestones increase accountability while providing a clear direction to work towards.

Challenges

· Prevent manipulation: Some key performance indicators (KPIs) can be manipulated, so they need to be carefully selected.

· Execution guarantees: A decentralized governance process or an objective third party is needed to ensure that tokens are unlocked fairly.

· Choose the right goals: Goals should be relevant to the long-term success of the project and reflect different levels of complexity.

Currently, there are few practices in our industry for goal-driven unlocking. Relevant cases include:

Algorand: Extended the vesting period to 5 years in 2019, but allowed early unlocking based on token valuation.

UMA:In 2021, it airdropped KPI options that can be redeemed based on the total value locked (TVL).

Filecoin:Part of its vesting is tied to the performance of the storage network.

While these attempts are innovative, none of them have goal-driven unlocking as a core element of the vesting design at the beginning, or only a small portion of the tokens are allocated. MetaDAO seems to have adopted this concept at the core of its design, and I hope more teams will try similar approaches in the future.

Is it suitable for token vesting of early investors?

Early investors also need to be aligned with long-term goals, but they have less control over achieving specific milestones. For this, a hybrid approach may be more suitable (such as a 50%-50% linear and goal-driven allocation, rather than 20%-80% for the team).

6. Conclusion: Call to Action

Because we cannot rely solely on regulation, especially when there is uncertainty about its implementation, the community cannot wait for the market to automatically adjust. While in the long run, more projects may achieve market fit (PMF), better valuation frameworks may emerge, and ethical actors may lead the way for others to follow,there are immediate steps we can take to address incentive misalignment:

· Face the problem:Recognize that incentive misalignment may undermine the industry’s long-term growth, innovation, and trust foundation.

· Promote transparency: Require all market participants to disclose information, reduce information asymmetry, and thus promote more informed decision-making.

· Hold bad actors accountable: Encourage the community to remain vigilant, support actions to expose value extractors, and establish identification mechanisms.

Call for innovative token vesting designs: Explore methods such as goal-driven unlocking, continuous issuance, uncapped token supply, and convex revenue distribution to better incentivize long-term behavior.

Improvements in these areas will increase the likelihood of sustainable project success and promote long-term development of the industry. Finally, it is worth mentioning that I would have liked to have a more quantitative analysis of value extraction in the industry, but the lack of transparency made it impossible to obtain relevant data, which also reflects the problems pointed out in this article.

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