Is unlocking equivalent to dumping? How to solve the problem of misaligned incentives in the encryption industry?

Original Title: 《Crypto’s Incentive Misalignment Problem》

Original author: Sergio Gallardo

Original translation: zhouzhou, BlockBeats

Editor’s Note: This article discusses the issue of misalignment of incentives in the cryptocurrency industry, pointing out that many market participants overlook the long-term success of projects in favor of short-term gains, leading to improper allocation of capital and resources and weakening industry credibility. To address this problem, the article suggests increasing transparency, strengthening self-regulation, optimizing token vesting design, and promoting industry sustainable development by setting clear project goals and incentive mechanisms.

The following is the original content (slightly rearranged for better understanding):

1. Introduction

In traditional Web2 enterprises, significant returns are usually closely linked to the long-term success of the enterprise. Founders and early investors are incentivized to build sustainable businesses because their profitability is closely tied to the long-term performance of the company. However, in contrast, Web3 allows some market participants to achieve high returns relatively quickly without the need for the project to achieve product market fit (PMF) or demonstrate actual utility, because Liquidity acquisition is much easier.

Different from the Initial Public Offering (IPO) in TradFi, the Token Generation Event (TGE) in Web3 can be conducted at any time without the project reaching specific milestones. This weak correlation between success and exit in Web3 has led to significant incentive misalignment issues, with many market participants pursuing short-term returns without the need for long-term success. The lack of transparency and regulation in the Cryptocurrency field allows for not only profitable but also often unpunished “predatory” behavior.

If this issue is not resolved, the rise and popularization of the industry will be threatened, as predatory behavior is more incentivized and rewarded than long-term sustainable development. Although there are well-intentioned individuals in the industry, this article aims to explore the problems caused by those who prioritize short-term gains over long-term considerations.

2. Description of Incentive Misalignment Issue

The “tragedy of the commons” triggered by the prisoner’s dilemma

In the encryption field, market participants’ decisions in different situations often resemble prisoner’s dilemma.

For example, KOL’s choice when deciding whether to disclose promotional activities, the considerations of centralized exchanges in setting Tokenlist standards or determining the valuation of Token listing, some insiders of Meme coin dumping a large amount of Token in the early stage, or project founders quickly cashing out through Over-the-counter Trading (OTC) and abandoning the project after the Token Generation Event (TGE). Many participants tend to extract value through short-term gains, although if the industry develops, their long-term potential returns may drop as a result.

With the continuous occurrence of the prisoner’s dilemma, it often triggers the tragedy of the commons. This theory explains how individuals deplete shared resources while pursuing their own interests, ultimately causing harm to everyone. In the field of encryption, such predatory behavior can lead to the incorrect allocation of capital and other resources, hinder the development of sustainable projects, and damage the industry’s reputation.

Logarithmic Utility of Wealth

As wealth increases, the marginal utility of additional wealth decreases non-linearly: initial returns can significantly improve quality of life, but the satisfaction from further returns gradually diminishes. This concept is particularly important for participants in the crypto market when evaluating 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, further encouraging 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 they need to be locked for 3 years. If the founder chooses to cash out early through Over-the-counter Trading (OTC) at a 60% discount, they can still obtain enough funds to retire. However, there is a higher risk in continuing to hold and waiting for long-term returns when the product-market fit (PMF) is achieved: after 3 years, this portion of tokens may be worth less than $4 million. Even if the project is successful, the founder may choose the guaranteed $4 million because the risk/return of waiting for higher returns is not attractive enough.

“The more successful the project is, the weaker the incentive for insiders to further drive its development. This explains why many projects gradually decline after going from 0 to 1.” - Proph 3 t of MetaDAO

Who benefits and who is harmed?

Misplaced Incentives Beneficiary

It should be noted that often, certain individuals have the opportunity to profit from incentive misalignment in more advantageous positions, although this does not mean that they all have malicious intentions. Among these groups, participants range from good intentions to malicious motives.

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

2. Venture Capital Firms: Early-stage capital allocation is crucial. If investing in unsustainable short-term projects and exiting early can bring higher returns, many venture capitalists would also tend to choose this approach.

3. Centralized Exchange: Although their incentives should be aligned with users, we often see CEX extracting value in ways that violate user interests, such as listing tokens at overvalued prices, charging high listing fees, or listing low-quality assets.

4. Market Makers: Some market makers may leverage their advantageous position and team reliance on the services to negotiate highly favorable terms for themselves.

5.KOLs: We often see undisclosed promotional activities, misleading information, and designs that harvest short-term value from the audience in a “pumpdump” manner.

In most cases, participants in these groups are incentivized to maximize returns, as they are essentially profit-driven. Therefore, it is reasonable to expect them to seek ways to optimize their own profits.

Victim

retail investors: They often lack sufficient experience and information to become an “exit liquidity” for more complex players. The lack of transparency, combined with the predatory behaviour of some groups, makes it more difficult for retail investors to participate in the liquid market.

Long-term participants: Developers, community members, and investors committed to sustainable rise may be disappointed by the prevailing short-term behavior. This could lead to talent drain and a lack of industry innovation.

Is the incentive misalignment slowing down industry progress?

This is a subjective viewpoint, but I believe that incentive misalignment does slow down industry development and expose it to future risks. If key market participants can focus on long-term goals, prioritize supporting sustainable projects, and reduce the difficulty of extracting short-term value, the industry will benefit greatly, a theme that is widely researched not only in the Cryptocurrency industry but also outside it.

3. On the Path to Consensus Incentives

Possible Solutions

a. Regulatory intervention:

By establishing laws and guidelines to regulate behavior and ensure transparency, it helps promote the healthy development of the industry. However, due to the globalization of Crypto Assets and the lack of restrictions from a single jurisdiction, achieving effective global regulation is almost impossible. In addition, regulation is beyond our direct control, even if we can promote it, implementation is still not guaranteed and may be detrimental to the industry. Therefore, although appropriate regulation may help address incentive misalignment issues, in the short to medium term, we cannot rely entirely on regulation.

b. Non-action, waiting for the market to self-correct:

Emerging markets typically self-correct over time to address inefficiencies. However, in the encryption industry, a lack of regulation, transparency, and accountability makes self-correction more challenging. Many participants may not even be aware of the value extraction taking place. While self-correction serves a purpose, improvements are still needed, such as better valuation frameworks. Without greater transparency, market self-correction may be delayed, wasting a significant amount of time and resources.

c. Encourage self-discipline:

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 market’s self-correcting process.

4. Encourage self-discipline: transparency and accountability

The Role of Transparency

Enhancing transparency is crucial for reducing information asymmetry, improving accountability for bad actors, and enabling the market to self-correct current issues more effectively.

Areas that Require Higher Transparency

Founder/Venture Capital:

• Increase transparency of internal Address holdings
• Disclosure of Over-the-Counter (OTC) Sales or Hedging Strategies
• Commitments, roadmaps, and progress of the public team

Centralized Exchange (CEX):

• Open Tokenlist standard, including listing fees and any related terms
• Disclose any conflicts of interest
• Provide transparency in the information related to upcoming Token listings

Market Maker:

• Public Market-making Protocol and Related Terms
• Disclosure of incentive structure and potential conflicts of interest
• Release activity report, including potential market impact

KOLs：

• Publicly disclose the financial relationship with the project
• Declaration of Token holdings or recent purchases
• Public Paid Promotion Information

Let participants take responsibility

Community Supervision: Encourage open discussion and criticism of unethical behavior.

Example: Publicly condemn key market participants on the community platform for lack of transparency or engaging in predatory behavior.

Transparent Group Support: Key market participants and independent researchers who contribute to making the industry more transparent should be rewarded and incentivized to continue providing transparent information.

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

Reputation System: Building a public platform that enables market participants to access information and understand the ethical behavior of key market participants. This will ensure accountability and prevent predatory behavior from going unnoticed.

• Example: Establish a neutral institution to provide public credit ratings for key market participants.

It is worth noting that in some cases, the anonymous identity of participants also increases the difficulty of accountability.

5. Improving Token Vesting Design

Token vesting plays a key role in shaping the incentive mechanism for market participants. The current common vesting designs have failed to address the problem of incentive misalignment, and even in many cases have encouraged value extraction behavior.

Key Design Requirements:

Avoiding excessively low circulation during token generation events (TGE): A reasonable proportion of token supply should be unlocked as early as possible, mainly targeting tokens held by 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 unlimited Token supply, so that more Tokens can be minted or minting can continue as needed. The fixed supply model originated from BTC, but most projects have completely different characteristics.

Designed for internal personnel’s convex revenue distribution: Unlocking tokens is tied to project success to incentivize long-term behavior, similar to the incentive structure of TradFi and IPOs.

Introducing target-based unlocking mechanism: Not all Token unlocks need to be time-based. Milestone-based internal staff unlocking is more able to motivate consistency, but beware of certain manipulable metrics. This approach has not been fully explored and is worth trying.

Example: Tokenvesting Design for ETH L2 Project Team Allocation

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

• 20% linear vesting over 4 years: Allows the team to sell a portion of the Token when needed, which is particularly beneficial for the founding team with 99% of the net assets in Lock-up Position Tokens. Partial cashing out can provide significant financial cushion and help the team focus on long-term development.
• 80% target-based allocation:

30% based on valuation: Whenever the Fully Diluted Valuation (FDV) increases by $1 billion within the range of $10 billion to $100 billion, 1% will be unlocked; for every $10 billion beyond $100 billion, 2% will be unlocked, based on the long-term moving average.

20% Based on delivery: such as product launch (Completion of Phase 2, Decentralization Sequencer).

20% based on performance: such as continuous normal operation, throughput, and other long-term operational indicators.

10% based on key metrics: such as total value locked (TVL), revenue, or the number of successful ecosystem applications.

• Continuous distribution: linear + target-driven:
• Linear distribution: 2% of the Tokens are rewarded to the team annually.
• Objective-driven: For every 20 billion USD exceeded by FDV, an additional 3% will be distributed.

Advantages

• Success and exit are more closely associated: Incentives are intended to build a high-quality project founding team, and Token unlock is linked to product development and project success.
• Harder to exit early via Over-the-counter Trading (OTC): If the team plans to exit through OTC and give up the project, achieving the goal will be more difficult, which may lead to increased discounts and thus deter the willingness to drop out early.
• Clear objective: Transparent and measurable milestones increase accountability while providing clear direction for efforts.

Challenge

• Preventing manipulation: Some key performance indicators (KPIs) may be manipulated, so careful selection is required.
• Execution Guarantee: Requires a governance process of Decentralization or an objective third party to ensure fair unlocking of Tokens.
• Choose the right target: The target should be related to the long-term success of the project and reflect different levels of complexity.

Currently, there are few practices in our industry that focus on target-driven unlocking. Relevant cases include:

Algorand: The vesting period has been extended to 5 years in 2019, but unlocking based on Token valuation is allowed.

UMA: In 2021, a KPI Options was airdropped that can be redeemed based on the Total Value Locked (TVL) value.

**FIL：**Some vesting is linked to the performance of the storage network.

Although these attempts are innovative, they did not prioritize goal-driven unlocking as a core element in the vesting design during the initial stage, or only allocated a small portion of Tokens. MetaDAO seems to have embraced this concept in its core design, hoping that more teams will try similar approaches in the future.

Is Tokenvesting applicable to early investors?

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

6. Conclusion: Call to Action

As we cannot rely solely on regulations, especially in situations where there is uncertainty in their implementation, the community cannot wait for the market to adjust automatically. While in the long run, there may be more projects that achieve market fit (PMF) and better valuation frameworks, while also respecting the role of ethical participants as role models to encourage others to follow suit, **we can take immediate measures to address the problem of incentive misalignment: **

• Facing the problem: Recognizing that incentive misalignment may weaken the long-term rise, innovation, and trust foundation of the industry.
• Promoting Transparency: Requiring all market participants to disclose information, reducing information asymmetry, and promoting wiser decision-making.
• Hold bad actors accountable: Encourage the community to remain vigilant, support actions to expose value extractors, and establish identification mechanisms.

Appeal for innovative Tokenvesting design: exploring methods such as target-driven unlocking, continuous distribution, unlimited 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 drive long-term industry development. Finally, it is worth mentioning that I had hoped to conduct a more quantitative analysis of value extraction in the industry. However, the lack of transparency makes it impossible to obtain relevant data, which also reflects the problem pointed out in this article.

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