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

The following is the original content (for ease of reading and understanding, the original content has been slightly reorganized):

1. Introduction

In traditional Web2 companies, significant profits are usually 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 tied to the company’s long-term performance. However, in contrast, Web3 allows some market participants to quickly achieve high returns without the need for a project to achieve product-market fit (PMF) or demonstrate actual utility, because Liquidity acquisition is much easier.

Unlike 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. The weak correlation between success and exit in Web3 has led to significant misalignment of incentives, 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 enables not only profitable but also often unpunished “predatory” behavior.

If this issue is not addressed, the rise and popularity of the industry will be threatened, as predatory behavior is more incentivized and rewarded compared to long-term sustainable development. Despite the presence of 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. Incentive Misalignment Problem Description

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

In the field of encryption, the decision-making of market participants in different situations is often similar to the prisoner’s dilemma.

For example, when KOLs decide whether to disclose promotional activities, the considerations of centralized exchanges in setting Tokenlist standards or determining the valuation of listed tokens, the internal personnel of some Meme coins dumping a large amount of tokens in the early stage, or project founders quickly cashing out and abandoning the project through Over-the-counter Trading (OTC) after the token generation event (TGE). Many participants tend to extract value through short-term returns, although their long-term potential returns may drop as a result if the industry develops.

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

Logarithmic Utility of Wealth

As wealth increases, the marginal utility of additional wealth decreases non-linearly: the initial returns can significantly improve the quality of life, but the satisfaction derived 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, 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 need to be locked for 3 years. If the founder chooses to cash out early with a 60% discount on Over-the-counter Trading (OTC), they can still get enough funds to retire. However, continuing to hold and waiting for long-term returns that align with Product/Market Fit (PMF) carries higher risk: these tokens may be worth less than $4 million after 3 years. Even if the project is successful, the founder may choose the guaranteed $4 million, as the risk/reward of waiting for higher returns is not attractive enough.

“The more successful a project is, 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 as a result?

Misaligned Incentives Beneficiary

It is important to note that, usually in more advantageous positions, some people have the opportunity to profit from incentive misalignment, although this does not mean that they all have malicious intentions. In these groups, participants vary from good intentions to malicious motives.

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

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

3. Centralized Exchange: Although their incentives should be aligned with users, we often see CEXs extract value by listing tokens at overvalued prices, charging high listing fees, or listing low-quality assets, which goes against the interests of users.

4. Market Maker: Some market makers may leverage their advantageous position and team’s reliance on their service to negotiate highly favorable terms for themselves.

**5.KOLs：**We often see undisclosed promotional activities, misleading information, and designs to harvest short-term value of the audience ‘pumpdump’.

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 optimize their own profits.

Victim

retail investor: They often lack sufficient experience and information, becoming the “exit Liquidity” for more sophisticated participants. Lack of transparency, combined with some predatory behavior by certain groups, makes it more difficult for retail investors to participate in the liquid market.

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

Is the misalignment of incentives slowing industry progress?

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

3. On the Road to Incentivizing Consistency

Possible Solutions

a. Regulatory intervention:
Regulating behavior and ensuring transparency through laws and guidelines can contribute to the healthy development of the industry. However, achieving effective global regulation is nearly impossible due to the globalization and lack of a single governing authority in the cryptocurrency space. Furthermore, regulation is beyond our direct control, and even if we can promote it, implementation is not guaranteed and may be detrimental to the industry. Therefore, although appropriate regulation may help address incentive misalignment issues, we cannot rely solely on regulation in the short to medium term.

b. Do not act, wait for the market to self-correct: Emerging markets typically self-correct over time to address inefficiencies. However, in the encryption industry, the lack of regulation, transparency, and accountability makes self-correction more difficult. Many participants may not even be aware of the value extraction taking place. While self-correction has its role, it still needs improvement, 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, in the short to medium term, it may be the most practical solution. It requires the community to advocate for higher 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 to 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

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

· Commitment, roadmap, and progress of the public team

Centralized Exchange (CEX):

·Public Tokenlist standard, including listing fees and any related terms

Disclose any conflicts of interest.

· Provide transparency on upcoming Token-related information

Market Maker:

·Publicly make market protocol and related terms

Disclose incentive structure and potential conflicts of interest

· Release activity reports, including potential market impact

KOLs:

The financial relationship between the public and the project

Declaration of Token holdings or recent purchases

Public Paid Promotion Information

Participants Take Responsibility

Community Supervision: Encourage open discussions and criticisms of unethical behaviors.

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

Supporting Transparent Communities: Incentivize and encourage key market participants and independent researchers who promote greater transparency in the industry to continue providing transparent information.

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

Credit System: Build a public platform that allows 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 credibility ratings for key market participants.

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

5. Improving Tokenvesting Design

Tokenvesting plays a crucial role in shaping the incentive mechanism of market participants. The current common vesting designs fail to address the misalignment of incentives and even encourage value extraction behavior in many cases.

Key Design Requirements:

· Avoiding a situation where the circulation volume is too low during the Token Generation Event (TGE): The Token supply should be unlocked in a reasonable proportion 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 mode: Most projects can benefit from a flexible and unlimited Token supply, in order to mint more Tokens or continue minting as needed. The fixed supply mode originates from BTC, but most projects have completely different characteristics.

· Design convex revenue distribution for internal staff: Link the unlocking of tokens with 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 personnel unlocks are more conducive to incentivizing consistency, but caution is needed for 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 Tokens 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 cushioning, helping the team to 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: For example, product launch (completed Phase 2, Decentralization Sequencer).

20% Based on Performance: For example, continuous normal operation, throughput, and other long-term operational metrics.

10% based on key metrics: such as Total Value Locked (TVL), revenue, or the number of successful ecosystem applications.

·Ongoing Distribution: Linear + Target-Driven:

Linear distribution: 2% of Tokens are awarded to the team annually.

Goal-driven: An additional 3% will be distributed for every FDV exceeding 200 billion US dollars.

Advantages

· Success and exit are more closely related: Incentivize the founding team that intends to create high-quality projects, and link token unlocking to product development and project success.

· It is more difficult to exit early through Over-the-counter Trading (OTC): If the team plans to exit and abandon the project through OTC, it will be more difficult to achieve the goal, which may result in a larger discount and drop the intention to exit early.

**· Clear goals: **Transparent, quantifiable milestones increase a sense of responsibility while providing clear direction for efforts.

Challenge

·Prevent manipulation: Some key performance indicators (KPIs) may be manipulated, so careful selection is required.

·Execution Guarantee: A Decentralization governance process or objective third party is needed to ensure fair unlocking of the Token.

**· 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 relatively few practices in our industry that focus on target-driven unlocking. Relevant cases include:

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

UMA: In 2021, a KPI Options airdrop was made that can be redeemed based on the total locked value (TVL).

FIL: Some of its vesting is tied to the performance of the storage network.

While these attempts are innovative, they did not make goal-driven unlocking a core element in the vesting design at the outset, or only allocated a small portion of Token. MetaDAO seems to have adopted this concept at its core design, and hopefully more teams will try similar approaches in the future.

Is Tokenvesting applicable for 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 hybrid 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 when there is uncertainty in their implementation, the community cannot wait for the market to adjust automatically. Although in the long run, there may be more projects that achieve market fit (PMF) and better valuation frameworks, while ethical participants set an example and encourage others to follow suit, we can take immediate action to address incentive misalignment issues:

·Facing the problem: Recognize that misaligned incentives can weaken the long-term rise, innovation, and trust foundation of the industry.

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

**· Holding Bad Actors Accountable: **Encourage the community to stay vigilant and support actions to expose value extractors, and establish identification mechanisms.

Appeal for innovative Token vesting design: Explore 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 originally intended 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 issues pointed out in this article.

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