Original title: (Crypto’s Incentive Misalignment Problem)
Original author: Sergio Gallardo
Original translation: zhouzhou, BlockBeats
Editor's note: This article discusses the incentive misalignment issue in the cryptocurrency industry, pointing out that many market participants neglect long-term project success in favor of short-term gains, leading to improper allocation of capital and resources and undermining industry credibility. To address this issue, the article suggests increasing transparency, enhancing self-regulation, and optimizing token vesting design by setting clear project goals and incentive mechanisms to promote sustainable industry development.
The following is the original content (restructured for readability):
1. Introduction
In traditional Web2 companies, significant gains are often closely tied to the long-term success of the enterprise. Founders and early investors are incentivized to build sustainable businesses because their profitability is closely linked to the company's long-term performance. However, unlike this, Web3 allows some market participants to quickly obtain high returns without the project achieving product-market fit (PMF) or demonstrating actual utility, as liquidity acquisition is much easier.
Unlike initial public offerings (IPOs) in traditional finance, token generation events (TGEs) in Web3 can occur at any time without the project achieving specific milestones. This weak correlation between success and exit in Web3 leads to significant incentive misalignment, with many market participants pursuing short-term returns without the need for long-term success. The lack of transparency and regulation in the cryptocurrency realm allows 'predatory' behaviors to profit, often without punishment.
If this issue is not addressed, the growth and adoption of the industry will be threatened, as predatory behaviors are more incentivized and rewarded than long-term sustainable development. Although there are many well-intentioned individuals within the industry, this article aims to explore the problems caused by those who prioritize short-term interests over long-term considerations.
2. Description of the incentive misalignment issue
The 'tragedy of the commons' triggered by the prisoner's dilemma
In the crypto domain, market participants' decision-making in different contexts often resembles a prisoner's dilemma.
For instance, KOLs' decisions on whether to disclose promotional activities, CEXs' considerations when setting token listing standards or determining token listing valuations, some insiders of meme coins selling large amounts of tokens early, or project founders quickly cashing out through OTC after a token generation event (TGE) and abandoning the project. Many participants tend to extract value through short-term gains, even though their long-term return potential would decrease if the industry developed.
As the 'prisoner's dilemma' continues to arise, it often triggers the phenomenon of the 'tragedy of the commons'. This theory explains how individuals pursuing their self-interest can deplete shared resources, ultimately harming everyone. In the crypto domain, such predatory behaviors can lead to misallocation 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 declines non-linearly: initial gains can significantly improve quality of life, but further gains bring diminishing satisfaction. This concept is particularly important for market participants in assessing their incentives.
In many cases, pursuing short-term value can significantly improve financial conditions. However, the additional benefits of aligning with the project's long-term interests may be limited, further encouraging participants to prioritize short-term gains.
For example: Suppose the tokens held by founders 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 through OTC at a 60% discount, they could still secure enough funds to retire. The risk of waiting for long-term returns that achieve product-market fit (PMF) is high: 3 years later, that portion of tokens may be worth less than $4 million. Even if the project succeeds, the founder may choose the certain $4 million because the risk/reward of waiting for higher returns is not attractive enough.
'The more successful the project, the weaker the incentives for insiders to further drive its development. This explains why many projects gradually decline after moving from 0 to 1.' – Proph 3t of MetaDAO
Who benefits, and who is harmed?
Misaligned beneficiaries
It is important to note that typically in more advantageous positions, some individuals have the opportunity to profit from incentive misalignment, although this does not mean they all have malicious intent. Within these groups, participants range from good intentions to malicious motives.
1. Team and founders: They have control over project design, token economics, 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 yield higher returns, many VCs would also tend to choose this route.
3. Centralized Exchanges: Although their incentives should align with users, we often see CEX extracting value through overpricing tokens, charging high listing fees, or listing low-quality assets, which goes against user interests.
4. Market makers: Some market makers may leverage their advantageous position and teams' reliance on their services to negotiate terms that are extremely favorable to themselves.
5. KOLs: We often see undisclosed promotional activities, misleading information, and 'pump and dump' schemes designed to extract short-term value from audiences.
In most cases, participants in these groups are incentivized to maximize returns as they are essentially profit-driven. Therefore, it is reasonable to expect that they will act to optimize their own profits.
Victims
Retail investors: They often lack sufficient experience and information, becoming 'exit liquidity' for more sophisticated participants. The lack of transparency, combined with some groups' predatory behavior, makes it harder for retail investors to participate in liquid markets.
Long-term participants: Developers, community members, and investors committed to sustainable growth may feel disappointed by the prevalence of short-term behaviors. This can lead to talent loss and a lack of innovation in the industry.
Is incentive misalignment slowing down industry progress?
This is a subjective opinion, but I believe incentive misalignment is indeed slowing down industry development and posing risks for its future. If key market participants could focus on long-term goals, prioritize support for sustainable projects, and reduce the difficulty of short-term value extraction, the industry would benefit significantly, a theme that has been widely researched outside the cryptocurrency industry.
3. Moving towards incentive consistency
Possible solutions
a. Regulatory intervention:
Establishing laws and guidelines to regulate behavior and ensure transparency contributes to the healthy development of the industry. However, due to the globalization of cryptocurrency and the lack of a single jurisdiction, achieving effective global regulation is nearly impossible. Additionally, regulation is beyond our direct control, and even if we can advocate for it, implementation remains uncertain and may be detrimental to the industry. Therefore, while appropriate regulation may help address incentive misalignment issues, we cannot fully rely on regulation in the short to medium term.
b. Inaction, waiting 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 realize that value extraction is occurring. While self-correction has its place, improvements are needed, such as better valuation frameworks. Without greater transparency, market self-correction may be delayed, wasting significant time and resources.
c. Encourage self-discipline:
Although self-discipline is difficult and imperfect to implement, it may be the most feasible solution in the short to medium term. It requires the community to advocate for greater transparency by exposing bad actors to increase accountability and promote a culture of ethical behavior. Better self-discipline will help accelerate the market's self-correction process.
4. Encourage self-discipline: Transparency and accountability
The role of transparency
Enhancing transparency is crucial for reducing information asymmetry, increasing accountability for bad actors, and allowing the market to self-correct current issues more effectively.
Areas needing higher transparency
Founders/Venture Capital:
Increase transparency of internal address holdings
Disclose OTC sales or hedging strategies
Publicly disclose the team's commitments, roadmap, and progress
Centralized exchanges (CEX):
Public token listing standards, including listing fees and any relevant terms
Disclose any conflicts of interest
Provide transparency regarding upcoming token-related information
Market makers:
Publicly disclose market-making agreements and related terms
Disclose incentive structures and potential conflicts of interest
Publish activity reports, including possible market impacts
KOLs:
Publicly disclose financial relationships with projects
Relevant statements regarding token holdings or recent purchases
Publicly disclose paid promotion information
Hold participants accountable
Community oversight: Encourage open discussion and criticism of unethical behavior.
Example: Publicly condemn 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 continue providing transparent information.
Example: Provide resources and funding programs for independent researchers to recognize their contributions to industry transparency, ensuring they remain motivated.
Reputation system: Build a public platform where market participants can access information and understand the ethical behavior of key market players. This will ensure accountability and prevent predatory behaviors from going unnoticed.
Example: Establish a neutral agency to provide public reputation scores for key market participants.
It is worth noting that in some cases, the anonymity of participants can also increase the difficulty of accountability.
5. Improve token vesting design
Token vesting design plays a key role in shaping the incentive mechanisms of market participants. Current common vesting designs fail to address the misalignment of incentives and even exacerbate value extraction behavior in many cases.
Key design requirements:
Avoid too low circulating supply during token generation events (TGEs): A reasonable proportion of token supply should be unlocked early, primarily aimed at non-insiders while including a small portion of internally held tokens.
Move away from fixed token supply models: Most projects can benefit from flexible and unlimited token supplies to mint more tokens as needed or continue minting. The fixed supply model originates from BTC, but most projects have distinctly different characteristics.
Design convex reward distribution for insiders: Link token unlocks to project success to incentivize long-term behavior, similar to the incentive structures in traditional finance and IPOs.
Introduce a goal-based unlocking mechanism: Not all token unlocks need to be time-based. Milestone-based insider unlocks can incentivize consistency but need to be wary of manipulable indicators. This approach has not been fully explored and is worth trying.
Example: Token vesting design allocated by Ethereum L2 project team
This is an example intended to provide general guidance rather than an exact design framework.
20% over 4 years in linear vesting: Allow the team to sell part of the tokens when needed, which is particularly beneficial for founding teams with 99% of net assets locked in tokens, as partial cashing out can provide significant financial buffer and help the team focus on long-term development.
80% Goal-based allocation:
30% based on valuation: Unlock 1% whenever fully diluted valuation (FDV) increases by $1 billion between $1 billion and $10 billion; unlock 2% for every additional $1 billion above $10 billion, based on long-term moving averages.
20% based on delivery: For instance, product launch (completion of phase 2, decentralized sequencer).
20% based on performance: For example, continuous normal operation, throughput, and other long-term operational metrics.
10% based on key indicators: For example, long-term locked value (TVL), revenue, or the number of successful ecosystem applications.
Continuous issuance: Linear + goal-driven:
Linear issuance: 2% of tokens annually incentivize the team.
Goal-driven: An additional 3% issued for every $20 billion increase in FDV.
Advantages
Success is more closely linked to exits: Incentives aim to create quality projects, with token unlocks tied to product development and project success.
More difficult to exit early through OTC: If teams plan to exit via OTC and abandon the project, achieving goals will be more challenging, potentially leading to larger discounts and reducing the willingness to exit early.
Clear goals: Transparent, quantifiable milestones increase accountability while providing a clear direction of effort.
Challenges
Prevent manipulation: Some key performance indicators (KPIs) may be manipulated, so careful selection is necessary.
Execution assurance: A decentralized governance process or objective third party is needed to ensure fair token unlocks.
Choose appropriate goals: Goals should be related to the long-term success of the project and reflect varying degrees of complexity.
Currently, there are relatively few practices targeting goal-driven unlocking in our industry. Related cases include:
Algorand: In 2019, extended the vesting period to 5 years but allowed for early unlock based on token valuation.
UMA: Airdropped KPI options in 2021 that can be redeemed based on total locked value (TVL).
Filecoin: Some of its vesting is linked to the performance of the storage network.
While these attempts are quite innovative, none have made goal-driven unlocking a core element in the early vesting design or allocated only a small portion of tokens. MetaDAO seems to have adopted this concept in its core design, hoping more teams will attempt similar methods in the future.
Is token vesting applicable to early investors?
Early investors also need to align with long-term goals, but they have less control over achieving specific milestones. A hybrid approach may be more appropriate (such as 50% linear and 50% goal-driven allocation, rather than the team's 20%-80%).
6. Conclusion: Call to action
As we cannot fully rely on regulations, especially when there is uncertainty in their implementation, the community cannot wait for the market to self-adjust. While more projects may achieve product-market fit (PMF) in the long run, emerging better valuation frameworks, and ethical participants serving as role models to encourage others, we can take immediate action to address misalignment of incentives:
Confront the issue: Recognize that incentive misalignment may undermine the long-term growth, innovation, and trust foundation of the industry.
Promote transparency: Require all market participants to disclose information, reducing information asymmetry and thereby facilitating more informed decision-making.
Hold bad actors accountable: Encourage the community to remain vigilant, support actions to expose value extractors, and establish recognition mechanisms.
Call for innovative token vesting design: Explore goal-driven unlocking, continuous issuance, unlimited token supply, and convex reward distribution methods to better incentivize long-term behavior.
Improvements in these areas will increase the likelihood of sustainable project success, driving the long-term development of the industry. Finally, it is worth mentioning that I initially hoped to conduct a more quantitative analysis of value extraction in the industry, yet the lack of transparency has made it impossible to obtain relevant data, which reflects the issues pointed out in this article.
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