(Views expressed are personal opinions of the author and should not be construed as a recommendation or advice to engage in varying investments or trading strategies)
I recently had a conversation with slimelife about current market participants and their behavioral profiles. We agreed on a few characteristics.
note: the discussion pertains to genuine market investors, not spread bandits who trade opportunistically and run delta-neutral/funding extraction strategies.
First, it's almost like there are four distinct categories of market participants:
Sophisticated (1) Retail
Leader (2) Funds
Follower (3) Funds
Native (4) Retail
The sophisticated retail investors are early adopters driven by profit, willing to risk capital in hopes of gaining a stake in a L1/L2 or dApp ( via governance tokens).
The leading VCs participate in seeds, setting foundations, etc.. (Ex: Polychain, BlockTower, and others)
Following sophisticated use and establishing metrics, foundations seek an A round, attracting follower funds who often mimic investment decisions based solely on who participated in the seed (ie. lacking independent thought).
It’s easy to find examples of these funds as their primary investments are often non-seed and capital commitments at 9/10 figure valuations. They are most vocal regarding investments across socials.
This stage often sees a surge in valuation.
Following fundraising, the project gains traction in the narrative, attracting uninformed retail investors who enter the market without much understanding, typically buying tokens shortly after the token generation event (TGE).
When leading and following VCs exit together, the follower funds, often lacking in effective market mechanics and strategy, inadvertently cause damage through their selling actions to both retail investors and other institutional peers.
This is a broad framework to describe the psychology and institutional-side of the industry.
Tokenomics
Tokenomics are difficult. Increased complexity in token design amplifies development difficulty due to the intricate interplay of various components. Accordingly, many teams follow the vanilla framework, token = governance.
Governance mechanisms can be straightforward.
With that clarification, let's delve into the Ouroboros problem, how it pertains to the current cyclical nature of token longevity across L1s and L2s, and why it’s a problem that requires extensive research.
Ouroboros—
Foundations: Develop Idea or MVP (*Minimum Viable Product)
Venture Capital/Angels/FnF: Seed nascent product (@ high valuation multiple)
Retail/Prop (incl. Sybil): Provide capital + TVL in effort to be rewarded downstream later
Foundations: Fundraising (*Metrics / KPIs provided by retail growth)
Venture Capital: Series A with apparent PMF (Product Market Fit) due to metrics
Foundations: Use raise as marketing which attracts additional TVL from Retail/Prop/LF
Retail/Prop/LF: Heavy airdrop farming, providing revenue/DAU/etc. towards foundation
Foundations/Venture Capital: Series B to acquire > valuation (end game TGE)
Retail/Prop/LF: Continuous farming, TVL incline/plateau
Foundations: TGE + Airdrop
Retail/Prop/LF: Receive airdrop + Sale of airdrop
Foundations/Venture Capital: Disappointment with token PA, citing “entitlement”
— Recursive decay of airdrop quality
— Poor token longevity over time as early investors also sell token months/years later
This is the theme underlying the Ouroboros problem, yet there are nuances that have been overlooked.
The Head
Onchain retail power-users are smart - they have demonstrated significant acumen in navigating ecosystems. These are your airdrop farmers. They subscribe to niche platforms like Frog Capital for advanced insights on new token launches and other platforms for wallet tracking services, launches, platforms in development, and others. Pooling resources, they are able to generate edge within micro-communities.
Notably, a substantial number of these users have backgrounds in TradFi or experience working within crypto institutions. Despite their expertise, these users represent mercenary capital. Their primary objective is to earn tokens, and they are often willing to invest in nascent platforms in exchange for bounties, providing testing, feedback, and contributing to TVL and other metrics like DAU, fees, and more.
Users operating at this level risk capital of all sizes and are subject to capital loss via bugs, exploit and even rug pulls. They form a critical foundation for teams striving to establish legitimacy (albeit, often artificially) and achieve product-market fit. Their participation is essential for teams seeking to refine their products and gain traction in the market.
The Body
Builders require capital to bring their innovations to life. These teams depend heavily on early adopters to use their primitives and provide feedback on the functionality and viability of their products. While the ultimate goal for builders is to reap the benefits of their hard work, they also derive satisfaction from the development process itself.
At a certain point, these teams recognize that they have developed a product with value. This realization prompts them to establish a reputation, however, the revenue generated from initial users often falls short of providing sufficient runway for future growth. Consequently, these teams seek external funding to ensure continued development and expansion. They typically engage in multiple fundraising rounds to secure the necessary capital.
Upon securing these funds, the focus shifts to delivering value to the industry while also generating returns for their treasury and compensating their team. This additional value extraction gets facilitated through the issuance of tokens.
The Tail
Often driven by profit, not industry advancement. These are the individuals typically found at funds operating on 2/20 models, funneling capital from their LPs' pockets into their own, while making mimic investments. They are not first-movers.
*Not all VCs are vaporous, but there happens to be quite a few that are
The 2/20 model is a common fee structure used by funds. Here's a detailed breakdown for those who are unaware:
Management Fee (2%):
This is an annual fee based on the Assets Under Management (AUM).
It’s intended to cover the fund's OPEX (Operating Expenses)
Example: if a fund manages $100 million, the annual management fee would be 2% of $100 million, which equals $2 million.
Performance Fee (20%):
Also known as "carry" or "carried interest," this is a percentage of the fund's profits that exceed a specified hurdle rate.
The hurdle rate is the minimum return that the fund MUST achieve before the performance fee can be taken. The hurdle is often set at a specific percent-return.
Example: if the hurdle rate is 8% and the fund's return is 15%, the performance fee would be 20% of the excess return (15% - 8% = 7%). If the fund manages $100 million and achieves a 15% return, the profit would be $15 million. The excess over the hurdle rate (7%) would be $7 million, and the performance fee would be 20% of $7 million, which equals $1.4 million.
Here’s the kicker — These funds HAVE to utilize the cash they have on hand, otherwise it will be returned to LPs. Capital efficiency is the name of the game. This creates an incentive for fund managers to actively seek and invest in opportunities.
Due to this requirement, they will often copy-trade, and pile into peer-fund allocations, causing fundraising rounds to become oversubscribed (which can incite further FOMO).
Clawback Provisions: Some funds include clawbacks which require managers to return a portion of their performance fees if the fund underperforms, ensuring alignment with LP interests over the long term.
This competitive nature to seek returns, while managing significant capital creates a poor standard for builders — First, being that it illustrates popularity from a social-capital perspective, but second, it can inflate fundraising views and skew an inordinate amount of capital (thus, a second-order inflation of potential ego).
This is not good.
The Problem
I know I’m going to get got, but I’m going to get mine more than I get got, though.
Crypto comes in the purest form of “investing”. Why? Because it’s transparent. Product market fit has been a struggle outside of settlement-rail use and niche verticals, so while investors await real products, they look towards secondary venues that are resemblant of legitimate products to focus on capital generation.
Casino Games
You drive to the casino and notice a new table game. There are very few people playing this game. You decide to sit down, and you place a $1,000 bet. The stipulation of the game is that you either win cash or you win an unknown % of something from the casino.
You hang around and continue playing. More people enter the casino and begin playing the game alongside of you. The Casino tracks how often you and others are playing, the position sizing you are taking, and the cash rake they are receiving. They take this information to investors and raise capital on the basis that they can offer additional table games.
Investors decide they will provide the casino with capital at a $1B valuation.
You take your unknown allocation % to the cage early. You feel as though you’ve earned it because you fronted capital as a speculative bet. Investors and teams intend to profit off of this as well, but you have exited the queue first, and they deem this as extractive (and occasionally unfair) so they dilute your earnings and all the other players to a measly 5% to be distributed amongst early bettors.
This is the gist of what is occurring at a high level when you farm an airdrop for an L1/L2. Think of the Casino as the OS, and the various table games as dApps.
Some readers might find all of these depictions in the Ouroboros crude, but it’s the harsh reality of the industry + how it feels to transact at the lowest end of the capital totem pole. Users are often short-changed. The current value-extraction model involves creating tokens with little to no intrinsic value, and relying on retail volumes to sustain the market long enough for an exit.
Despite this, it’s important to note that funds do offer value beyond what traditional retail users typically provide. They help with up-listings, marketing, introductions, and integrations with portfolio companies, adding significant strategic support and resources to the projects they back.
But does any of this warrant nine or ten figure valuations prior to token generation events? The short answer is no.
Diminishing Returns
There’s no clear-cut solution to this problem. Everyone is at fault.
Users: low retention + speculative use = no real PMF at later stages
Teams: no real use for retail + use of artificial and inorganic metrics for fundraising
Funds: large funds vs opportunities available + oversubscribed valuations
But it’s important to understand why airdrops will continue to result in diminishing returns and how this impacts the wider industry and growth potential. For what it’s worth, there’s likely a few scenarios that play out:
Scenarios:
1. Teams revert back to the old ICO / fair launch models
2. Venture Capital firms cut back on fund sizes with the intent to provide capital to new products at fair valuations that don’t resort to retail becoming exit liquidity immediately
*not likely
3. KYC/DID involving single wallet airdrop + vesting structures with built-in slashing mechanisms forcing deflationary measures
4. Fair launch tokens + airdrop w/ built in tax mechanisms upfront for X amount of blocks ensuring teams raise adequate runway, followed by OTC + vesting structures at a discount for large block purchases
Remarks
Generally speaking, the landscape presents significant challenges, particularly in the realm of maintaining governance and broader ecosystem dynamics. The Ouroboros problem aptly illustrates the cyclical and often detrimental nature of current token longevity practices across L1s and L2s.
The foundational stages, from developing an MVP to securing institutional capital, set the stage for an ecosystem driven by metrics and user engagement. Dumb retail participants, and sophisticated retail users, play a critical role in this cycle, providing necessary capital and activity but often facing risks and eventual disenchantment.
Builders, needing capital and early adoption, rely heavily on these early participants. However, as projects mature, the influx of venture capital seeking high returns can lead to inflated valuations and unrealistic expectations, contributing to the erosion of token value, user trust over time, and bloated team Ops.
Despite the transparency and potential of the industry, the current value-extraction model remains problematic. Casino Games underscores the speculative and often exploitative framework of these bets, where early adopters may feel short-changed as larger investors and teams prioritize their own returns. To be clear, in the Casino Games example it is important to distinguish that:
Control via Governance Power != Equity
The diminishing returns of airdrops and the broader issues within the industry highlight the need for more sustainable and equitable practices. Despite uncertainties and the unwillingness for change across the entire system, this topic warrants thorough investigation and further research.