The FTX fiasco and other high profile failures and mishaps in the crypto world including Luna/Terra, 3AC, Blockfi, Celsius, Voyager, Genesis, Digital Currency Group, and Axie Infinity have helped to expose two things:
The crypto/blockchain industry is laden with fraud and horrible risk management
For some reason, leading VCs keep getting implicated via their funding and promotion of these frauds and ponzis.
What I think has gone unnoticed is the fact that the same dynamics that led funds like A16Z, Sequoia, Tiger Global, Bain Capital, Softbank, Mark Cuban, and many others to fund these companies have also led to the severe technical shortcomings observable across the blockchain landscape. Punctuating a long series of failures by leading blockchain solutions to provide adequate services was a serendipitously timed announcement by the South Korean government that their 10-month effort to create a working prototype for a CBDC using Ethereum and its various “scaling solutions” culminated in failure. The same week that FTX unraveled in record time as the world watched, Ethereum, the second oldest blockchain ecosystem which has received by far the most investment from VC and which has the largest community of developers and supporters, was ruled unworkable for yet another use case.
How did we get to a place where the world’s largest, most sophisticated venture investors are pouring billions of dollars into frauds, ponzis, and useless technology? Kevin Zhou, co-founder of Galois Capital, on an episode of the Unchained Podcast released November 21, 2022, articulated the perverse incentives in the blockchain funding market much better than I could have. If you want to listen for yourself, the clip begins at 1:05:00 and was edited for clarity.
“The VCs tend to benefit a lot from what happened, at least earlier on with FTX and the Sam coins. If you’re a VC and you’re buddy buddy with SBF and you get allocation into all of these different Sam coins, then you as a fund now get to mark up the book extremely high because the float is so low, FTV is so high, and then if you were to do distributions based on mark-to-market profits to investors in the token itself, then you get to mark your carry at an extremely high overvalued price. This would be very different if they had to sell the token back down into dollars and then distribute the dollar profits to their LPs.
There are a lot of synergistic, symbiotic relationships between the VCs and Sam just on the Sam coins. And then, on the FTX side, I think a lot of the VCs honestly are willing to overlook a lot of things. If you look at the web2 playbook way back in the day, there are these VCs that surely didn’t think that some businesses were good, but they still invested in them because they thought the growth would be good enough that they could get it to the softbank round and then get it to the public and then finally dump on the public. So it’s not like crypto is unique in that sense of these games of people buying illiquid stuff, and with enough momentum flipping it high enough to then dump it onto the public’s head. This has been the playbook for a lot of web2 VCs for a long time already, and now we are just seeing the crypto variation of that.
All of these VCs, I don’t really take them at their word because I think there are a lot of mixed incentives, as well as with the exchanges themselves too, not just FTX, but exchanges in general. There’s all of these dealings between the token market makers and the exchanges who get listing fees, especially in 2017. It’s literally in everyone’s incentive. Everyone makes money except for retail, and they all, not even in a collusive or conspiratorial way, but just out of their own incentives, cooperate with each other to dump on retail as the inadvertent action. Even though it is none of their goals to dump on retail, that is the nash equilibrium outcome if they are all following their own interests and they all take a little piece of the pie. So I think we have a lot of this kind of behavior. It’s not that they are outright colluding, it just happens that their interests are aligned to dump on retail, and then some people just don’t say anything. It’s not that they think it’s right, it’s just that it benefits them so they don’t say anything.”
Retail Preferences Drive Investment Decisions and Product Development
Kevin sees clearly that the incentive in the crypto/blockchain market is to build and fund projects which can ultimately be dumped on retail investors. In an environment where companies can print their own money (token) virtually for free and then sell it to retail investors for hundreds of millions or billions of dollars, it is no wonder to see why so much of the industry’s talent and financing goes towards this goal. Why do the harder, riskier thing in building a great product when you can focus on dumping the tokens you printed out of thin air to deep pocketed retail investors.
What Kevin and most others still miss is the relationship between this dynamic and the quality of the products in the crypto space. One might think - even though the goal is to dump on retail – that retail investors would still prefer investing in great products all else equal, so the products that get funded should be the better products. Unfortunately, crypto retail investors have a highly distorted and ideologically-driven view of what makes a great product, and this does not align well with what real businesses or application users need from a product.
Who is the crypto retail investor? What are they looking for in an investment? At the end of the day, any market is really a Keynesian Beauty Contest - everyone is optimizing for how they think the market will value things, not necessarily what they think is truly valuable. So, what is the aesthetic of the crypto world then? This is where the cypherpunk origins come into play. From true believers to opportunistic investors paying lip service, crypto-anarchism is the ideology of the crypto market. What is most important is decentralization and censorship-resistance - euphemisms for outside of the reach of governments.
Skeptical that this is what is valued most highly in the crypto world? Well, on the very same episode of Unchained, host Laura Shin read the following ad for sponsor Minima:
“What’s the most important thing about crypto? It’s not transactions per second, it’s not convenience, and it’s not even smart contracts, it’s decentralization - to achieve censorship resistance, so we can all be free. Minima is a new layer-one blockchain designed to run in full on a smartphone so that anyone can participate in building Minima’s decentralized network as an equal. Join over 300,000 Minima node-runners on the incentive program today, to start earning every day until mainnet launch. Get started at Minima.global”
Yes, this company is VC backed. And yes, they have their own token, 49% of which will be allocated to the team and investors when they eventually launch.
Certainly there are true believers who think that the problem with blockchain today isn’t a lack of throughput or convenience, but rather that the technology is not decentralized enough. This is probably true from their standpoint given that the transparency of blockchain has proven to be a huge impediment to the ability to act outside the reach of governments.
At the end of the day, this is just a convenient example of the same type of pitch heard around the blockchain world. Typically, the pitch is one of three things…
We are doing something different, but decentralized;
We are still decentralized, but a little bit less terrible of a product; and
We are even more decentralized than our competitors.
And crypto retail investors have historically eaten it up. This is why so much money has flown into products that are optimizing for these optics instead of the things Minima has so casually discarded such as throughput, UX, convenience, or even product-market-fit. As to product-market-fit, so far the only market for decentralized products is crypto retail traders. This is why all of the fields end in “fi”. Defi, GameFi, SocialFi… the “fi” means that we have a token to dump on retail.
The Market is Speaking
Nassim Taleb, a leading risk expert with a predictably negative view of the crypto world, warns that the best performing traders in one market landscape are often the worst when the landscape shifts. I think this is what we are seeing play out today in the VC world.
Over the past few years, the number one skill set to make money in the crypto markets is to accurately predict what crypto retail traders would like, or better yet, be able to create a project that crypto retail traders would eat up. The best way to do this is to be a true believer of the crypto ideology, since aligning with that ideology is necessary for attracting capital from crypto retail investors. Accordingly, VCs across the world have cultivated, hired, or consulted with “true believers”. This community of VC-aligned true believers has been instrumental in directing billions of dollars of VC capital into products like FTX, Blockfi, and Axie Infinity.
Now that the market landscape has shifted, newer funds such as A16Z’s $4.5B crypto fund may end up as some of the worst performing venture funds of all time (and that is without factoring in potential criminal liability). I think the crypto bubble collapsing around us is really a bubble of ideology. With crypto retail traders losing money hand over fist and with their ideology having failed to achieve product market fit, it’s unlikely that products that are catering to this ideology will see success in either the funding market or with customers. In my mind, this includes leading blockchains like Ethereum and BTC which really only even claim to have fundamental value through a crypto-ideology lens. Even that value is being thrown into doubt by ever-encroaching government interventions.
Where will Alpha come in the next blockchain epoch?
As the crypto bubble continues to collapse, investors are naturally wondering where value will come from in the next phase of blockchain. Some will argue that this market collapse is just a bump in the road, and that the same playbook will still work in the long run. Others will say that blockchain has no value at all and that there won’t be another blockchain epoch.
My career over the past 5 years reflects a different view. I’ve long stated that the current crypto bubble driven by ideological retail traders is doomed to failure because it leads to the creation of products which have no real market value. However, I’m a major bull on blockchain technology. The strategy at Unbounded Capital where I was a founding partner, and the strategy I’m pursuing as the co-founder and CEO of Asset Layer, a blockchain infrastructure company building SaaS tools for creating and managing digital assets, is simple - focus our energy and capital on companies building products which serve real customers, not crypto retail investors.
It’s a simple thesis, but it isn’t always easy to execute. When other funds and companies are raising money hand over fist for doing the wrong thing, it isn’t easy to stick by your guns. But, for better or worse, Unbounded Capital, Asset Layer, and the companies we work with and serve are a stubborn bunch, and we are convinced that our abstinence from this bubble and our focus on building real value will pay off in the long run.
I know that there is real pain and loss being felt around the crypto world, especially by retail investors, as the consequences of years of capital misallocation comes to a head. I hope that the next generation of blockchain investors, be they the same investors or new entrants, will use their capital to help incentivize the creation of real value, and not simply foster another bubble based on speculation and “dumping on retail”.