Observations on the Crypto Markets Going Into Coinbase Day

Private crypto markets echo what we see in the public crypto markets, which is mostly confusion

Disclaimer: Both Smart Money Ventures’ Yield Farming Fund and I hold positions in Sushi and EPS. None of what is discussed here should be taken as investment advice.

It’s only been 10 months since I wrote about DeFi being completely off the radar, but market conditions are now definitely en fuego. And given this impending Coinbase public offering, I wouldn’t bet on that trajectory slowing down anytime soon.

But in some ways, the more things change the more they stay the same. It was only 18 months ago I wrote about Information Asymmetry in Crypto and that part hasn’t changed a bit. If one takes a closer look at the hot Web3 markets, there are a wide range of trends and deal types, not all of them healthy.

Broadly, I’d bucket them as follows:

True Innovation: The hype around DeFi in particular is real today, and DAOs, social currencies and NFTs are equally exciting and disruptive, if not slightly behind DeFi in their relative maturity. It’s also fair to suggest that 95% or more of this innovation is coming from the Ethereum community and happening on the Ethereum blockchain. It’s still fair to say the broader market remains criminally underexposed to this opportunity set.

Informed Speculation: Growing adoption of non-ETH blockchains and protocols is forcing both users and investors to consider the potential and role of these competing ecosystems. The fast ascent of forks of core DeFi protocols, on Binance Smart Chain (BSC) in particular, forces everyone to revisit the age-old questions of centralized vs decentralized, and rehashes all of those debates ad nauseum. Even if these ecosystems were to only exist as smaller satellites around Ethereum, that would still represent a whole new set of investment opportunities in underwriting early liquidity (DEXes, Lending protocols, yield aggregators, etc) and speculation around high yields may be enough to bootstrap these ecosystems. Exciting developments in NFTs and social currencies, in particular, support additional rational speculation and even justifiably bubblish activity, even if some of these worthy experiments will inevitably and necessarily end poorly.

Copy and Paste Forks: The forkability of DeFi protocols has led to rapid innovation cycles, which has come with both positive and negative aspects. On the positive side, forks that bring a useful twist have proven to be critical experiments that helped drive DeFi forward, CREAM and SUSHI being prominent examples. And the opportunities for clean forks are apparent in bootstrapping ecosystems on BSC or SOL, as we’ve seen with CAKE and EPS among others. But we’re also seeing this used for scams and rug pulls. Early DeFi experiments are being repurposed with new names and layered in an abundance of DeFi buzzwords (because the retail speculators investors don’t *really* understand DeFi and rebasing *does* sound cool if you hadn’t heard about it before), and are going to result in folks getting rekt.

2017 ICO Redux: The dominant majority of the money that has come into Web3 falls into this last category, as shocking as that may be. The bulk of the institutional money wants “exposure” to crypto, but don’t know why they want that exposure with any greater clarity than they did in 2017. They still think crypto is all about “the Shitcoin Casino” and this is reflected in the continued existence of tokens like XRP, LTC and XLM near the top of crypto market cap lists. This group, which did not learn the appropriate lessons from the 2017 era, also includes many institutional crypto funds, most of whom will sheepishly admit off the record that they don’t quite understand DeFi, and are thus syndicating 2017-era “token sales”.

A Lack of Basic Knowledge and Proficiency

A more interesting case study of these market inefficiencies was the recent Genesis launch of the decentralized stablecoin, FEI, and its governance token, TRIBE. The launch included a 4-day “Genesis period”, during which investors could commit ETH to the launch, with all investors getting the same discount tied to the total amount committed. Investors had the option of minting FEI at the genesis price dictated by the bonding curve, or pre-converting their FEI for TRIBE.

The project attracted $19M in private capital pre-launch from a handful of prominent investors in a very “buzzy” space, decentralized stablecoins.

Without getting into too much detail, a basic understanding of how bonding curves work and the game theory behind this launch dictated that the optimal strategy was to delay any commitment or decision until near the end of the genesis period. At which point, with the knowledge of how much ETH had been committed and how much of that ETH had been designated to be auto-converted for TRIBE, an investor would have a fairly accurate estimate of the discount available if minting FEI on the bonding curve, and the resulting valuation for TRIBE if converting.

At the risk of leaking the alpha that we understand how bonding curves work, waiting and watching was the Yield Farming Fund’s approach going into the FEI Genesis period. So while we were expecting to be hitting refresh a few times over the course of the 4 day period, we were surprised to see that ~50,000 ETH sub-optimally committed within a few hours, all but ending the game before it started. Worse, these early commitments came during the busiest time on Ethereum last week, with average gas prices >200 gwei.

Said another way, ~$100M didn’t just ape into an investment contract they didn’t understand, they needlessly overpaid in gas to do it.

Despite there being no clear incentive beyond a total of $250M committed, a whopping $1.3B piled into the FEI Genesis launch, possibly derailing the project’s viability going forward.

Reconciling the Similarities and Differences

While there are different types of stupidity worth lampooning in the various categories, there is definitely a hierarchy here. As stupid as the FEI/TRIBE Genesis situation was, those were supposed to be the smart investors. The simple lesson here is those who don’t understand how bonding curves work shouldn’t invest in mechanisms that work on bonding curves. Seems like pretty basic stuff to be screwing up. But at least those investors know how to use Metamask, and thus are clearly closer to figuring out how Web3 works than the others, even if both are almost certain to get rekt when this next bull cycle tops out.

(Note: some of the lessons specific to FEI are unique to decentralized stablecoins, a particularly tricky category, and most experienced DeFi investors have battle scars and horror stories from trying to invest in that space.)

The excitement over the FEI project related to its novel use of market forces to maintain a peg for a decentralized stablecoin. Now we’re forced to wonder, did the $19M and subsequent $1.3B raised serve any useful purpose, and further did it outright kill the mechanism’s ability to maintain peg? Chris Burniske asks a related question here, referring to overfunding or too much capital as “the Original Sin”.

Web3 Fundraising: Less is More

These questions come at a time when “Fair Launch” principles are proliferating, as we pointed out in a research note last week. Projects are making an explicit point to note that they are launching a token publicly before raising any money privately.

And we’re starting to see that these projects, which align interests with a decentralized token distribution from launch, organically achieve better outcomes and healthier protocol economics.

In fact, eliminating the preferred capital stack and offering that dilution up as yield farming and staking rewards thus far looks to be a superior alignment of interests between the protocol and capital. This also applies to any product-customer relationship, representing a revolutionary new business model and go-to-market strategy that works much better for everyone involved.

Except for the VCs.

It’s not so much that valuable feedback and productive capital would no longer add value, but rather the realization that 10-year closed-end vehicles will not be viable sooner than later as this model gains traction.

Volatility Ahead

The crypto markets have some exciting times ahead, but you can already see some growing disasters waiting to happen. Lots of money will be made by investors doing stupid things in the coming months, but the problem is that more dumb money is being pumped in before the market has yet to extract its pound of flesh from the XLM and LTC investors.

Yet this has been a godsend to crypto investors who understand the underlying technology and cryptoeconomics, because for all the blind ape-ing, there is plenty of alpha available to those who aren’t just chasing hype cycles around crypto-Twitter. The cut-and-paste jobs are just enough to throw those less savvy off the scent of the real alpha, at least briefly.

Smart Web3 investors should produce transcendent returns over the coming cycle, while another round of 2017-bubble pain appears in the cards for the many others. But what’s really interesting is that most of the institutional and retail capital have yet to figure out which investors fit into which bucket.