Token: Considered Harmful

In which I tell my peers exactly where they can stick their unlicensed securities.

I’ll probably do plenty of ragging on projects I’m familiar with. It doesn’t mean they’re exceptionally bad, or that other projects are exceptionally good, just that I am more familiar with how things went down.

Hot take: Ponzi schemes can be beautiful

You have to give proof-of-work and proof-of-stake L1 chains their due credit: the trick startups do, where they hand out equity to the long-suffering early employees, is brilliantly repurposed to direct the long-term reward towards the exact action needed to create and secure the chain. One of the coolest things about our industry is how aggressively we blur the lines of compensable work, although we’ve since proceeded to beat the concept to death several times over.

Startups have long paid their early employees in equity or options- in exchange for a high performer’s opportunity cost elsewhere, they get a piece of the future value of the venture, which encourages them to fight for their team to win. Startups have also often subsidized early customers’ costs with investor money, hoping that they will build sufficient network effects before the money runs out and stick the landing into profitability. Businesses frequently craft creative compensation packages for executives and salespeople to induce them to achieve certain goals. Bringing game theory in to accomplish something cool isn’t new. Using it to convince selfish humans to collaborate and scale something beyond their wildest dreams is also not new. What is new is how creative we got with it and how we automated it to remove the bureaucracy.

Smart contracts have built novel ways to bring people together, making markets, investing in startups, running network nodes, attempting to create digital museums, and more. They’re just helpless dead code until they induce humans to execute and interact with them. What animates them is when programmers weave intricate systems of monetary forces into code and data to induce people to interact with the system and accomplish interesting things cooperatively without any mediating entity. Successful examples of this include millions of ASICs executing SHA256 until they find a small enough output, adding transactions into blocks and executing them, liquidating bad debt, connecting hard drives to a network to ostensibly store files, or building an intricate crypto-backed dollar-pegged stablecoin. It’s insane; it feels like magic that you can literally write some text to summon millions of dollars and thousands of people with your computer.

Of course, legal codes, contracts, and inspiring speeches can also muster and direct outsize resources like this. But I’ve never seen something so fast and automated. A permissionless piece of code where legal contracts, security issuance, citizenship concerns, KYC, and all the other accumulated bureaucratic kruft are thrown out in exchange for “execute this computation, this other number will increase, and you can trade that number for dollars” is cool. It is limited in that it is sort of difficult to incentivize things that cannot be directly validated by a Turing machine, but oracle technology is good and getting better.

It’s awesome. You can summon up massive swarms of organized humans and machines with a text file. You can even get them to do interesting and useful things if you’re careful.

Misfiring the Money Cannon

That “careful” bit is quite load-bearing. The first fall from token grace is when people do the classic government trick and incentivize something very similar to, but not exactly, the goal. Lots of people like to quote Stafford Beer in saying that “the purpose of a system is what it does”, and this gets poetically illustrated when the (public) incentives on the (public) protocols are released into the wild, everyone in the project behaves mostly in good faith, everyone outside the project behaves rationally, and they all proceed to accomplish something hilariously orthogonal to the stated goals of the project.

My favorite examples of this are BitTensor and Filecoin, with their “innovations” of useful proofs of work (UPoW). BitTensor attempts to link a computational proof of work to useful machine learning inferences, while Filecoin attempts to link useful data storage to hard drive consumption as their proof of work. In practice, both of these are not useful. It is very difficult (one might even say “obviously paradoxical”) to build a resource-intensive potlatch that the participants make to secure the chain as a credible and costly signal, which also serves as a competitively-priced computational commodity (without taking the “pump” side of the pump-and-dump as permanent). In the end, you waste the content of the potlatch regardless of whether you choose UPoW or PoW, but you add the waste of years of your team’s time trying to bring your unsellable UPoW “resources” to market. Instead of salvaging some waste, you waste inestimably more.

(Note that we found a very nice solution to the conundrum: the potlatch can choose to sacrifice financial optionality, from which we get the more resource-efficient (although potentially with cyclical risk issues) proof-of-stake.)

My favorite ill-designed incentive is not alone; the industry has far more failed evolutions than successful ones. Again and again, we see token inflation going to airdrop farming, fake “users” who are farming for tokens instead of using the product (see: crypto games like Axie Infinity), alt-L1 “usage”, ecosystem protocol deployment of unusable “apps”, and the ridiculous economic situations we invariably discover under the promising metrics when DePINs scale.

It’s not a fun trap to find yourself in: you cast your spell when you deploy your ecosystem, and the value accordingly floods in. Suddenly, every move has sky-high stakes for your protocol and token price. Changing the topology of the financial reality you have now created is a high-friction process, especially if you (like most of web3) are sticking to democratic governance ideals that prevent you from rapidly iterating on your prototypes like a startup ought to be. Unfortunately, it may be hard to break away from this and iterate freely, as your stakeholders have often sunk significant amounts of capital into their interactions with your incentive scheme. You’ve become beholden to them, at least reputationally, if not legally.

Another common failure is a mismatch of the incentives’ velocity to the project’s goals. Most projects’ incentives use a bit of ponzinomics, or rewarding early contributors with outsize token shares in order to reward them for taking a risk. This is to induce the network to grow to a size where you start getting nice valuable network effects. Uber did this for years, by softening both sides of the market with venture capital money.

The most common failure mode here is shooting off all the bonus incentives for bootstrapping before the network reaches a steady state. I believe this is the way that Bitcoin will eventually die. Ethereum seems to be doing better with getting sufficient inbound gas fees to feed the validators, at least as long as there are people attempting to build apps atop it. (but my previous post discusses why this might not last either)

In my opinion, judiciously used ponzinomics are fantastic jet fuel. Properly built, they’re the financial energy that converts ideas to reality. Clumsy, naive, or predatory ponzinomics are the problematic side of tokens. Now, we’ll start to discuss the more predatory ones.

Vesting and “trying to get in early”

A core tension is the one between the difficulty of the things we’re trying to accomplish and the perverse timelines we’ve set for ourselves. Most things that are sufficiently cool to excite a community to participate in the incentive scheme, and most things with sufficient market to draw venture capital investment, are extremely ambitious. Ambitious things are hard. Ambitious things take time. Building something massive, as a key person or founder, may take a decade of hard work, which is not even reflected in standard four-year startup vesting. Contributing substantially to a product as an employee takes years, which is probably reflected well in standard startup vesting paired with stock refills.

The standard in web3 is two years from token creation. Oh, word, and we’re planning to rebuild the internet? Extending this vesting schedule probably won’t happen because a vesting schedule is a Mexican standoff between the investor and the founding team, and they both benefit financially by bringing their exit to USD closer to the present. The eventual “community” has nothing to do with it. For this to end up otherwise, both parties would have to make an altruistic and self-sacrificing agreement for the health of the networks they build.

The problem is complicated by the fact when the network is live, the token is usually liquid (if it’s even pretending to have a purpose). Suddenly, an organization that probably has the maturity of a seed-stage startup is beholden to the public market. At this point, the product is usually too immature to be doing anything that anyone wants (other than attempting to hit it like a piñata so it drops some tokens to market-sell). The founding team finds itself answering to angry speculators who want the price to go up, but not to users. Becoming deeply useful is years of hard work away.

The optimal and obvious strategy becomes yelling about techno-optimism while pretending to ship for two years until they can sell their shit to the remaining rubes and abscond. It’s extra easy to pull off when you’re marketing to naive people who don’t understand your industry, are easily swayed by fake or misleading statistics, and are intoxicated with collective effervescence in a bull run. The lack of securities enforcement on these tokens means that people get away with saying anything they want to manipulate the token price upwards.

Even for projects that haven’t rationally decided to rug, if they misalign the ponzi-versus-vesting-versus-building schedules, they can end up in situations where the team is rich and unwilling to work but the product isn’t working. Another fun one is where the system not collapsing depends on maintaining the token price and tokenholder interest, which requires a massive amount of energy from the team, and prevents them from ever focusing on building anything useful, which dooms them to an excruciatingly slow death of perpetual useless PR announcements and no users.

The right way to shape these incentives is to make it so that it’s approximately the same expected value to participate early (with a small chance of hitting a jackpot on your earned token value and little useful product) as it is to participate late (with a useful product and no rewards), unless the early participant is bringing rare and useful information to the market by participating. This means that the team and investors need to be locked in for the appropriate amount of time to iterate, get the thing built, and grow it to where the incentives can take care of themselves.

Secondly, users’ needs ought to be mostly figured out before non-user token-holders come into market play. You need that as baseline because that’s where you’ll get your sustained steady-state revenue after the ponzi scaling phase. In standard startup parlance, you need to achieve PMF before you dump resources into scaling. However, in crypto, the stakes are significantly higher because you can only launch the token into orbit once. You have one toss at achieving network effects through a good pump, so don’t jump until you have a plan for how you’ll stick the landing.

Lack of securities regulation, much time-wasting trying to define tokens as a not-a-security

In the last section, I alluded to the lack of securities law allowing teams to exploit information asymmetries freely. I’ll discuss that further here.

Much of the innovation in incentive schemes that I talked about in the first section is possible because of the lack of regulation. Realistically, the closest cousin to what we’ve built is usually some kind of security, whether it’s as simple as a growth or dividend stock, an option, or some exotic financial derivative we’ve historically banned from traditional markets.

Sometimes, protocols attempt to force users to pay for services in their token, and they make the legal claim that it isn’t a security but a “utility token” more akin to a coupon or airline point, even though all their users treat it like a growth equity share. Sometimes this works out for them (Ethereum, thanks to immense network effects), sometimes it doesn’t, and they fail to force users to pay for their goods in their token (Sia, most alt-L1s).

Regardless, nitpicking definitions to figure out whether a token is or is not a security is stupid. Securities regulation is meant to prevent people from scamming and defrauding each other when they trade financial instruments. Rigidly clinging to the Howey test is not useful in terms of determining which financial transactions ought to be regulated for the good of society, where the goal is to prevent people from harming each other with the practices that securities law is built to prevent.

Right now, the SEC seems to be fighting very slowly through the massive fog of misinformation, and our industry is spending half its time and attention attempting to prevent ourselves from being defined as a security so that we don’t all get hit with charges for issuing and selling unlicensed securities. For me, the right answer to clean the industry up is probably amnesty for that charge in particular, retroactively defining tokens as securities, retroactive enforcement for bad-faith securities violations, and hard work writing a lot of policies to start enforcement going forward.

Things are not well here

Under all these perverse incentives and a total lack of healthy regulation to prevent crime, all sorts of ill effects have taken over the industry. To me, it has felt diseased for years now. It’s hard to take hopeful people seriously.

Vampire attacks have been in vogue for a while, where a company barely innovates in anything useful except attracting more liquidity for no good reason, but they succeed in stealing liquidity from the other project that might have been more technically innovative. Zero-sum liquidity and order flow battles feel like the main frontier of innovation in the industry, with a small minority of projects trying to solve real problems instead of building masturbatory incentives. Innovation has moved from the technology and game theory to the social and memetic layers, which is not where it ought to be when our tech is still unusable and not solving problems.

People have moved from launching protocols that use a token, to launching protocols with a useless token hastily glued onto the side, to launching a token with a fake protocol attached to lend the techno-optimistic bullshitting an air of legitimacy, to launching naked memecoins with absolutely nothing but the meme attached. Flagrant bullshitting has become completely acceptable, and the speculation doesn’t even pretend to be based on techno-optimism: nobody in the industry believed these goofy AI narratives, but everyone believed that the cavemen Coinbase drags in will buy.

The people who are left in the industry are (with a few small pockets of exception) trapped by contract or income, too clueless to understand what’s happening, do understand but are completely past caring, or are sociopaths actively exploiting anyone they can drag into their net. This is not a recipe for bringing together smart-kind-passionate people who accomplish world-historical things with technology. This is how you attract apathetics, losers, mercenaries, and villains. What you accomplish is crime and failure.

The people who are allocating capital aren’t entirely to blame, although there are a lot of them who are colluding heavily with the worst offenders, because their LPs pressure them to return the fund, and there’s not much honest money left to be made in this industry (or competent founders). Founders can’t always be blamed either because they’re making rational decisions in a social environment that finds these sorts of schemes allowable. The pressure for all parties to predatorily extract capital now at the expense of long-term value is coming from every possible direction at this point. The incentives have decayed into a nasty situation for everyone involved.

As a founder, I’ve felt trapped and sick for a long time. Few in web3 want to pay for useful things because they’re all attempting to juice money out of the industry as fast as they can. If you’re trying to sell to people who aren’t in the cult, you have to make up new jargon to avoid the distasteful (well-earned) associations. In the past year, talent from within the industry is nearly always worse than talent sourced from outside, which I’ve verified across so many interviews. Teams trying to achieve product-market fit by solving real problems in people’s lives instead of playing various predatory zero-sum games are very difficult to find funding for (we’re a rare exception), although every VC and ecosystem lead is constantly bemoaning the lack of founders building consumer apps to self-immolate on the pyre of a post-TGE ecosystem’s corpse.

Can we clean it up?

I mean, maybe. We need some regulation and better norms. As I said earlier, there’s a good reason that we have the SEC, restrictions on how you can buy and sell securities, and restrictions on speech related to securities where you inherently have asymmetric information.

It’s to prevent what we’ve been watching happen, to prevent all of society from exploding out of control with speculation and then rotting in its wake. Thank god this was contained to a tiny corner of the market. It’s been entertaining (albeit bloody) to watch history repeat itself and justify securities law before my once-libertarian eyes.

As I said earlier, a sketch of the right approach is probably to start enforcing retroactive securities law on tokens, with an exception for offenses related to selling unregistered securities as long as everything else was done mostly in good faith. Work needs to be prioritized immediately to allow useful game-theoretic innovations without legalizing scams. There’s a fine line between “cool useful protocol” and “derivatives so complex that they’re inherently predatory”, and our regulators need to buckle down and do their homework to figure out the difference. I’m not naive, I know it won’t be easy, bureaucrats will have to analyze Redacted Cartel and (3,3) and shit called “Space Race”.

We already have some groundwork to start from: we know what the common scams look like and what financial crimes like manipulating markets look like. We can green-light situations and provide guidance for places where things are fine and investment is derisked- fair valuations for growth and cash-flowing tokens are something that we’ve known how to calculate for ages. It’s a difficult problem because a lot of regulation is protection from exotic derivatives that only your MIT PhD quant can understand (and not your cousin who loves /r/wallstreetbets), but exotic derivative structures are basically our whole thing. Nevertheless, we must start figuring this out if we hope to rescue anything.

Secondly, we need longer vesting, long enough to build and stabilize the product. It should attempt to be scheduled to last until the end of the ponzi phase (e.g. get to where system inflows match outflows and inflation is aligned with growth, risk, and work done), with a stabilization lockup overhang to let the steady-state sit. This would be similar to waiting for the startup to have mostly saturated its target markets and be executing a robust financial model before an IPO.

We also need better standards about when projects should take on the responsibility of answering to a population of tokenholders at TGE, which should be after sufficient attention has been given to serving the needs of the people who will be paying to obtain value from the protocol.

The other question is, once we’ve cleaned up the piranhas, what remains to be salvaged? Very little technology is ready to solve problems for users. Much of our innovation has been into scams, infrastructure that enables scams, and infrastructure that helps people win zero-sum games. Some areas that I think have immediate hope include:

• CBDCs and distributed enterprise ledgers,
• stablecoins,
• socialFi and regulated gambling,
• privacy tech/fundamental cryptography like ZK,
• and fundamental p2p/local-first/distributed systems research.

Unfortunately, we’re used to massively inflated valuations, because both founders and VCs are accustomed to exiting their investments in a flaming pump-and-dump. There will be carnage for venture funds if these practices end; they’ll have to significantly mark down almost all their investments. There may not be a lot of liquidity to deploy into whatever’s left, which is a problem, because there’s still a significant amount of work left before any of these products could make money.

conclusion

• Novel incentives in code (as smart contract or distributed system) are extremely cool, and you can do really cool things with them.
• People aren’t always very skilled at designing these, and when they mess up, it can go catastrophically wrong for all sorts of sad and unavoidable reasons.
• There are major unsolved incentive alignment problems between the teams building the protocols, the tokenholders, and the health of the useful protocol itself. These are probably surmountable, but there are perverse incentives against fixing them.
• Lack of securities regulation, and the entire industry fighting getting regulated, has led to this technology developing into a hotbed of crime and scams. We have built financial products that nearly always ought to be regulated as a security for the good of society, but instead of attempting to work with regulators, we’ve mostly acted like children (and are now receiving our just Wells notices).
• We are seeing increasingly short-sighted, extractive, and wasteful behavior across the industry. Meanwhile, the industry rots from the inside out as everyone except the bottom of the barrel flees. However, individuals aren’t entirely to blame for this sad situation, because perverse and powerful incentives are coming from all sides at this point.
• I believe a quick and brutal cleanup is both possible and desirable: the SEC should retroactively consider almost all tokens securities by default, grant amnesty to projects that sold unregistered securities in the past and ongoing until better regulation has been developed, and start aggressively prosecuting the most egregious and predatory violators from the past few years (as in, probably not Uniswap and Coinbase, certainly not to an existential level of judicial attack)
• Longer-term (but starting immediately), the SEC ought to rapidly develop some guidelines against the worst scams (inspired by the obvious parallels in history and securities law) and start a good-faith collaboration on figuring out how to constructively regulate complex financial incentive schemes over distributed systems that are marketed to non-accredited investors.
• This will be a bloodbath for crypto VC funds and many founders. What’s left may feel small and sad, and venture interest may dry up for a while. That’s okay because we’ll be left with the core of what’s true and valuable. If the technology is truly useful, we’ll eventually get back on our feet, this time stronger without parasites.