Crypto's knowledge gap: Why does it matter?
Part 1 looked at how we've I know what you’re thinking. Who cares? What’s the harm? If projects want to waste their money propping up their price and endangering hype then who am I to criticise?
But it does matter. It matters for a whole host of reasons because it:
- Weakens the ecosystem
- Increases volatility
- Increases exploitation of prospective investors
Weakening of the sector
Resources flow inefficiently across the industry. In any industry, resources (capital and talent) should flow towards the strongest whilst the weak die out. In crypto, however, capital currently moves to the strong and the weak. If you can market, you can raise millions - regardless of actual competency or experience in building anything. This has three effects:
- It slows down development in the space
- Weak teams are too rich to die out, given their huge ETH reserves. They can function as zombie companies, too rich to die, too inept to thrive
- Capital and resources are funneled to teams that do not have the best interests of the ecosystem in mind
The first point should be self-evident, although a slower rate of progress is probably acceptable if it’s the worst outcome. Zombie companies, meanwhile, are not ideal and will contribute to (1) but will not do lasting damage to the ecosystem beyond sharp shocks such as liquidating their reserves and winding the company down suddenly or launching a new company with their previous ICO raise and starting all over. However, this can be contained.
The third point is probably the most dangerous in the long term.
What happens if a project raises sufficient capital that it can bulldoze the competition regardless of its qualities as a decentralised network? What if the decentralised dream is simply co-opted, just like the Internet? Having billions of dollars behind means you can achieve quite a lot. Decentralisation doesn't have to win.
A final point; many have made mention of the importance of governance. Users are increasingly expected to be an active participant in governance decisions. DPoS networks, amongst others, rely on this participation for the security of the network. How are users meant to vote when they lack the technical knowledge? Most don’t even know they are meant to vote. What impact does that have on the security of the network and the risk of centralisation on a network?
The crypto markets are volatile. This is to be expected – we are still building models of how to value them, there are competing thoughts as to how/when/if they different cryptoassets can be monetised, there is little adoption. In short, it is a new and developing market where we are in price discovery - volatility is to be expected.
However, I would conjecture that a lack of knowledge is increasing the volatility. Instead of speculating on potential, an industry has sprung up to support the weight of money speculating on speculation. The alt run of late 2017/early 2018 highlighted that cryptoassets were divorced from any rationality, a period during which it was a waste of time to read any whitepaper or think too hard about a cryptoassets because only one factor mattered – the ability to garner hype.
I am not merely restating the common observation that valuations as a whole exceeded any realistic potential valuation, but rather that certain cryptoassets exceeded the volatility of the wider cryptoassets market. They became (and many still remain) divorced from any realism and were instead traded by a majority of people who did not understand them, did not understand the market and did not understand the components needed to even begin to value them. As such, they will have ended up owing assets which lost 95%+ of their value:
Exploring these in detail is beyond the scope of this article, but I would conjecture that the most poorly understood assets (or the ones most hyped) were hit the hardest when the crash came whilst also proving surprisingly resilient to genuine bad news (such as hacking, plagiarism, delays and other such small inconveniences). Why? Because bad news can’t impact on the price of something not based on reality.
I could touch upon some of the unregulated aspects of trading here (washtrading, market manipulation etc) but I think these will be phased out as the market develops, bigger players launch exchanges and regulation is enforced.
However, the current practices of most ICOs are frequently appalling and aren’t discussed enough because there are too many parties profiting off an all too often opaque process. ICOs were initially conceived as essentially a means of crowdfunding and most of the early ICOs were bought up by retail investors in a single phase. As 2017 progressed this shifted, with more and more starting to do presales as a means to reward early members of the community or those who had contributed to the project in some way. This has now been even more stretched, with these presales now preceded by private sales and seed rounds.
Most ICOs now sell the majority of tokens in these early rounds, making them inaccessible to retail investors (citing regulatory reasons). They then either sell a tiny amount (5-10% of total supply) in the crowdsale or cancel it altogether. This creates both a pent-up demand and a concentration of supply.
I do not wish to downplay the regulatory risks of selling to retail investor, as these are valid. However, this shift to prohibition has been accompanied by a lack of transparency and keeping the rest of the token distribution model the same – to the detriment of the average person.
Traditional startups sell at a steep discount to early investors because they take on the substantial risk of project failure. This is why the traditional model sees the valuation of a successful startup increase over a series of funding rounds – because many die out along the way.
Too many projects have adopted this model and condensed it to make it meaningless. A seed round may take place mere weeks before the crowdsale starts. Many presale rounds end literally the second before the crowdsale starts. Many even run private sales with large discounts whilst also running the main sale (as at least one project is doing right now!).
So what is that funding for? Why are these heavy discounts given out? The way it works is thus:
- T-8 weeks: Firm does raise for say 2.5% of total expected raise (e.g. $500k on a $20m hard cap) with VC or other reputable company in the space. They will get a 50-90% discount (or a 100-1000% bonus, which sounds slightly more egregious)
- T-4 weeks: They take that money and go out to raise more money, buying some positive coverage on leading sites, maybe getting an ‘advisor’ to shill for them to get hype from lesser quality VC funds or – more likely – pools (raising $1-2m). This process could continue for a while, with some pools getting better discounts than others. Pools (or sole accredited investors) will probably get 25-70% discounts in most cases. Oh, and some VC companies will sell some of their allocation during this period to pools. Project teams will be made aware and any questions deleted or ignored
- T-0: Firm then takes that money and starts marketing in earnest so they can reach their $20m hard cap in the crowdsale. VC/reputable company backer logo will be plastered everywhere, as proof of how ‘solid’ the project is
- T+2 weeks: Token launches. If it opens at a 3-5x price then this means the team's tokens (say 20-30% of total supply) are probably now worth $12-20m in addition to the $20m of raised ETH. If the token dumps on launch – who cares? It can drop 50-90% and the VC fund and pool will still have made money.
The funds being raised aren’t being used to allow the team to continue development before a subsequent funding round. Most teams only do one token generation event and sell off the token supply early on. No, they give steep discounts as a shortcut to the hard work of building a community actually interested in their work. They do this in order to raise as much money as they possibly can in a crowdsale. This despite the evidence that raising too much money too early can actually be of the detriment to the project.
But who cares? Well, investors get screwed because they are both unable to partake and are often not privy to the details of the huge bonuses and discounts being given out, usually with pathetically small (no, a six-week vest period doesn’t count as a lockup!) or no lockup periods. These investors then get dumped on by VC funds and pools. There is no good reason not to provide the details of prior raises to all investors. Transparency is a good thing, not bad.
Trends such as these (and there are more) will reduce trust in the space, lead to increased regulatory action and ultimately stifle adoption because teams aren’t building up a community of interested users, they are simply involving a small set of people who wish to flip their tokens quickly. It is in the interests of everyone to do more to counter it and highlight flagrant abuses
Part three looks at how we can improve.