Token Unlocks, Dilution, and How They Screw You

Think of the crypto market as a seesaw.

When sellers are perfectly matched with buyers, price stays the same. But when you have more tokens looking to be sold than buyers looking to buy, price falls.

Meanwhile, in bullish times, everyone wants to get their hands on new tokens. Sellers are depleted, more and more people pile in, price pumps, creating FOMO (fear of missing out) and things pump. The market goes like this, seesawing between sellers and buyers for all of time. Momentum pushes in both directions, creating bullish or bearish conditions.

At least, that’s how it looks in a simple market with a fixed supply--but rarely is it that simple. Even Bitcoin inflates at a rate of about 1.87% per year. If we assume miners sell 100% of their supply and everyone else just holds onto their coins, price will still fall every year.

In short, unless a coin is net deflationary, new demand must come in to push price up. This leads some to believe that the steady state of crypto is a slow bleed out (bear market), with reflexive pumps in upward price.

Meanwhile, traditional markets have steady inflows: 401ks, monthly S&P 500 buys, pension funds, stock buybacks. Thus price trends up by default; occasionally we experience reflexive periods of selling (dumps/recessions/bear markets).

But today we’ll chat a bit about how tokens are typically issued, why they’re fundamentally different from stocks, how that generally screws over investors, and what you can do about it.

Let’s start with what many consider to be one of the worst culprits: perpetual future exchange dYdX. Below is a chart of its token inflation since late 2021.

Pre-2024 we see a slow token issuance upwards, mostly due to liquidity incentives (necessary for the token to trade on public markets) and trading incentives. That’s all reasonable, but it undoubtedly provides downward pressure on price.

More egregious is early 2024: investor unlocks, team tokens, employee rewards, and future consulting rewards all increase at eye-watering speeds. That’s not to mention trading rewards and liquidity incentives, which increase (just not as much).

Let’s break this down simply, if we eyeball today’s unlocked tokens at 300 million, with today’s market cap at about $300m dollars, and no new buyers come in, price per token will decrease massively over the next four years. Assuming a static market cap; price will decrease by about 66%—a massive loss for anyone holding dYdX tokens.

On the other side of this equation, founders try to signal a decrease in supply, or at least a decrease in supply to be released in the future. Check out the tweet by Binance’s CZ, promising a burn of the Binance exchange tokens, BNB. And while a small amount is actually taken off the market with buybacks, most of that is just tokens that were created in 2017 that never came on the market being ‘burned.’

There’s no actual effect on supply and demand; those tokens were never owned by anyone; they were never traded back and forth, they never had any impact on market price of the BNB token.

To be fair--buyback-and-burn models aren’t great either, in my opinion. Sure they might have a positive impact on price temporarily, but I’d rather that money go to research and development driving towards product market fit and true profitability (very few, if any, crypto projects are profitable if we eliminate token incentives). Spend that money on profitability, not artificial price pumps, I say.

Returning to the original point: unlocks exist for two reasons:

• People want devs to be incentivized over the long term

• People don’t want devs to dump tokens on them

Noble goals, for sure, and worthwhile. The logistics of getting this equation right, though, are a lot trickier. On some level it requires market timing: I’d rather have my token unlocks occur in a massive bull market than during a two-year slide. Game theory has other things to say. Investors and founders would rather have tokens now, long term price be damned.

Lately, I’ve seen an interesting mechanic for founders that incentivizes performance. Tokens are locked at certain milestones; TVL, for example, or fee revenue, or user numbers. These can be manipulated to some extent but it does mean that founders have to get results before they get their tokens. Investors are sometimes obliged to take the same terms: a protocol must achieve $100m in TVL before the token unlocks.

As the industry evolves, people get more and more jaded around how retail investors have been treated in the last 10 years of the industry: if founders and investors want retail capital to come back, they’ll have to prove good faith to their retail counterparts, and it could be a good thing for smaller investors.

On the flipside, we’ll probably see less VC-subsidized airdrops, liquidity mining programs, and unprofitable products. Either way, if the industry moves towards product-market-fit, profitability, and functions more like traditional tech, it’s good for everybody.