Disclaimer: This is not investment advice, just a curious inquiry into the anatomy of crypto cycles. Zee Prime is very long and this is bullposting.
In hindsight, things may seem inevitable. Sometimes the difference between inevitable and impossible is very small – perhaps just a couple of weeks of price action. I’d like to explore that difference with the benefit of hindsight.
Two interacting forces form crypto bull markets. The top-down flow of resources (capital) and the bottom-up flow of products (ideas). Marrying capital with the right idea leads to an innovation trigger or, at least, an imagination trigger. This is when exploration turns into exploitation.
I will share personal anecdotes from past years and after that discuss the difference in explore versus exploit stages of the cycle. As a closing remark, I will conclude with possible future scenarios and a personal commentary.
The Setup: Resources
In crypto, we have experienced a rapid transition from peak fear through peak apathy to a high expectation environment. All this in roughly 12 months. We can say the collective always displays a lack of foresight, yet the momentum created by the crowd corners individual decision-making.
After peak fear in late 2022, most investors were apprehensive to deploy capital while some have written off crypto completely. During the peak apathy of summer 2023, many deterred deploying as they thought about capital constraints - present and the future, as the macroeconomic momentum painted bleak prospects.
As the market surged in late 2023 driven by top-down narratives of ETFs and the opportunity that was the oversold Solana, it started to create a perfect storm for capital allocators in the market. Talking to many peer investors during 2023 I have to say few, if any, expressed optimism. Few of those that had resources were actually deploying them.
Many investors in crypto, both on the liquid and venture side, were caught by surprise expecting six more months of winter to say the least when the markets suddenly turned bullish. The prospects of a golden bull run happened almost overnight and investors suddenly felt cornered.
Those on the liquid side are rushing to buy coins they should have bought a year ago and VCs, those who do have resources, are chasing the hottest narratives – mostly L2s and AI vaporware. We can tell this by observing the number of rounds that are:
Oversubscribed
KOL/angel-only
Priced aggressively
Closing at the end of the week
Those who felt overallocated in December 2022 do feel underallocated in March 2024. The capital inflows in liquid funds have picked up pace in late 2023 followed by capital calls of venture funds, those few who still have resources at their disposal.
Drawing from my personal experience of raising a venture capital crypto fund from mid-2023 until now, it was almost impossible to find actively allocating LPs. On the fund-of-fund (FoF) side most were struggling to raise themselves, delaying capital deployment every quarter, and those few who had resources went with bigger names.
In the summer of 2023, one of the GPs at a large FoF said they are sweating for every $500k check. Another FoF disclosed in a private conversation they had talked to around 100 crypto VC funds raising in 2023 (I can’t even name that many) but allocated to none. This was not exclusively a crypto phenomenon as risk-on capital dried up across the board.
For crypto, there was however an additional micro-crisis to the general macro meltdown - the FTX story. Shortly before the FTX blowup, I had a conversation with a US-based FoF who said they have committed tens of millions to crypto managers but the FoF itself will only start raising in late 2022. I have not heard about them actually raising successfully. Many LPs found themselves unable to honour their capital commitments when crypto funds came calling.
The FTX situation has also postponed the entry of new capital into crypto, many smaller and bigger family offices and funds who were eager to get crypto exposure lost interest. Few investors are actually able to think independently and that’s why we have manias and disillusionments.
However, comparing the crypto winter of 2018 and 2022/23 is that TradFi was giving crypto a much greater benefit of the doubt to bounce back. Actually, pre-FTX almost everyone in TradFi I talked to, who was not in crypto or marginally in, thought that crypto is here to stay. That was absolutely not the case in 2018.
To summarize, from my (limited) personal experience, venture and liquid allocators were sidelined by the rapid change in sentiment. This means a funnel has been created around existing narratives and the market is picking up pace.
The bull catalysts are the top-down inflow of capital into ETFs and liquid crypto funds, repricing the secondary market (already happening). On the primary side of things, I expect resources flowing to crypto VC to increase in the second half of 2024, but mostly in 2025, fueling the already competitive primary market.
The Setup: Ideas
The bear market turned into a quick purge by Luna collapse and FTX blow-up, the sellers sold fast and those still in the arena remained shell-shocked. If they were allocating it was with an uneasy feeling. The inflow of founders dried up as many turned their sight to the AI bandwagon.
The narrative reset came fast. The disillusionment period in crypto serves to explore new ideas, choosing the best ones that get exploited in a narrative turning to mania. The exploration phase sets the scene for what later turns into a copycat race. Exploration is the search for the fabled “innovation trigger”.
Throughout 2023 the dealflow was the most diverse as there were no particularly strong narratives. There was some clustering around e.g. intents, ZK, rollups/L2s, ordinals, and some others, mostly on the infra side.
Founders were actually forced to think for a while before getting VCs excited. At this point, both founders and investors were keen to explore. This is when crypto is at its creative finest. Marginal improvements over the hot thing don’t work as much as there is no hot enough thing. But excitement over things doesn't really last in the bear market.
As the market soared in late 2023, the search for an “innovation trigger” concluded – the cards were dealt. I believe the Overton window of this bull market has been set. It does not mean, however, that the best performers are already out there and investible.
Uniswap was probably one of the most copied products in the past cycle, however, the second most copied product, the godfather of DeFi 2.0, OlympusDAO, only came a couple of months after DeFi summer. There is still space to innovate, however, one has to do so by exploiting the existing narratives.
The narrative with the highest potential that we see today:
Crypto AI/Agents
Restaking
Layer 2
ZK
Infrastructure
DeSci
SocialFi/Web3 Social
The above are rather under-defined categories, more like buzzwords that serve to vaguely identify what people are building. Many products could be a combination of two or more of the above. The winners will be those who’ll master user acquisition via two traditional tools: yield and leverage. “Number going up” is always the best user experience.
Explore vs Exploit
Let us discuss in brief the game theory of explore/exploit. There are two acts for a crypto cycle. The one where people are forced to come up with seemingly new things and the one where people exploit these new things with inflated narratives.
In the bear markets, we are stuck in a local maxima. As the old narratives have crumbled and they cannot prop up the market further, founders are forced to explore and investors are hesitantly willing to follow. The “innovation trigger” is the potential foothill of the new global maxima. This becomes the objective of the exploration around which new narratives could be built.
Founders are back at the drawing board as the previous ideas are a dead-end, expanding the exploration space. As the prices keep dipping or growing stagnant, the greater the incentive to abandon the safety of the old narratives and explore greater surface area for the potential novelty.
And at some point, the explorers set a sight on what could become a foothill of a new global maxima. Usually, the forming of the foothill is a function of novelty and price recovery. While this could be more of a correlation rather than causation - it’s good enough to start climbing up and form narratives at large.
The climb up signals the exploration phase is over, we set up a basecamp and began to exploit the market's momentum. At this point, the reflexive relationship between novelty and price action begins to push the global maxima higher. The price becomes a leading indicator of adoption.
As of March 2024, it seems that we have found the foothill and everyone is rushing to climb the new mountain - as it seemingly offers better payoff than to explore further.
What’s Next?
The exploration phase is over and given that most investors are reactive they will not waste time exploring but double down on exploiting since they have to cover the lost ground. Funding rounds beginning to get oversubscribed signal investors are already in full exploit mode.
2024 is similar to 2020 and 2016 – years marked by mostly internal hype. The actively participating retail base in crypto is already higher than was in 2020 meaning we already begin at a higher watermark. Despite innovating very little in the last two years, we are powering through with resources.
The exploiters focus on resources while explorers focus on ideas. There is a subtle difference between being an investor and “being in the business of investing” (investor versus allocator).
The exploit strategy is also a function of size. Most funds with an abundance of resources are exploit-only because innovation or exploration is not capital-intensive as competing on the exploit axis. There is much more dumb money than outsiders would believe and insiders would admit.
Given that during any mania the abundance of capital seeks the scarce genius, many compromise to meet their deployment targets. Or as Hobart & Huber put it: “While genius is rare, the demand of the credulous will always be met by a healthy supply of fraud”. The expectations get inflated and founders are incentivized to enter resource wars, subsidizing yields of exotic kinds.
The top-down flow of capital will also increase gradually as the fundraising machine of VCs has already begun to move. The early internal competition for rounds means that until the retail arrives en masse the insiders and institutional money will prop up the market. Also retail is not one homogeneous mass but various waves of adoption within a cycle.
Those who were afraid the most are transforming into fearless bulls. But this is just the other side of insecurity. Good to keep in mind that insecurity is the mother of greed and there is an abundance of insecurity in the market these days.
The truth is there hasn’t been much innovation in crypto in the past two years so it is hard to see this bull run as a standalone from the previous one. Thematically it seems to be an extension of the previous cycle but with size, as the yield arbitrage gets more lucrative and the institutional floodgates opened with ETFs.
For an unhinged mania – an imagination trigger is a more potent ingredient than an innovation trigger. The reflexivity has been let loose again and most people in the space are endorsing kayfabe. The role of credit has still not played out this cycle.
A couple months ago I wrote in our investor letter:
Every crypto cycle tends to perish by excess of its basic principle. 2017 ruined itself by overindulging in the ICO mania, the 2021 by overleveraging the DeFi narrative; the underlying principle of every mania is the imitative scramble for immediate wealth.
This move upward has started with a top-down flow of institutional capital. No true shiny new thing. The foundation of the potential upcoming mania is the institutional inflow (and credit?) and the price action itself. Will this cycle perish by excess exposure to tutes?
Thanks to Arthur0x, Long_solitude, Luffistotle for providing feedback.
