Analysis of the cryptocurrency cycle: Institutional funds lead the bull market, beware of market reversals caused by overheating
Original title:《But They Won’t Trap Me》
Original author: MATTI
Original compilation: Deep Chao TechFlow
In hindsight, things may seem inevitable. Sometimes, the difference between certainty and impossibility is small, perhaps just a few weeks of price action. I want to explore this difference through the lens of hindsight.
Two interacting forces formed the cryptocurrency bull market. Resources (capital) flow from top to bottom, and products (ideas) flow from bottom to top. Combining capital with the right ideas leads to innovation, or at least imagination. At this point, exploration turns to exploitation.
Ill share a personal anecdote from the past few years and then discuss the differences between the exploration phase of the cycle and the development phase. To conclude, I will summarize possible future scenarios and make a personal comment.
resource
In the cryptocurrency space, we have experienced rapid transitions from extreme fear to extreme apathy to an environment of high expectations. All of this was completed in approximately 12 months. It can be said that the collective always lacks vision, but the momentum of the group hinders individual decision-making.
After the extreme panic of late 2022, most investors were reluctant to commit capital, while some have given up on cryptocurrencies entirely. During the period of extreme apathy in the summer of 2023, when many were reluctant to commit capital because of capital constraints, macroeconomic momentum painted a bleak picture.
As markets rallied in late 2023, markets soared, driven by the tone of ETFs and top-down narratives like Solanas. Talking to many fellow investors in 2023, few expressed optimism. Of those who have the resources, few are actually deploying them.
In the cryptocurrency space, both in terms of liquidity and venture capital, many investors have been caught off guard by the sudden market bullishness, with at least six more months of winter expected. The prospect of a bull market in gold happened almost overnight, and investors were suddenly confused.
Those with liquidity are scrambling to buy tokens they should have bought a year ago, while venture capitalists with resources are chasing the hottest stories – primarily L2 and AI projects. We can judge by observing the following aspects:
oversubscribed
Only for KOL/Angel Wheel
Fierce price competition
The shares were quickly sold out
Those who felt over-provisioned in December 2022 will feel under-provisioned in March 2024. Capital inflows into liquid funds accelerated in late 2023, followed by additional capital demands from venture funds (the few that still have resources at their disposal).
Based on my personal experience raising venture capital crypto funds from mid-2023 to present, it is nearly impossible to find LPs with active allocations. On the fund-of-funds (FoF) side, most funds are struggling to raise capital and are delaying capital deployment every quarter, while the few that have the resources have opted for larger companies.
In the summer of 2023, one of the partners at a large FoF said they were fretting over checks for $500,000 each. Another FoF revealed in private conversations that they have spoken to around 100 crypto VC funds raising capital in 2023 (I can’t even name that many) but have not allocated to any of them. This isn’t just a cryptocurrency phenomenon, as venture capital in general has dried up across the board.
However, for cryptocurrencies, in addition to the overall macro collapse, there is an additional micro crisis - FTX. I spoke to a US FoF shortly before the FTX crash, and they said they had committed tens of millions of dollars to cryptocurrency managers, but the FoF itself would not start raising capital until the end of 2022. I havent heard of them actually raising money yet. When cryptocurrency funds came around, many LPs found themselves unable to meet their capital commitments.
The FTX situation has also delayed the entry of new capital into the cryptocurrency space, with many smaller and larger family offices and funds eager to gain access to cryptocurrency investments losing interest. Few investors are truly able to think for themselves, which is why we have fanaticism and disillusionment.
However, comparing what happened during the crypto winter of 2018 and 2022/23, the result is that traditional financial confidence in cryptocurrencies has increased significantly. In fact, before FTX, almost everyone I talked to in the traditional financial world, those who were not involved or even marginally involved in cryptocurrencies, believed that cryptocurrencies were here to stay. That’s definitely not the case in 2018.
In summary, from my limited personal experience, venture capital and liquidity allocators are sidelined by rapid changes in sentiment. This means a funnel has been created around the existing narrative and the market is picking up pace.
Bull market catalysts are flows into ETFs and liquid crypto funds, repricing secondary markets (which is already happening). On the primary market side, I expect resource flows to crypto venture capital to increase in the second half of 2024, but primarily in 2025, driving an already competitive primary market.
idea
With Luna crashing and FTX plunging, the bear market quickly turned into a purge, with sellers selling off quickly and those still in the market still in shock. If they do asset allocation, they will feel uncomfortable. The influx of founders diminished as many turned their attention to the artificial intelligence craze.
The narrative reset comes quickly. Periods of crypto disillusionment serve to explore new ideas and select the best ones to be exploited when the narrative turns to mania. The exploration phase lays the foundation for the later imitation competition. Exploration is about finding the legendary “innovation trigger.”
Throughout 2023, deal flow was the most diverse as there was no particularly strong narrative. There are some clusters like intents, ZK, rollup/second layer, ordinarys, etc., and some others, mostly infrastructure.
Founders are effectively forced to think for a while before getting VCs excited. At this point, founders and investors alike are eager to explore. This is when cryptocurrencies are at their creative best. Marginal improvements to hot things are not that big, because there arent enough hot things during a bear market, and excitement about things doesnt last long in a bear market.
As markets soar in late 2023, the search for the “innovation trigger” is over – the cards have been played. I believe that this bull market’s"overton window"Already turned on. However, this does not mean that the best performing companies have emerged and are available for investment.
(Editors note: The Overton Window is a theory of the range of policies that are politically acceptable to most people over a period of time.)
Uniswap may have been one of the most copied products of the last cycle, but the second most copied product, the granddaddy of DeFi 2.0, OlympusDAO, only emerged a few months after DeFi Summer. There is still room for innovation, but it must be done by leveraging existing narratives.
The narratives we see today that have the greatest potential are:
Cryptocurrency AI/Agent
re-pledge
Second floor
ZK
infrastructure
DeSci
SocialFi/Web3Social
The above are fairly undefined categories, more used to vaguely identify what people are building. Many products may be a combination of two or more of the above. The winners will be those who master the traditional tools of user acquisition: revenue and leverage. Numbers go up is always the best user experience.
Explore and exploit
Let’s briefly discuss the exploration/exploitation game theory. The encryption cycle has two behaviors. One is when people are forced to come up with seemingly new things, and the other is when people exploit these new things through exaggerated narratives.
In a bear market, we are stuck in a local maximum. Since the old narrative has collapsed and cannot further support the market, founders are forced to explore, and investors are reluctantly willing to follow. The “innovation trigger” is the foothills of the new global maximum. This becomes the goal of exploration around which new narratives can be constructed.
As previous ideas become dead ends, founders go back to the starting point and expand their space for exploration. As prices continue to fall or stagnate, the incentive becomes greater to abandon the safety of old narratives and explore larger territories of potential novelty.
At some point, explorers set their sights on the foothills of what might become a new global maximum. Typically, foothill formation is a function of novelty and price recovery. While this may be more of a correlation than causation - its enough to start the climb and form an overall narrative.
The climb signals the end of the exploratory phase, where we establish a base camp and begin capitalizing on the markets momentum. At this point, a reflexive relationship between novelty and price action begins to push the global maximum higher. Price becomes a leading indicator of adoption.
As of March 2024, we seem to have found the foothills, and everyone is rushing to climb the new peak because it seems to offer better rewards than exploring further.
Whats next?
The exploration phase is over, and considering that most investors are passive, they dont waste time exploring but double down because they have to make up for what they lost. Funding rounds are starting to be oversubscribed, indicating that investors are already in full utilization mode.
2024 will be similar to 2020 and 2016 in that it will be a year of mostly internal hype. The retail base for active participation is already higher in crypto than in 2020, meaning we are already starting from a higher starting point. Although there has been little innovation over the past two years, we are leveraging resources.
Developers 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 vs. allocator).
Development strategy is also a function of scale. Most funds with deep resources do development only because innovation or exploration does not require as much capital as competing on the development axis. Theres a lot more to dumb money than outsiders believe and insiders admit.
Given that during any mania, large amounts of capital are on the hunt for scarce talent, many will compromise to achieve their deployment goals. Or as Hobart and Huber put it: Although genius is scarce, the needs of the gullible will always be satisfied through massive fraud. Peoples expectations are exaggerated, and founders are incentivized to engage in resource wars and subsidize exotic varieties. income.
With the VC funding machine already cranking, top-down capital flows will gradually increase. Competition for early insider rounds means that insiders and institutional money will support the market before retail investors flood in. Additionally, the retail industry is not a homogeneous group but rather various waves of adoption within a cycle.
Those who fear the most are transforming into fearless bulls. But thats just the flip side of insecurity. Remember, insecurity is the mother of greed, and there is a lot of it in the market today.
The truth is, there hasn’t been much innovation in cryptocurrencies over the past two years, so it’s difficult to think of this bull run as a separate phenomenon from the previous one. Thematically, it appears to be a continuation of the previous cycle, but on a much larger scale, as income arbitrage becomes more profitable and as ETFs open up, so do institutional doors.
Imagination triggers are more effective than innovation triggers for a period of out-of-control mania. Reflexivity is unleashed again and most people in the space are supporting kayfabe. The role of credit has not yet been played in this cycle.
A few months ago, I wrote in an investor letter:
Every cryptocurrency cycle tends to be destroyed by an excess of its fundamentals. 2017 was ruined by the over-addiction to the ICO craze, and 2021 will be ruined by the over-leveraging of the DeFi narrative; the basic principle of each craze is an imitative scramble for immediate wealth.
The rally began with a top-down flow of institutional capital. Nothing really shiny new. The basis for the underlying frenzy to come is institutional inflows (and credit?) and the price action itself. Will this cycle be doomed by overexposure to institutions? let us wait and see.
