Original title: But They Won't Trap Me The Anatomy Of The Cycle

Original author: Matti, Zee Prime Capital

Original translation: Kaori, BlockBeats

Editor's note: Matti, partner of Zee Prime Capital, wrote in this article that as capital flows within the market gradually increase, especially the influx of institutional funds, the development of the market and price action are driven. Despite relatively limited innovation, the market remains active, and investors are constantly faced with the balance between the pursuit and exploration of immediate wealth and new opportunities. However, the market outlook has become more complex and uncertain, and overexposure can lead to disastrous consequences. Nevertheless, for practitioners in the cryptocurrency field, the opportunities for exploration and development continue to bring opportunities.

Disclaimer: This article does not constitute investment advice, but only a curious exploration of the cryptocurrency cycle. Zee Prime is persistently bullish, and this is a bull market view.

In hindsight, something seems inevitable. Sometimes the difference between "inevitable" and "impossible" is subtle, perhaps just a few weeks of price action. I want to explore this distinction in hindsight. Crypto bull markets are formed by two interacting forces: the top-down flow of resources (capital) and the bottom-up flow of products (ideas). Combining capital with the right ideas leads to innovation or at least imagination. At this point, exploration becomes development. I will share my personal insights from the past few years and then discuss the differences between the exploration and development stages of the cycle. To conclude, I will summarize possible future scenarios and make my own comments.

Resources

In the crypto space, we have experienced a rapid transition from extreme fear to extreme apathy to high expectations, all in the span of about 12 months. We can say that the collective always lacks foresight, but the momentum created by the group limits individual decisions.

After the extreme fear at the end of 2022, most investors were cautious about allocating capital, while some gave up on cryptocurrencies altogether. During the extreme apathy in the summer of 2023, many gave up on allocating capital given the capital constraints (now and in the future) and the bleak outlook painted by macroeconomic momentum.

As the market surged in late 2023, fueled by the top-down narrative of ETFs and the opportunity presented by the oversold Solana, this began to create a perfect storm of capital allocation in the market. Speaking to many of my fellow investors in 2023, I have to say that almost no one was expressing optimism. The few who had the resources were not actually deploying them either.

Many investors in the crypto space, both in terms of liquidity and venture capital, were surprised by the sudden turn to a bullish market, which at least expected another six months of cold winter. The prospect of a bull market in gold appeared almost overnight, and investors suddenly felt trapped.

Those with liquidity are rushing to buy coins they should have bought a year ago; while venture investors, even if they have the resources, are chasing the hottest narratives - mainly layer 2 solutions and AI. We can tell by looking at the following:

1. Oversubscription

2. KOL/Angel Investors Only

3. Aggressive Pricing

4. Weekend Close

Those who felt over-allocated in December 2022, felt under-allocated in March 2024. Liquidity inflows start to accelerate in late 2023, followed by VC fund capital calls, those few who still have available resources.

Based on my personal experience raising a crypto VC fund from mid-2023 to date, it is almost impossible to find LPs that are actively allocating. On the FoF side, most are struggling, delaying capital allocations every quarter, while those few who have resources have chosen larger institutions.

In the summer of 2023, a partner at a large FoF said they were nervous for every $500,000 check. Another FoF revealed in a private conversation that they had talked to about 100 cryptocurrency venture capital funds raising funds in 2023 (I can't even list so many), but did not allocate to any of them. This is not just a phenomenon in the crypto space, as venture capital is declining worldwide.

In addition to the general macro crisis for the crypto space, there is another micro crisis - the FTX incident. Shortly before the FTX outbreak, I had a conversation with a US FoF that said they had committed tens of millions of dollars to cryptocurrency fund managers, but the FoF itself would not start raising funds until the end of 2022, and I didn't hear that they actually succeeded in raising funds. When cryptocurrency funds seek funds, many limited partners find themselves unable to fulfill their funding commitments.

The FTX situation also delayed the entry of new money into the crypto market, with many smaller and larger family offices and funds eager to gain crypto exposure losing interest. Few investors can really think independently, which is why we have manias and disillusionments.

However, comparing the crypto winter of 2018 to 2022/23 shows that traditional finance is much more optimistic about the crypto rebound. In fact, before the FTX incident, many people in traditional finance I spoke to, many of whom were not involved in crypto or only in the fringe, believed that crypto was here to stay, which was definitely not the case in 2018.

To summarize, in my (limited) personal experience, venture capital and liquidity allocators were squeezed out by the rapid change in sentiment, which meant that a funnel formed around the existing narrative and the market accelerated.

The catalyst for the bull market was the inflow of funds into ETFs and liquid crypto funds, which was re-pricing the secondary market (which was already happening). On the primary market side, I expect to see an increase in inflows into the crypto venture space in the second half of 2024, but mostly in 2025, which will boost an already competitive primary market.

Ideas

The bear market was quickly cleaned up by the Luna crash and FTX crash, with sellers quickly selling out and those who were still in the market shocked. If they had positions, the mood was uneasy. The influx of founders decreased as many turned their attention to the AI craze.

The reset of the narrative came quickly. The disillusionment period in crypto helps explore new ideas, select the best ideas, and exploit them in a process where the narrative turns to fanaticism. The exploration stage sets the stage for the subsequent imitation race. Exploration is the search for the legendary "innovation trigger".

Throughout 2023, deal flow is the most diverse because there is no particularly strong narrative. On the infrastructure side, some are coming together, such as intent, zero-knowledge proofs, Rollups/L2, Ordinals, etc. Founders are actually forced to think about it for a while before sparking VC interest. At this point, founders and investors are eager to explore. This is when crypto reaches its creative peak, and small improvements on hot things don't work as well as hot things because there aren't enough hot things in a bear market, but excitement about things doesn't last long in a bear market.

With the market soaring in late 2023, the search for an "innovation trigger" is over - the cards have been played, and I believe the Overton window for this bull market has been determined, however, this does not mean that the top performers have emerged and are investable.

Uniswap is probably one of the most copied products of the past cycle, however the second most copied product, OlympusDAO, the founder of DeFi 2.0, did not appear until a few months after the end of DeFi Summer. So there is still room for innovation, but it must be done by leveraging existing narratives.

The narratives with the greatest potential we see today are:

· Crypto AI

· Restaking

· Second Layer Solutions

· Zero Knowledge Proofs

· Infrastructure

· DeSci

· SocialFi/Web3 Social

The above are relatively undefined categories, more like buzzwords 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 can master user acquisition through the two traditional tools: yield and leverage. "Numbers up" and "fingers up" are always the best user experience.

Exploration vs. Exploitation

Let’s briefly discuss the game theory of exploration/exploitation. There are two phases in the cryptocurrency cycle, one where people are forced to come up with something seemingly novel, and the other where people exploit these novelties and exaggerate the narrative to exploit.

In a bear market, we are stuck in a local maximum. As old narratives collapse, they cannot further support the market, founders are forced to explore, and investors are hesitantly willing to follow. The “innovation trigger” is the potential foothill of the new global maximum, which becomes an objective condition for exploration, around which a new narrative can be built.

As previous ideas become dead ends, founders go back to the starting point and expand the exploration space. As prices continue to fall or stagnate, the greater the incentive to abandon the safety of the old narrative and explore greater areas of potential novelty.

At some point, explorers set their sights on what could become a new global maximum foothill. Typically, the formation of the foothill is a function of novelty and price recovery. While this may be more correlation than causation, it is good enough to start the climb and form a broad narrative.

The climb signals that the exploration phase is over and we set up camp and start to exploit the market's momentum. At this point, the reflexive relationship between novelty and price action starts to drive the global maximum higher and 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 this new hill as it seems to offer more benefits than further exploration.

What's next?

The exploration phase is over and given that most investors are passive, they will not waste time exploring but will double down on the already established advantage as they must make up for lost ground. Funding rounds are starting to get oversubscribed, indicating that investors are already in full exploitation mode.

2024 is similar to 2020 and 2016, the year of internal hype. The retail base of active participants in crypto is already higher than it was in 2020, which means we are starting from a higher starting point and despite the lack of innovation in the past two years, we are making great strides with resources.

Developers focus on resources, while explorers focus on ideas. There is a subtle difference between investors and "people in the business of investing" (investors vs. allocators).

Development strategy is also a function of scale. Most well-resourced funds focus solely on development, because innovation or exploration does not require a lot of capital compared to competing on the development axis. There are many more stupid funds than the outside world believes, and insiders will not admit it.

Given that during any mania, the abundance of capital will seek scarce genius, and many will compromise to meet their deployment goals. Or in the words of Hobart and Huber: "While genius is scarce, the demand of the credulous is always met with a healthy supply of fraud." Expectations are exaggerated, and founders are incentivized to participate in resource wars, subsidizing all kinds of exotic returns.

The top-down flow of capital will also gradually increase as the venture capital firm fundraising machine is already in motion. Internal competition for funding rounds at an early stage means that insiders and institutional money will support the market before retail investors arrive in large numbers. In addition, retail investors are not a homogenous group, but various waves of adoption within a cycle.

The most fearful are transforming into fearless bull market participants, but this is just the other side of insecurity. Remember insecurity is the root of greed, and there is a lot of insecurity in the current market.

In fact, there hasn’t been much innovation in crypto over the past two years, so it’s hard to view this bull run as a separate event from the previous one. Thematically, it appears to be a continuation of the previous cycle, but on a larger scale, as yield arbitrage becomes more profitable and institutional doors open with the opening of ETFs.

For a period of crazy mania, the imagination trigger is more powerful than the innovation trigger. Reflexivity is unleashed again, most people in the space are supporting kayfabe, and the role of credit has not yet been played out in this cycle.

I wrote in our investor letter a few months ago:

Every crypto cycle tends to perish by the excess of its fundamentals. 2017 was doomed by overindulgence in ICO mania, 2021 was doomed by over-leveraging the DeFi narrative; the fundamental principle of each mania is a copycat scramble for instant wealth.

This rally was started by a top-down flow of institutional capital, with nothing truly shiny and new.

This rally was started by a top-down flow of institutional capital, with nothing truly shiny and new.

The basis for the potential upcoming mania is the inflow of institutional money (and credit?) and the price action itself. Will this cycle die because of overexposure to institutional money?

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