Two things drive the price of an asset: liquidity, which refers to the amount of capital available for buyers and sellers to enter or leave a market, and belief. Belief motivates buyers or sellers to take action, and narratives play a significant role in shaping belief. When collective faith is shaken, we tend to rush to sell or buy assets.
The recent bank run on Silicon Valley Bank serves as an example of collective belief being shaken. But what happens when a consensus on an asset is formed, and people rush to trade it quickly? Does an inverse bank run occur?
Well, I wanted to explore that. So today's piece examines on-chain data to understand who trades meme assets, how much returns are generated, and whether investing large sums of money into them is a good idea. I may have taken a serious approach to what should be a joke.
Laughing Straight To The Bank
PEPE token has rallied over sixty times in the past few weeks. As I pen down these words, PEPE has generated more trading volume than Solana, Avalanche, Polygon, and even Doge. Is an emerging joke worth more than well-established incumbents? I must admit, I don't quite know. One way to assess the answer to this question is by examining the behaviour of the token holders.
Going by data from Nansen, over 100k individual wallets own these meme assets. Over 1.4 million wallets are holding an older meme asset like Shiba Inu. Protocols struggle for years to see those kinds of numbers. For a sense of scale, Aave and Compound each have only about 300,000 unique wallets holding their tokens. Part of the reason for that lower figure is that exchanges are likely where many of these users hold their tokens.
So initially, you see an uptick in the number of wallets holding these assets, as decentralised exchanges are the only places you can acquire them. Notice the chart flatlining around the 5th of May in the chart below? That is when Binance listed the token. So it is possible that traders purchased these tokens on centralised exchanges instead of going through a decentralised alternative.
Meme assets are an interesting phenomenon because they simultaneously show us the power of enabling anyone to make their own digital assets. And the perils that come with it. On the one hand, permitting the creation of censorship-resistant, customisable digital instruments is core to the ethos of crypto. On the other, these can be weapons of mass value destruction.
One way to regulate them would be to mandate exchanges to not list them. But it would simply mean volume accrues to an alternative like Uniswap. Even at a margin of 0.1% in fees, exchanges have made $1 million daily on the coin, granted its volume has been in the billions.
But why would individuals even buy these assets in the first place? Part of the reasoning is that they fill the void left by lottery tickets. Tossing a figure as low as $100 on PEPE would have resulted in a $6000 outcome at its peak. That is close to the annual income in emerging markets. As a result, speculators routinely deploy small sums in multiple meme assets in hopes of making a quick flip. The challenge is that many of these assets trade with no fundamentals and entirely on momentum and "vibes". So there will be enough people bidding to buy these assets and be early entrants if they believe others will be willing to buy it. To a certain extent, it is a classic example of greater fool theory.
Read the early entrant's bit? That sounds like a Ponzi scheme to me. In a constantly inflationary environment, most things look (and feel) like a ponzi. But consider how these instruments work for now. When a meme asset is released in the wild, a decentralised exchange is the first place it is traded at. Developers set up what is called a "liquidity pool". It is a mix of dollars (or ETH) and the token itself.
Assuming there is $50 (in dollars) and 50 tokens, the price of a token is $1.
Someone comes in, sends $10 into the pool, and acquires $10 tokens. There is now $60 in the pool and 40 tokens.
Given more dollars are chasing fewer tokens, the on-chain price for it would now be $1.5.
I wrote a more prolonged breakdown of how this works in 2020 here. Meme assets often trade like Ponzi schemes because they operate on similar principles. Initially, a few early insiders purchase the token at very low prices. They contribute small amounts of dollars to the liquidity pool and receive many` native tokens in return. Essentially, they acquire a significant quantity of tokens for just a few dollars.
As people start discussing the asset, the supply of meme tokens in the pool diminishes, creating a perception that it is now worth "more." As users witness their unrealised gains, the buzz intensifies, attracting more individuals to buy the meme token. Consequently, millions of dollars start chasing something that emerged out of thin air. Once they attain a certain level of liquidity, Meme assets like PEPE may persist for years without any fundamental reason for their existence.
Lindy Effect of Uselessness
I used to think these assets trend to zero and die a sad death. But memes have their version of the Lindy effect. The longer an asset has traded in the market, the higher its probability of sticking around so long as it does not claim to serve a purpose. Doge fits that description quite well.
If it does serve a purpose and fails to serve it, an exchange like Binance would quickly point out that the “utility” the asset promised does not exist and gradually delist you if the volume requirements of staying listed are not met. You can see this playing out with Mirror Protocol and Anchor Protocol here.
There's a possible reason for this. Most tokens issued by teams have a handful of benefactors. Usually, these are the founders, venture capitalists and early employees behind the foundation, protocol, labs or whatever the cool kids (and their lawyers) call it these days. On the contrary, when a meme launches, the early benefactors are early adopters that send in dollars to buy the token. This perceived fairness lends legitimacy.
Think about how Bitcoin was released to a mailing list of some of the smartest cryptographers in the world. Or how during DeFi summer, the general approach to releasing a token was running yield farms. Markets care about perceived fairness even when investing in literal on-chain Ponzi schemes. Ironic, isn't it. (I could go on a different tangent about how this relates to dating apps, but let's stick to the markets for now).
Now you may think I am making up the Lindy effect thing. But if we look at on-chain statistics from meme tokens that rallied in the past, you will notice a mix of data. The average on-chain Ponzi, err, I mean meme, ends in net profit for a handful of early entrants. The chart above is for Shiba Inu.
Much like PEPE over the past week, it had narrative tailwinds in 2021 and set a new high. Wallets like this made millions of dollars from an initial investment of as little as $1067. The data from Nansen shows that the average realised PnL over time is around 249% on the network. Looks beautiful right? Well, only until you categorise the net outcome across sellers.
The graph above shows the distribution of the gains from wallets trading Shiba Inu tokens. The very same token that made a millionaire off someone investing $1000 is also one that has led to half of all its traders realising a loss. If you see, only about 6% of the wallets generate an outsized return north of 600%. This was in 2021 - a year when Bitcoin rallied from a low of ~$20k to $64k (assuming you purchased it in December 2019).
So for the risk and effort taken to be early to a meme, the returns are not precisely justified unless you consider the absolute edge cases. Those are the stories we read about on Twitter—the ones where millionaires are minted off a meme.
Generally, a meme asset “crosses the chasm” to see lindy effects when an exchange lists it. For example, some 23% of Shiba Inu is on exchanges. For a token like Dogelon, it is ~33%. Exchanges transform meme assets into financial products by placing them in the hands of millions of unknowing retail users that toss a few hundred dollars into them.
Memes then transition to providing outperformance of Bitcoin or Ethereum, each time the market rallies as liquidity finds its way to riskier assets during periods of market exuberance. You know a meme is here to stay when it becomes less about the community and more of an instrument to trade on an exchange. Charismatic CEOs like Elon Musk understand the relevance of making memes of themselves and their businesses as shown by the iconic tweet below.
There is a credible case to question if meme assets are a zero-sum game. In traditional assets or protocols with revenue, there is a base amount below, which makes no sense for the asset to trade at. If it does, consider yourself a value investor and allocate capital. Bear markets mean assets trade at deep discounts. Uniswap, for instance, generated some $28 million in fees last month alone. You can make an optimistic, rosy valuation model around that data because people use it.
The assumption is that price will follow usage, and eventually, use will grow to a point where it justifies the price for the asset. When a person buys a traditional investment, they are paying to assume the risks (and probability) that the investment will rally. When you buy a JPEG, you buy pixels that may find relative value owing to the social graph of other individuals that own the same asset. The Veblen effect of an NFT rallying because Elon Musk mentioned it is evident with Miladys’ recent run-up.
Meme tokens are different because the vibes determine the valuation. When the vibes are immaculate, the numbers look good. But faith runs out eventually, and people sell the token at a profound loss or hold until the market rallies again. So you take from a much larger subset of users to enrich a select few early entrants.
To understand why, consider the distribution of wallets that own meme assets. The data below is for Shiba Inu. If you see, some 78% of the wallet holders own less than $1000. Most token economies follow a similar bell curve. Still, it shows the prevalence of retail capital that goes to meme assets and the concentration of tokens in a few wallets. For example, some 80% of Shiba Inu’s supply is held in 58 wallets, according to data from IntoTheBlock.
Now there is a caveat here. And that is that new meme projects rarely ever see large-scale returns from small sums of capital being deployed. The most significant return on a six-figure sum I saw from PEPE’s recent rally was a $100k investment turning a million dollars in three weeks.
To see how investment profiles work on meme assets like PEPE - I took a sample of the top 100 wallets in terms of realised gains—then plotted the initial capital they deployed. Of the 100 wallets, only three had deployed more than $10k. As you would expect, most investors that saw outsized returns were smaller wallets that deployed smaller sums of money. There are two ways to interpret this data.
That meme assets give smaller investors a way to make outsized returns (by being early)
Or these are generally insider wallets that took part in a Ponzi before anyone else did.
One way to test this hypothesis would be to study the historical activities of these wallets. Unfortunately, that goes beyond the scope of this article and maybe something to consider for an academic project. (E-mail me if you want to explore that)
I shall resist the urge to do more on-chain analysis on these assets. But if I had to summarise what we have seen so far, it is that.
Meme assets can become lindy, financial goods as long as large exchanges support them.
A handful of small, early entrants makes outsized returns so long as they are early. The key word is early.
Most investors have under $1000.
Much of the significant returns we see come from investments under $10,000
Meme assets are similar to Ponzi schemes in that they can die quickly if inbound liquidity on the buy side stops. Exchanges bridge that gap.
But what is the psychological rationale behind investing in Meme assets? A behavioural economics paper is likely waiting to be written about these investors. But here’s what I have for now.
A Season of Biases
People are often optimistic about the world. This is because we believe in positive outcomes over terrible ones. This tendency is often referred to as the Pollyanna Principle. Optimism is a necessary trait for society to function. But if you are a gambler or an investor, it can cause undue harm. A gambler may believe the outcomes would be in their favour. An investor could often presume others investing have done the necessary due diligence.
One way this plays out in the market is with the stories we often hear. A year after Luna's crash, much is not talked about how $40 billion in value was wiped out. We are, on the contrary, bothered with where the next big rally would come from. A different bias at play is recency bias. The availability of news about prices going up in the recent past makes us believe it would be a continuing trend.
This excludes the memetic desires emerging from seeing others on social media, making it big. If you look at YouTube or Instagram, the idea that one should be "in charge" of their finances is constantly sold to individuals. And that is true. One should be in charge of their finances, much like they should be in charge of their health. But being in charge does not translate to deploying your life savings into a funny-looking token. Often, investors are better off doing nothing if they have thematic exposure to an asset class like crypto.
There is a third and far more likely reason. And that has to do with volatility. Many crypto-native users measure their wealth in Bitcoin or Ethereum terms. To outperform peers in the market, you are required to take more risk. During periods of low volatility, trading even on leverage cannot necessarily create the returns profile traders are shooting for. So they take on increasing levels of risk across dubious assets with the idea that most of them will go to zero, and some of them would help them create outsized returns.
As the meme coin becomes less relevant in public circles, its volatility begins imitating any other coin. In the chart above, ELON and Shib - two meme assets from earlier have begun behaving similarly to Bitcoin.
Ironically enough, large fund managers also share this tendency to take on riskier bets and hold until it is too late to sell. A recent paper titled “Competition and Speculation in Cryptocurrencies“ studied mutual fund managers involved with cryptocurrencies in any capacity between 2016 and 2022. It noted that managers that were early entrants, with their own capital in the fund, outperformed peers who came in much later to mimic their peers.
Early adopter managers were also better at hedging and exiting crypto during the bull and bear cycle. Not too different from our retail friends that are simply trying to be early to a meme-coin boom.
The truth is, no matter what moral stance we take, meme assets are here to stay. The instruments to issue and trade them are as accessible as a few clicks. And so long as communities are willing to rally around them, we will see a surge in the speculation around these assets. Indeed, the regulator can play a role in requiring exchanges to have a framework on what is acceptable for listing and what isn’t.
I don’t quite know what “fundamentals” the team at Binance glossed over while doing their diligence on the PEPE token whilst conveniently ignoring the hundreds of teams with actual products seeking a listing. But any framework from a regulator is unlikely to mean anything if the liquidity moves to decentralised exchanges. The extreme would look like the sanctions Tornado Cash got on itself.
The problem we have as an industry is that the ones (pretending to be) building cool things are also (often) peddling these junk instruments. It is hard to take anybody seriously when one praises degenerate behaviour and simultaneously asks for regulations. Imagine if Jobs or Zuckerberg were busy talking about their stock portfolios instead of obsessing about the user's needs.
As a result, the industry comes off as juveniles conducting financial fraud whilst sitting on top of world-changing technology. And in the process, we discount countless builders and researchers that work day in and day out to make the asset class and technology useful.
We live in an age and time where money has become a meme. Our generation is staring at an economic crisis between inflation and rising unemployment. (The Millenials can stop mentioning 2008 now). It is a slow bleed marked by cute filters from Instagram and catchy tunes from Tiktok. We even have generative AI making art and essays too—so much fun. People will do everything they can to make an extra buck. And sometimes, that would involve meme assets and NFTs.
What we can do as an industry is to be more vocal about the risks of investing in meme assets. One can always show what decentralisation (as a concept) and blockchains (as a technology) can offer without requiring people to put their life savings into on-chain Ponzi schemes. Also maybe shed light on the builders creating useful tools people can use here and now. Each time we celebrate the gamblers, we completely ignore the builders.
And the establishment of a sustainable ecosystem requires celebrating both.
P.S. - Much gratitude to everyone that tweeted about this publication after I asked for it the last time. We are very close to the milestone I mentioned. We should be crossing it by the time I send the next newsletter.
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Had so much fun reading this!
Good one Joel as always!