VCs 'pre-farming' DeFi projects raises questions about ethics in crypto investing and airdrops

Last week, pseudonymous crypto user Gabagool.Eth sent a shockwave through the crypto universe with a Twitter post that made a case, based on-chain evidence, that an employee at Divergence Ventures appeared to be using multiple Ethereum addresses to profit based on insider information.  

Technically, it appeared the Divergence employee had been engaged in a so-called Sybil attack — in which the attacker uses multiple pseudonymous identities to gain an advantage over other participants in a network.

In this case, the scheme was to “pre-farm” a DeFi protocol — use it a lot, basically — with several wallets in the hopes of getting an outsized airdrop. Airdrops are a common mechanism by which a crypto project will release a new token, dropping the crypto in the wallets of its protocol's users — often in amounts that correspond with how active a given user is. 

It's not uncommon for crypto enthusiasts to pre-farm a project in the hopes of getting an airdrop. And the ethics of using multiple wallets are debatable. The real source of intrigue in this story is that Divergence is an early investor in the project in question, called Ribbon Finance. That's why Gabagool and others suspected the firm had essentially been trading with insider knowledge. 

Over the weekend, another piece of damning evidence emerged: the founder of Ribbon said in a community Discord that the first time he alerted investors that there would be an airdrop was on May 17 — just a few days before Divergence began pre-farming. 

Divergence also wasn't alone, according to Gabagool. "At least two other entities with insider info from the Ribbon team engaged in Sybil attacks in the days after that information," he said in a phone interview with The Block. "Most are better at opsec than Divergence's analyst," he added, referring to operational security. 

These schemes highlight the state of the crypto investment landscape: a world in which venture investors are also traders looking to profit from market inefficiencies and other idiosyncrasies. They also raise new questions about the mechanics of airdrops. 

The games that some crypto VCs play

After Gabagool’s revelation, Divergence put out an explanation that cast what had happened in terms of a game.

"In playing this game, we try many tactics, all the time," Divergence said in a tweet. "Most fail. This one 'worked,' and obviously worked in a relatively big way."

Still, tricks to make money are not always legal, nor are they always ethical. 

Garret Allen, who founded OpenSea rival Infinity, said it is already known within the industry that VC firms and other investors are engaged in these kinds of tactics. "I kind of feel like it was an open secret among VC and investors," he said.

It’s also hard to see how it can be stopped. The pseudonymous nature of crypto is all that a skilled attacker needs to obfuscate their actions. "I’m not sure if the problem goes away, or whether people just become better at hiding it,” said Allen.

Still, the situation isn’t completely unprecedented. Phil Berg of law firm Otterbourg told The Block that the state of crypto today is reminiscent of the early days of derivatives. "It is analogous … no one had jurisdiction and it was kind of a Wild West situation and then the industry got together and created a set of rules."

Berg said crypto investors should work on creating a set of principles for how to avoid potential ethically dubious situations. Crypto airdrops don’t have a clear analogue in U.S. equity markets, but Berg said they could be likened to sweepstakes giveaway deals, which are monitored by certain regulators.

“Employees of the company conducting the sweepstakes and the company whose brand is part of it is not eligible to receive them,” he said. “You have to avoid conflicts.” 

Problem with Airdrops and deal structure?

The Divergence incident also raises fresh questions about airdrops themselves. Among cryptocurrency users, they're very popular: it's effectively free money. For the most active users, airdrops can amount to tens of thousands of dollars. 

Still, they're not perfect, and it’s hard to make them both fair and resistant to the kind of attacks seen in the case of Ribbon. 

Cozy Finance's Tony Sheng recently penned a Twitter thread about what he called “the airdrop trilemma.” In Sheng's view, a project can't make an airdrop accessible to all users, resistant to whales and Sybil resistant.

The goal is to "distribute to the widest number of people who will be good stewards of the protocol. You need to come up with the least wrong version of that,” Sheng wrote.

Tom Schmidt of crypto VC Dragonfly added that it's not just airdrops that are the problem. He said the trend of hedge funds — which typically engage in liquid strategies — participating in venture investment is also contributing. "Really muddies incentives and styles," he said, admitting his own bias as a pure venture capital investor. 

Ultimately, projects should be more careful when they pick investors, according to Fractional founder Andy Chorlian. “We need a lot better vetting of VCs.”