Web3 economy

4 Mar 2022

How are protocols structured?

Why would participants be rewarded?It’s important to distinguish between the different groups of people to be found within a DAO (decentralized autonomous organization). In the last newsletter, DAOs were described: briefly, they’re social vehicles that can be set up for a wide array of uses. They contrast with traditional organizations where a legal form, such as a company, LLC, non-profit, or government entity has been required to coordinate individuals’ efforts around contractual terms.

Within web3, this nexus of traditional organizations is replaced by smart contracts: pieces of code programmed to behave in a particular way according to predefined triggers. This coding of actions means that individuals are now able to collectively form complex contracting relationships in the absence of a legal, fictional entity serving as the coordinator. This has led to the popular mantra, “Code is Law”, since technology is used to enforce rules. Currently, there are four main groups of people within a DAO: core contributors or developers, bounty hunters, network contributors, and token holders.

  1. Core contributors. The typical full-time employee focused on a single organization or project. They have a regular employment contract with the project or DAO. They focus on a single topic, allowing them to develop specific knowledge and strategic thinking about their DAO, enabling it to grow and provide value through the rest of the chain. Because DAOs are inherently more open than traditional corporations, it’s possible for outsiders of the DAO to know what those core contributors are doing or even reach out to them directly.
  2. Bounty hunters. These complete defined work. They are often functional experts in areas such as finance, development or design, who provide services to many DAOs at a time and fulfill specific tasks with clear boundaries. These services could range from treasury management and software development, to governance, research and development. They are comparable to contractors and professional services firms, where a task is performed for a pre-agreed fee.
  3. Network participants. DAOs reward an individual contribution based on the value it provides, regardless of whom it comes from. This means that everyday actions that are valuable to a network or the DAO will be turned into income-earning opportunities. This could be labeled as ‘participate-to-earn’, as participants are being monetarily incentivized to use a service. This economic incentive is usually done with the native token of the protocol, but DAOs can form partnerships with other DAOs and offer other tokens as a reward. Those rewards to participants have evolved over recent years and can take various forms (see below).
  4. Token holders. Given that any network participant can purchase tokens, every single person can become an investor. Thus investments will turn into a major source of income for an increasingly large portion of the population. Not every investment will appreciate, but individuals will have access to opportunities previously reserved for a select few. This can be labeled as an ‘invest-to-earn’ model.

There are additional ways to reward participants of a project. For example:

  • Play-to-earn games for players who provide labor (their time, skills and energy) and capital (often purchasing NFTs to participate in the game) and in return are rewarded with fungible tokens, such as the native token of the game, for achievements and progress within the game. For example, a user purchases an object in the form of an NFT, and after completing certain tasks or using it during certain hours, that object acquires a new attribute that then makes it scarcer. Subsequently, the user could sell the NFT at a higher price to other participants.
  • Learn-to-earn is a new education model where instead of paying to learn, a person is compensated for demonstrating that they have learned something. This allows for a positive-sum interaction: users learn a new skill or way to use crypto and the ecosystem gains knowledgeable users.
  • Create-to-earn where creators are paid for the value they add to networks beyond the individual earnings they make on their work. For example, an NFT marketplace can reward early users, collectors, and artists on their platform, acknowledging their role in creating value. For example, Audius, a decentralized music streaming platform, is giving creators an ownership stake in the network as a result of the value they bring by uploading music and curating playlists.

 While core contributors and bounty hunters are usually paid in fiat currencies, especially US dollars and Euros, they can also receive payment for their services in tokens. The other two groups, network participants and token holders, only receive value from the protocol’s token.

Given that the core contributors and bounty hunters are a minority of DAO participants, it is of great importance that the tokenomics of the protocol are sound. But its importance extends beyond value accrual for participants.

Token + Economics = Tokenomics

What are Tokenomics? They’ve been defined as, “The science of the token economy, covering all aspects involving its monetary policy as coin (token) creation, supply and demand management, and removal from the network.” Source: Link, Link.

The tokens can be used for several use cases:

  1. Infrastructural tool (enabling the normal functioning of a blockchain)

    Tokens can be used for transmitting value or storing wealth. Additionally, in blockchains like Bitcoin that use a proof of work (PoW) consensus mechanism, the native token (e.g. BTC) is used as payment to miners for maintaining the network’s infrastructure. In blockchains like Ethereum, the native token (e.g. ETH) can be used to pay transaction fees. In blockchains with a proof of stake (PoS) mechanism, the native token needs to be locked (staked) to secure the network.
  2. Governance tool (providing rights to participate in the protocol’s development)

    Decentralized protocols don’t have a C-suite or management board running the protocol and determining its course – instead it’s the users who can submit change proposals, which can then be voted on. In order to gain governance rights, users need to purchase the native token and then, commonly, stake it – that is, lock it up. Given that many protocols suffer from ‘governance apathy’, it is common either to share a fraction of the protocol revenue with stakers and voters, or allocate a percentage of the native token as reward for stakers or voters. A new wave of protocols like OlympusDAO have created game theory-based models where there’s an optimal scenario for all participants (‘prisoner’s dilemma’). OlympusDAO was initially founded to launch the token $OHM, a ‘decentralized reserve currency’ – $OHM is not a stablecoin keeping its price equal to the US dollar, but rather an asset that would increase in value relative to the principal investment. • OHM can be both bought and sold in the market, referred to as a -3 scenario.• Anyone can sell certain tokens directly to Olympus in exchange for discounted OHM, this would be the +1 scenario. • When users stake their OHM at OlympusDAO, the percentage of the total supply they hold remains constant. That is, when new OHM is minted through bonding, users who have staked their OHM will receive more OHM from OlympusDAO. This is the +3 scenario.This has led to the following payout matrix: Link
  3. Marketing tool (allowing access to the platform or promoting its usage)

    A popular marketing maneuver is airdrops: sending coins or tokens to wallet addresses that have interacted with certain protocols to promote awareness of a new protocol. To qualify, a recipient may have been an early user or need to hold a minimum quantity of specific crypto coins in their wallet. Alternatively, they may need to perform a specific task, such as posting about the currency on a social media forum, connecting with a particular member of the blockchain project, or writing a blog post. The most common way to promote the usage of a protocol is through liquidity mining rewards. It’s also used as a way to bootstrap liquidity by rewarding participants who bring liquidity to the project. For example, in a lending protocol both lenders and borrowers will be rewarded with the native token of the protocol.
  4. Profit-sharing tool (giving its owners a claim to dividends or an equivalent)

    Similar to equities, where the profits of a company are distributed to shareholders in the form of dividends. In DeFi, instead of paying a dividend, protocols can directly distribute earnings to owners. Nonetheless, like some traditional companies, protocols may opt to use profits in other ways, for example, token buybacks, business development, R&D, treasury diversification, etc.An important concern when implementing profit-sharing tools is the location of the network participants. The SEC has raised concerns among such protocols, given that the definition of security by the SEC is, “Transferrable certificate of participation in any profit-sharing agreement”. Therefore, tokens that are used as a means to share profit could be deemed as a security under US law.
  5. Source of funding (either to expand the core team or as a reward to developers)

    In 2017 this was the most common use for tokens or coins. It was a simple way for protocols to bootstrap capital and develop their product. This led to what is known as the ICO (initial coin offering) mania. In November 2017, 430 offerings were raising an aggregate of $4.6bn. Source: Link. Nowadays, due to the ease of acquiring capital from VCs and investment funds, most protocols raise funds through a seed round or private token sale. The allocations are usually vested, anywhere from a few months to as much as 3 or 4 years in some cases. The vesting schemes can have a wide array of options, from big cliffs (e.g. 50% of the allocation is released after 1 year, then linearly for 3 years), to releasing it linearly after only 1 month.

Case study: Uniswap token model

Uniswap is a decentralized exchange (DEX) built on the Ethereum blockchain, offering non-custodial token trading, usually referred to as swapping. The protocol’s native token is UNI. In the last month, Uniswap generated a revenue of $86m (Link) and owns the largest treasury in DeFi of $4.4bn (Link). Revenue is generated from the trading fee charged when tokens are exchanged.

  • On UniswapV1 the trading fees were 0.30% and fully allocated to the liquidity providers.
  • On UniswapV2 trading fees were 0.30%, with 0.25% allocated to the liquidity providers and 0.05% to UNI holders.
  • On UniswapV3, stablecoin fees were 0.05%, fees for highly liquid non-stable assets 0.30%, and for illiquid assets 1.0%. By default, the fees are fully allocated to liquidity providers, but via governance a protocol fee could theoretically be set at a later point in time.

To present a governance proposal, at least 2.5m worth of UNI (0.25% of the supply) voting rights must be delegated to a wallet. Users can either buy and self-delegate the voting rights to themselves, or delegate them to someone else that best represents their views and interests. Once a proposal has been presented, the duration of the voting period is 7 days. If there are more votes ‘For’ than ‘Against’ (simple majority) and there are total votes worth at least 40m UNI (4% of the supply), the proposal is approved. For example, a recent proposal was passed that reduced the amount of UNI needed to submit a proposal, from 1% to 0.25%. Another approved the launch of Uniswap on a new chain.

Initially, 60% of UNI was allocated to the community, which broke down as 15% allocated retrospectively to Uniswap users and 45% as participation incentives. A further 21.82% was allocated to the team and 18.81% to investors. The allocations to the team and investors were vested over a 4-year period that ends in 2024. All UNI tokens are expected to be distributed over the next 10 years.

While a big chunk of the total supply has been allocated to the community, research done by Von Wachter 2020 (Link), proved that in reality most of the decentralized protocols are not really as decentralized as one might expect. Quickly analyzing the current distribution of UNI, less than 50 wallets would be able to submit a proposal.

Economics basics: Supply and demand

Knowing the distribution of a token is paramount. How many tokens exist right now? How many will exist? How quickly are they being released? Is there anyone who controls a big part of the total supply? Is the token inflationary, so that more tokens will be created in the future, or is it deflationary and tokens will be ‘burned’ so total supply decreases?

Bitcoin and Ethereum are the most popular and well-known cryptocurrencies. Yet their supply and demand models are drastically different.

Bitcoin has a hard cap to its supply of 21m bitcoins and no more than this can be created. Of those, roughly 19m already exist and the 2m remaining will be created over the next 120 years.

Ethereum on the other hand doesn’t have a hard cap to its supply. Theoretically, there can be an infinite number of Ether. Initially, Ethereum deployed a proof of work (PoW) consensus mechanism, like Bitcoin, where miners received a reward for each block mined. Through a governance proposal, Ethereum Improvement Proposal EIP-3675 (Link), a change to a proof of stake (PoS) consensus mechanism was approved – its final roll-out is forecast to be in 2023. Another critical proposal was EIP-1559 (Link) in which the current fee model was changed. Previously, miners were incentivized to pick up transactions that pay the highest amount of gas. After EIP-1559 passed, users pay a base fee plus an optional miner tip if they want their transaction to be recorded faster in the blockchain. The base fee is burned, which means high network usage could see a large number of ETH put out of circulation. So in certain conditions, ETH could turn from an inflationary to deflationary currency. Currently, there are 119m of ETH in circulation and it’s estimated the supply will stabilize at between 118 to 120m.

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