Tokens models to bootstrap network effects in multi-sided platforms: the chicken and egg problem resolved

This article explains that the consensus mechanisms of blockchains enabled by a token create trust among independent participants and a powerful set of incentives that bring long-term alignment to its users. Undeniably the biggest challenge to multi-side platforms, network effects are propelled due to the economic flywheel enabled by tokens, which incentivize participants and coordinate all economic activities in crypto networks. Those token models being new and developed out in the open, the kind of network effects that emerged vary widely between different projects, and that’s because the design space is vast, and only the project that is designed with network effects in mind end up benefiting from them. Which will bring us to Layer 2 protocol in DeFI, and the emergence of governance tokens with dynamic mechanisms and incentive scheme that is going to work in the wild and might have unintended effects for the protocol.

A token on the blockchain is the business model at the heart of crypto and the factor that allows companies to build moats as it incentivizes participants and coordinates all economic activities in crypto networks. Combined with developers’ ability to rely on each other’s networks using autonomously executing smart contracts, tokens have resolved the bootstrapping issue of early start-ups and increased their defensibility.

First, I’ll quickly explain what a blockchain is and that the consensus mechanism of blockchains creates trust among independent participants in decentralized networks.

Introduction to blockchain infrastructure:

A blockchain is a network of participants that comes together via a consensus algorithm. A blockchain can be separated into four different layers:

First, there is the hardware layer (layer 0), which includes miners and validators. It consists of the peer-to-peer network protocols that allow the participants of that layer to communicate with one another. This layer brings the computational resources that ensure that there are bandwidth and connectivity between the various nodes in the network.

Second, there is a consensus and computational layer (layer 1). Here, the stakeholder of the system communicates via peer-to-peer networking algorithms and needs to agree about the actual state of this blockchain computer and work toward maintaining it (i.e. which individual has which currency, how many crypto collectible, track them). Once in agreement about the state of the network, they compute on top of it in a verifiable way, guaranteed by the network’s game-theoretical mechanics.

Thirdly, Layer 2 is a kind of computational substrate for the programs that developers write that run on the blockchain computer. Those programs are known as smart contracts, which are the fundamental building block for everything that ever gets built on top of a blockchain.

Finally, Layer 3 is the user interface, the code that runs on a mobile phone or web browser (for a wallet, exchanges, application that one uses to interact with smart contracts such as crypto kiddies).

We will now focus on layer 1 and layer 2, as those are the aggregation point where a token model enables value capture/creation.

Layer 1 Token model

The core fundamental value capture mechanism of layer 1’s business model is instances of multi-side platforms, and how a token, through a well-designed incentive structure, helps bootstrap a network value and resolve the chicken and egg problem.

A multi-sided platform is a common ground that creates value by enabling the direct interaction between multiple kinds of participants in the network. Like Lyft, where drivers directly interact via the Lyft app with riders. At its beginning, the Lyft app doesn’t add much value to its drivers, if there are no riders. Conversely, if there are not many drivers, and so the waiting time is quite long before a course is filed, there is not much value for the rider. This supply and demand problem is conceptualized as the chicken and egg problem.

Like multi-sided platforms, the Layer 1 protocol has a set of stakeholders, each with its function, commanded by the incentives structure and enforceable rule of the network.

It begins with the founding team having the idea for the protocol and reaching investors to help it build the vision and bootstrap some initial token value. In exchange for providing capital, those investors are given the native token of the protocol. This token is the core value capture mechanism for each stakeholder participating in the protocol. Once some initial token value exists, that creates a powerful incentive for miners or validators to provide some of their computational resources and hardware that gives the platform security and functionality. In the bitcoin network, as bitcoin’s value grew, and its vision came to light, more and more miners entered the market. Those miners contributed their hardware and electricity to produce new blocks that entitled them to a reward in the form of bitcoin. Once the functionality exists, third-party developers have an incentive to build useful applications that offer utility to end-users and eventually, a community begins to form. Such a third-party developer’s activity around bitcoin include things like wallet, trading exchange, ETF, and the Lighting Network. The same is true for Ethereum with its token ETH, which currently sees the rise of DeFi, with many DApps and token build on top. The more useful application on the Ethereum network, the more utility for its users, which creates a powerful network effect for the protocol and increases its token value and defensibility.

This highlights the bootstrap process of Layer 1 protocol. This is all made possible due to the token models built around specific markets or businesses with the intent of creating a better method of circulating value between their participants. The tokens are about how they allow stakeholders to engage with the products, while the actual price and value of the token are reflective of the value of the service being provided.

To create a sustainable layer 1 protocol, one needs first to create the correct token economics and set of incentive structure for the protocol to function as intended. Second, the vision/idea of the protocol needs to be appealing and find product-market fit. This tokens economics deals with how robust its blockchain system is designed to produce desirable outcomes for all network stakeholders. One of the most important forces for which to account when designing such models is incentivization. With blockchain involving a decentralized architecture, there is no need for relevant parties within the ecosystem to trust each other. With adequate incentives, the relevant stakeholders will act in the best interest of the system. In turn, this should instill confidence in the integrity of the system and thus facilitate greater user adoption of the system’s token.

Then, the stronger the vision for the protocol is, the more useful it is to its stakeholders, the more the token is valued, which results in even greater incentives for miners and validators to provide security and functionality which encourages developers to build even more apps and which in turns creates even more utility for end-users, and eventually, a community begins to form creating a feedback loop.

The Ethereum network token model

Let’s dive deeper into the layer 1’s Ethereum network, and how its token ETH was able to bootstrap value around the protocol and ultimately create a value take most protocol.

Ethereum is a global, open-source platform for decentralized applications. It is meant to be a platform for the deployment and execution of smart contracts. As with Bitcoin, miners validate new blocks and are rewarded with ETH. Besides, the Ethereum ecosystem also requires users to pay ETH if they want to execute smart contracts on the platform. Thus, ETH is commonly referred to as the crypto-fuel that runs the applications on Ethereum’s decentralized network. To kickstart the development of the Ethereum protocol, Vitalik Buterin, it founder, did a pre-mine of 60 million ETH for its ICO, through which anyone could participate. Also, 12 million ETH were pre-mined for distribution to early contributors. This ingress of financial capital entered the ecosystem, through outside investors, made it more attractive to miners and validators because now there’s a greater token value incentive for them to provide production capital. The same applied when new developers joined; the network became more useful to users because that user can leverage now more applications. Through the ETH token, developers were incentivized to commit to the development of the Ethereum network, improving its usability and, ultimately, the token value. Such application development has seen the rise of DeFi, which refers to digital assets and financial smart contracts, protocols and decentralized applications built on Ethereum. The more useful apps are created on top of Ethereum, the more attractive the users are, the more valuable and defensible the protocol is. Plus, those applications that run on top of the network can interact with one another: smart contracts are composable, increasing further network effects around the platform and third-party developers choosing one blockchain over another to build on top of. The same reasoning goes for users, which once they use an dapp present on the Ethereum blockchain, they might find more utility in using the other dapps in the ecosystem, driving a robust engagement around the protocol. DeFi apps need to use ETH to create a smart contract, they burn gas for transacting on top of the protocol, but most also require users to deposit ETH as collateral to use their services (borrowing, lending). As a result, the token ends up taking the monetary premium as the form of money that coordinates all economic activity within the ecosystem, improving its defensibility and network effect.

Layer 2 Token model

The same range of though applies for layer two smart contract applications that are instances of multi-sided platforms that themselves are built on top of layer one blockchain, which also are multi-sided platforms.

Let’s take the example of Compound.

Compound is a lending platform that is a smart contract running on Ethereum. Any lender can lend out some of their assets to borrowers who pay interest in return for that loan. As in the Maker protocol, keepers keep the network safe and make sure the loans whose risk parameters are not desirable are folded or can liquidate loans in time so that the entire system stays sound. There is a governance token that provides governance over the network and is a factor for financial capital to enter the system.

Lenders provide liquidity into the Compound smart contract, and in return for those deposits, get a ctoken that they can use to redeem their deposits if they want ever to withdraw. On the other side, some borrowers can borrow from that pool of capital. Whenever borrower pays interest for the loans, the loan’s share of that interest payment goes to the depositors who initially deposited assets in the contract, and some percentage of that interest payment goes back to the governance token holders who originally potentially were investors early on and provided financial capital to the system.

The playbook and template for the business model on layer 2: you end up with a smart contract at the center where the supply side provides some service, and the demand side pays for that service and the governance token holders capture some share of the payment, all in a way that’s entirely automatic where a contract just divides up the fee that’s being paid and distributes in many ways.

How does a token here bootstrap the supply and demand present in the platform: For the Supply-side, by depositing assets into the smart contract, they can earn interest on that deposit, just like a bank. However, the COMP token holder also receives a percentage of that interest. Thus, by providing liquidity to the platform and holding COMP token, one can earn interest from both canals. Compound also recently includes a smart way to bootstrap liquidity to its platform by rewarding governance tokens to its lenders and borrowers. The idea is to incentivize people to use the platform by subsidizing their usage and hopefully grow a community. It helps a protocol to launch, grow and govern themselves with their communities, shifting from “buying to own” to “participating to govern” and aligning the long-term interest of their participants to the growth of the protocol.

In Compound finance, a reservoir contract was created, which transfers 2,880 COMP every day during a period of 4 years, to the user of the protocol on the supply and demand side. Thus, users depositing funds to lend money on COMP earn from the interest of their deposits, but as well from the COMP they make (the subsidy). The same thing happens to borrowers in the protocol. The COMP token was released in June 2020 as a mechanism to decentralize the protocol’s governance, with the subsidy aimed at distributing the token to its community. This new business strategy has skyrocketed TVL in Compound, from $90 million to $900 million in just three months, as users could earn interest and COMP token. Adding a tone of liquidity to the protocol and thus improving functionality for lenders and borrowers.

However, the increase in the performance metrics of the COMP protocol is not driven by organic growth and committed community members, but by speculators who are attracted to maximize their yield. By subsidizing deposits, this kicks off a positive feedback loop where more deposits imply more value captured in the community-controlled reserve and higher growth, which makes COMP more valuable. As the COMP price increases, the amount of the subsidy increases, which attracts more capital to the protocol, making the COMP appear more valuable as the TVL increases.

While the protocol’s key performance metrics are up across the board, it remains unclear whether momentum can be sustained as competing protocols begin to issue equivalent subsidies. This dynamic only works as long as the reward on COMP is the highest. If one other platform has a higher yield, since most early users are speculators, most will leave the protocol in search of the higher yield, mostly having spent those subsidies on early speculators not here for the community and protocol, but for maximizing their return. As users pull out their fund of Compound to deposit them on the highest yield’s protocol, the COMP token trades down, creating a negative feedback loop.

This begs the question of how sustainable those subsidies are? In terms of the acquisition cost of the community and if effective at all? Effective means there is a degree of reflexivity where some early speculators turn into community members.

Seeing this explosive growth of new users in Compound, many other DeFi protocols have used the same strategy to attract users, continually increasing the reward it offers to new users. This chase of new users has even coined the term “yield farming” where user go to whichever money market has the highest interest rate, in another world, which protocol subsidize its community the most. To put this into perspective, a protocol such as Aave did the same and grew in value from $60 million in TVL to $800 million from June to August 2020, however, experiencing massive drawdown in TVL (-40% in 2 days) during its rise due to yield farming.

So far, those subsidies have been used as rocket fuel to attract capital allocation for those protocols that increased in value and defensibility as more capital borrower have access to and the more stable interest lender can earn, helping them reach the network effects required to achieve exit velocity (meaning for the protocol to live out of its network effects). It remains to be seen if each protocol’s ability to convert early speculators into community members. The critical point here is for the protocol to reach a critical mass during the four years give away to users for it to live out of its network effects.

Those SAFG represent a new business model that is tried (and tweaked) out in the open. These governance mechanisms are dynamic, and one never knows precisely how an incentive scheme is going to work in the wild when these users don’t exist in a vacuum; they are participants in the broader DeFi and crypto ecosystems and can have unintended effects.

One proposal that aims to create a more sustainable path toward reaching scale and network effect for those Layer 2 protocol would be to subsidize the use of the protocol with a decreasing subsidy over time, similar to bitcoin havening. The idea goes as follows: having a high reward function at the beginning is vital as it attracts many speculators. As time goes by, a certain number of speculators are reached, and some percentage of them convert to community members, and a critical mass of platform users starts to form. Then, value distributed by the subsidy is a much smaller percentage of assets under management, same for participants in the protocol that are receiving governance reward in a much lower portion than they currently do, thus reaching an equilibrium where users that stick are the one interested in the protocol. For later coming users, the idea is that eventually, through trading, tokens find their way into the hands of people who are interested in governance.

One caveat of this decreasing subsidy over time (or even to non-decreasing subsidy) is that given how early we are in the lifetime distribution of these assets, most of the circulating supply is owned by team members and key stakeholders and venture capitalists. Thus, most of the early, higher part of token distributed is given to the same owner of the protocol, limiting distribution and thus decentralization.

From this lens, we can see that token-based network bootstrapping is very similar to the traditional start-up financing model. In both cases, a project can use the speculative future value of its cash flows to finance the subsidization of network utility building actions & user growth. However, one key difference is that instead of economic value being used to subsidize goods or services provided by the start-up, token-based network bootstrapping rewards participants with an asset tied to network value. Some participants may sell these rewards; however, those that hold are essentially converted into “network shareholders”. These holders have a long-term alignment with the project and can potentially support the project as users and/or investors.