By Alex Tapscott
Many Web3 proponents tout the ‘frictionless and efficient’ nature of value transfer. While it’s true that transactions in Web3 settle instantly (or nearly instantly) and peer to peer value transfer enables greater economic freedom and autonomy online, they are not free!
Bitcoin users pay a hidden fee in the form of the ‘inflation rate’ of new Bitcoin getting created to incentivize the “miners” to contribute vast computing power to secure the network. Ethereum holders “stake” their ETH to the network to help secure it in exchange for a “yield.” Matt Levine of Bloomberg once wrote an insightful (and humorous) piece describing how these so-called “stakers” are a lot like lenders in traditional finance. By tying up their ETH as stakers, they are effectively lending money to the network to maintain a decentralized ledger of transactions, earning a reasonable rate of interest in return. The staking yield helps capitalize a decentralized network where previously a bank or other company would have played the same role. The punch line of the article was basically, “leave it to crypto people to reinvent…interest!” Levine still concedes that what Ethereum is doing is also genuinely innovative.
Well, if you thought reinventing interest was amusing, hold my beer! Because now Web3 is reinventing…earnings! On last week’s DeFi Decoded, Andrew Young, my co-host, described how 2023 will be the year when investors start to look more closely at so-called “protocol revenue.”
Potocol revenue typically refers to the revenue generated by a decentralized protocol or decentralized application through the collection of transaction fees or other charges on the network. For example, Uniswap, a decentralized exchange (DEX) built on Ethereum, charges a small fee on each trade made on the platform. Compound, a decentralized lending platform that allows users to borrow and lend cryptocurrency, generates revenue through interest charged on loans. MakerDAO, a decentralized platform that mints the DAI stablecoin, also charges a small fee. The revenue generated by these protocols is often used to cover operating costs and to fund development of the protocol or platform, accruing over time to a ‘DAO Treasury’ which is basically an on-chain wallet that functions like a bank account.
DeFi and other Web3 applications which make money should not surprise anyone. Web3 founders are a capitalist bunch like any other group of entrepreneurs. But do the native tokens of the applications who generate the most earnings, see the best returns? Not necessarily. In DeFi specifically, many projects offered eye-watering ‘token rewards’ to attract users and liquidity to the platform. This can be a powerful way to scale your project, however it is a double edged sword. Let’s say a hypothetical ‘Protocol XYZ’ has 10 million tokens outstanding and it makes $10 million in protocol revenue in year one. Protocol revenue per token is $1.00 ($10/10). By year two, there are now 11 million tokens and $10.5 million in revenue. Protocol revenue is now about 95 cents, less than before. Hence, if the issuance of new tokens increases more than the growth in protocol revenue than the “revenue per token” declines. This makes any new issuance of tokens “dilutive” to revenue per token, rather than “accretive.”
Starting to sound a little familiar? Public companies routinely tap the equity markets, raising capital by issuing new shares. With the same earnings as before but with more shares, earnings per share declines (at least in the short term). Although, if the company takes that money and launches a new product or acquire another company, then it can be accretive to earnings. Protocol revenue per token is basically Web3’s answer to earnings per share. Andrew pointed this out on the podcast, arguing that successful projects will grow revenue more than their new token issuance, making it accretive to existing holders. His point was also that offering ‘liquidity rewards’ which basically means massive dilution long-term, will be unsustainable. Instead, quality projects will build a moat around their functionality, not just liquidity. To dive in deeper to this subject, check out last week’s episode of DeFi Decoded.
Author’s Note: The January 5th edition of Digital Asset Digest essay titled “Is Ownership Always Good? Challenging One of the Core Arguments of Web3” and the December 1st edition of Digital Asset Digest essay titled “Does Web3 Create Perverse Incentives?” both included paragraphs that were substantially similar. We apologize for the error.
