0. Opening Remarks
- This article mainly focuses on the applicability as well as the necessity of Token economy for Web3 applications from a reflective perspective.
- The specifics of the token economy design are not covered in this article, meaning an economic background is not required for reading.
- Web3 iterates very fast, and many concepts are still in the exploration stage. Keep questioning and thinking independently.
- This article only represents personal opinions and has nothing to do with Chainbase.
This is the second part of the article, read part 1 here: Is Token Economy a Necessity for Web3 Applications? Part 1
2. The Particularity of the Application Layer in Web3
2.1 The Web3 Ecosystem
(Web 3.0 Stack, Source: IOSG VC)
According to the picture above, the Web3 ecosystem is divided into five layers:
Layer4 = Decentralized Applications
Layer2 & 3 = Middleware Stacks
Layer1 = Protocol Layer
Layer0 = Infrastructure and Network Layer
Among them, layers 0-1 are on-chain, and layers 2-4 are off-chain.
It gives the reader an overview of Web3 in a clear and comprehensive way: Layer0 & 1 lay the foundation for the ecosystem; most users only access Layer 4; and Layer 2 & 3 help better connect Layer 1 & 2.
Next, we focus on the protocol layer at Layer 1 and the application layer at Layer 4.
2.2 Web2 to Web3: Value Reversion of the Application and the Protocol Layer
Applications and Protocols in Web2
Application is the product that most C-end users interact with daily. Protocol is a system of rules that allows data/information exchange/transmission between two or more parties for better telecommunication. Obviously, general C-end users will not interact with the protocol layer.
In Web1 & 2, most of the value was captured by the application layer, while the protocol layer was difficult to capture value. For example, Google, Meta, Amazon, Alibaba, Tencent, etc. all gained a lot of value due to the success of their applications, and eventually became Web2 giants. However, underlying protocols such as TCP/IP and HTTP cannot directly capture value, and thus cannot make profits.
In Web2, why can the application layer capture value while the protocol layer cannot? Because the protocol layer is the underlying technical infrastructure of the Internet, it is often open-source and free, and everyone has been using them for many years. The protocol layer does not have a mature and practical business model.
The application layer, on the contrary, faces the end users directly and has a much higher possibility to make profits. Most Web2 applications open the market through product experience and subsidizing, continuously increase the cost of users migrating to other apps, control a large amount of user data, and finally form a solid user pool and product line - under the interaction of these elements, Web2 Internet tech giants are formed.
Talents and capital are profit-seeking. In Web2, the profitability of the application layer is much higher than the protocol layer.
Web3: "Fat" Protocol Layer, "Thin" Application Layer
In August 2016, Joel Monegro at Union Square Ventures (a well-known VC headquartered in NYC, now he is with Placeholder VC) published an article called Fat Protocols. He advocated that Web3 showcases the rise of the protocol layer. His views gained lots of repercussions and even directly affected the capital flow in Web3.
(Fat Protocols, https://www.usv.com/writing/2016/08/fat-protocols/))
Based on blockchain technology, Web3 fundamentally prevents the application layer from monopolizing data (commonly seen in Web2), because value-capturing data exists on the decentralized blockchain network, where each user has the right to input and search the data. This qualification is not tied to a certain application. Therefore, even applications that were once in a monopoly position in Web2 will degenerate into "entrances" for users to connect to the blockchain networks - note that users can switch the entrance providers easily.
The protocol layer has also achieved its value amplification in Web3 thanks to the characteristics of blockchain. The blockchain network is trustless, and it observes the saying that "code is law". It is the fully open-source protocol layer that enables zero-trust, autonomy, and decentralization. In Web3, the protocol layer is the foundation, the operating principle, as well as the cornerstone of the application layer.
In such an ecosystem, the token economy provides a perfect solution for the protocol layer to capture value, which they couldn't do before. The higher the consensus of the protocol, the higher the market value, and the stronger the value capture ability. This is why Web3 has "fat" protocols and (relatively) "thin" applications.
(Token Feedback Loop, from Fat Protocols, https://www.usv.com/writing/2016/08/fat-protocols/)
Token Economy is also the First Choice to Capture Value for the Application Layer
Token economy has made the protocol layer prosperous, and it is the first choice for most Web3 applications to capture value as well. It has become normal that applications have their own economic models and issue tokens. Moreover, there are "super" applications that have developed their own protocol layers.
Theoretically, the token economy may be the only way for the protocol layer to capture value, but it should not be the only way for the application layer to do so. The application layer has a wider user base than the protocol layer, making it easier to establish user trust. What is more, unlike the protocol layer, which can only achieve value capture through a set of established rules, the application layer is more flexible and user-friendly. If these advantages can be well-utilized, the ways in which applications capture value can be as diverse as possible.
Let's dig deeper into this topic.
3. Chemical Reaction of Token + dApp
3.1 How to Understand Value Capture
As the token economy helps capture value, we need to have an understanding of value capture before discussing applicability and alternatives of token economy. Value capture does not simply equal to the generation of money, it can be understood from a conceptual point of view as well as from different perspectives of projects, investors, and users.
Outside the context of the Internet, there is a classic concept called land value capture. It refers to the process of recovering all or part of the land value appreciation attributed to community contributions back to the community through means such as levying taxes and fees.
Imagine a real community. In the early days, there were not many supporting facilities, and the comprehensive value of the land was not high, making it difficult for the community to attract real estate developers, shopping malls, large companies, etc. Later, as more and more infrastructures are built, high-value commercial entities start to settle in. This process refers to the land value appreciation, contributed by the community.
The community can then generate financial income by (for example) taxing the businesses that settle in. This process is called land value capture. It is obviously different from simply generating money. It requires you to contribute first and then get rewards.
Think of the community as a Web2 application. In the beginning, there were no users, so it had no value capture ability. As time goes by, an increasingly rich ecosystem is built through various means, including subsidizing, which is often adopted in Web2. When the ecosystem grows to a certain level, the application can capture value and convert it into revenues/cash flows through payment, traffic, and other channels. This is the value capture in Web2.
Value capture in Web3 is similar to that in Web2, while the former is more decentralized, and value distribution tends to be decentralized as well.
Understanding from Different Perspectives
Value capture is
- Project: The ability to raise funds or generate revenues through the product or other means
- Investor: The ability of the portfolio to generate returns on capital
- User: The ability of the project to cheat ordinary users of money (in a bad way) or create values together with users (in a good way)
Combining the above two viewpoints, we should have a clear understanding of value capture. If value capture is the goal, is the token economy suitable for all application-layer scenarios? Let's try to analyze the advantages and disadvantages of the token economy for Web3 applications.
3.2 Advantages and Disadvantages of Token Economy for Web3 Applications
- Advantages: Token economy is
- An excellent incentive for Web3 projects to bootstrap
- A decentralized voting and profit distribution system
- A method of self-financing
- A good way for VCs to quickly exit
- May lead to the shortsightedness of multiple parties due to short-term high returns, further resulting in speculation instead of building
- May cause the project to over-rely on the token economy as a way to capture values and not explore other solutions
- Required token marketcap management leads to more costs and resources spent, as well as a higher threshold for building startups
- Good projects may be forced to terminate due to token value collapse
- In the short term, it will incentivize a large number of users to enter the market. However, those who are attracted by speculative mentalities will also leave the space if there is no room for speculation
- A large amount of capital inflow will facilitate the rapid development of Web3
- It will provide tools to build a new mechanism of production, collaboration, and profit distribution
- Decentralized operation makes it easy for hackers to find loopholes
- Prevalence of fraud and MLM (Multi-Level Marketing, which often offers money-making opportunities for user growth) keeps most Web2 users away
- May cause further dilution of Web3 core believers, as well as the limiting utility and complete financialization for Web3 applications
Whether from the project's micro perspective or the ecosystem's macro perspective, the token economy is a double-edged sword. Howzever, the token itself is neutral. It is the people who use it as well as how they use it that determines the outcome of the token economy.
3.3 What Will Happen if Web3 Applications Do Not Have Token Economy?
Having analyzed the advantages and disadvantages of the token economy, let's look at its best-fit scenarios and alternatives.
Applicability of Token Economy
- Projects not good at capturing value but having a strong need for commercialization should consider applying the token economy
The introduction of the token economy will add a revenue stream for projects without a sustainable business model (in nature or intended). For example, open-source projects, DAOs, infrastructures, etc.
- For projects with a strong ability to capture value, the token economy is not a must
There are various ways of generating revenue other than the token economy on the application layer. The value of an application mainly comes from the product/service and user engagement. Therefore, whether in Web2 or Web3, maintaining a solid user pool is definitely valuable. Based on the number of users and flexibility of the product, multiple ways of monetization can be designed and executed. In contrast, a thoughtless introduction of or sole reliance on the token economy may result in the losing of focus, de-concentration of resources, etc.
- It is difficult for projects with centralized product features to directly utilize token economy
If the project follows a centralized scheme, combining it with the token economy is difficult. Without a healthy synergy between the token and the product, both the value of the tokens and the value of the product cannot be realized - because the usage of tokens does not closely link to the functionality of the product, and a consensus is hard to establish.
Alternatives to Token Economy
When the existing token economy is not applicable or is not a necessity, we can boldly imagine what alternatives are available. For example:
- More rational ways of financing, like quadratic funding
- Less speculative/financialized tokens, and related incentive systems, such as SBTs
- Traditional ways of value capture, like user subscriptions, ad revenues, etc. (Some people may think they are anti-Web3. However, Web3 does not intend to revolutionize the way the application layer captures value (though it may do sometimes). The essence of the Web3 revolution is to give the ownership and the right to choose back to people.)
- Introduction of sovereign-backed digital currencies such as digital USD
4. Ending Notes
Outside of our office in Hangzhou, there is a bayberry tree. Every time it bears fruit in late spring, the tree becomes the focus of people passing by. They first tried to pick one or two, then a string of berries, and then they started to bring boxes, step on stools, and pick berries in large quantities.
After some time, the branches were torn off, the leaves were scattered, and the shrubs planted around were trampled in a mess. Finally, the tree was off the berries and no one would pay attention to it.
This bayberry tree is very similar to Web3 now, bustling and profit-seeking.
If everyone only pays attention to short-term earnings and no one is dedicated to long-term building, Web3 will be like a bayberry tree that is not fertilized, watered, and dewormed - in general, not carefully maintained. It will eventually be drained of the last drop of nutrients and will never bear fruit again. In Web3, "nutrients" are belief, and belief is hope. The final squeezing of nutrients will be the starting point of the ecological collapse.
This should be taken seriously by every Web3 practitioner.
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