How do Web3 infrastructure protocols attempt to capture value?
In order for the protocol's tokens to capture value, well-designed token economics is essential.Article Author: Sami Kassab Article Compilation: Block unicorn
Key Insights
The Burn-and-Mint Equilibrium (BME) model and the Stake-for-Access (SFA) model are the two most common token models used by Web3 infrastructure protocols. They address speed issues and establish a relationship between network usage and token price.
In the BME (Burn tokens to access services) model, end users need to burn the protocol's native tokens to access services, essentially converting protocol usage into token purchasing power.
The SFA (Stake tokens for access) model requires service providers to stake the protocol's native tokens to perform work on the network, converting network participation into token purchasing power.
The SFA model is best suited for protocols that provide undifferentiated commodity services, while the BME model is more suitable for protocols that operate similarly to businesses, as they can price themselves and compete in business development and collaboration.
Value creation and value accumulation are not the same thing. While cryptocurrencies have succeeded in value creation, the industry is still grappling with issues of value accumulation. The gap between value creation and value accumulation can be clearly seen in Uniswap. Although it is the most popular decentralized exchange (DEX) with the highest trading volume, Uniswap's token has struggled to accumulate value, as its only utility is protocol governance.
In recent years, there has been explosive growth in infrastructure protocols serving the middleware layer of the Web3 stack. They all face the challenge of aligning network usage with token price. This report evaluates the two most popular utility token models used by Web3 infrastructure protocols to capture value: the Burn-and-Mint Equilibrium (BME) model and the Stake-for-Access (SFA) model.
Investors generally believe that if the supply of a protocol's utility token is fixed, the price will rise with increased demand for the protocol's services. However, this belief does not take into account the velocity of the token, which measures how often the currency changes hands. Velocity is a key input in the exchange equation (MV=PQ). Chris Burniske defines the variables as follows:
Velocity Issues
M = Asset base size
V = Velocity of the asset
P = Price of the digital resources provided
Q = Quantity of digital resources provided
According to Burniske's equation, when solving for M, the token price can be derived by dividing by the circulating supply, and the velocity of the token is inversely proportional to its value. In other words, the longer people hold the token, the higher its price. In the absence of additional token utility, users acquire tokens to use services and then sell them, creating downward pressure on the price.
To address the velocity issue and increase the time users hold tokens, protocols implement mechanisms to increase token utility and attract holding incentives.
Token Value Accumulation
Token prices are driven by two components: a speculative component and a fundamental component. Initially, the price of utility tokens is often driven by speculation. Over time, as the protocol matures and network usage increases, the value of a token should transition to being driven by its utility and demand.
Governance Mechanisms
On-chain governance: Empowers token holders to make decisions about the protocol.
Voting delegation: Allows token holders to delegate their voting rights to another participant.
Continuous governance: Incentivizes token holders to stake their governance tokens to maximize voting power.
Staking Mechanisms:
Proof-of-Stake: A consensus mechanism that requires validators to stake tokens for a chance to create new blocks and earn rewards.
Stake-for-Access model: Requires participants to stake tokens to act as service providers for the network.
Reputation mechanism: Incentivizes token holders to stake their tokens to provide a source of truth for the protocol.
Profit Distribution Mechanisms
Burn-and-Mint Equilibrium model: Requires users to burn native tokens to access the protocol's services.
Direct revenue distribution model: The protocol distributes a portion of the revenue generated to staked token holders.
Treasury/donation model: A portion of the generated revenue is allocated to the protocol's treasury, where it can be distributed for various purposes.
These mechanisms help tokens accumulate value. They reduce velocity (increase the time tokens are held) by locking tokens and incentivizing users to hold tokens in exchange for rewards or protocol voting rights. Additionally, token burning reduces the total supply of tokens, leading to a decrease in the number of tokens chasing the same value. Token value is also influenced by several other important design considerations, including a fixed supply of a protocol token, inflation, and deflation.
For a protocol's token to capture value, well-designed token economics are essential. As Web3 protocols are still in their infancy, they need to reach a consensus on the best standards for token economics. Therefore, protocols will continue to experiment with different value capture mechanisms and token economic models.
Linking Network Usage to Token Price
The two most popular token models are the Burn-and-Mint Equilibrium model and the Stake-for-Access model. Web3 infrastructure protocols use these models to create a connection between network usage and token price. Essentially, the BME model works by converting protocol usage into token purchasing pressure, while the SFA model converts network participation into token purchasing pressure. Burn-and-Mint Equilibrium Model:
Burn-and-Mint Equilibrium uses a dual-token model: 1. A tradable value-seeking token 2. A non-tradable payment token, referred to as credit
To use the BME model to access the protocol's services, end users must burn the protocol's tradable token to obtain the proprietary payment token (credit) needed for payment. The way token credit works is similar to prepaid mobile phone cards.
The dual-token system allows the protocol's services to have fixed prices, priced in dollars or other less volatile assets/currencies. Instead of pricing services with the value-seeking token amid price fluctuations, the protocol sets a fixed dollar price for the credit.
To help explain, let’s look at the Helium network, where each point is fixed at $0.00001. To obtain 100,000 points used on the network, $100 worth of Helium's value-seeking token (HNT) must be burned. Thus, the ratio of points to HNT will ultimately fluctuate, rather than the price of transmitting data on the Helium network.
Once the value-seeking token is burned and payment credit is obtained, the end user will use this credit to pay the protocol's service providers. Once the network verifies that the service provider has completed the work requested by the end user, the protocol mints a predetermined number of value-seeking tokens, unrelated to the token burning process, to reward the service provider.
Therefore, if the number of burned tokens equals the number of newly minted tokens, the system will be in equilibrium. However, if the number of burned tokens exceeds the number of minted tokens, a net deflationary effect will occur, and the reduction in token supply will ultimately create upward pressure on the price. Under this price increase pressure, fewer tokens need to be burned to obtain the same amount of credit, which ultimately brings the system back to equilibrium.
A token supply cap is a common design feature of protocols, although it has some drawbacks. Once the supply cap is reached, it becomes impossible to continue incentivizing network participants. Fortunately, a new cryptocurrency economic innovation known as "net emissions" allows the BME model to work in coordination with supply caps.
Net Emissions recovers burned tokens and reissues them as rewards to ensure that the protocol can continuously incentivize participants indefinitely. To avoid offsetting the desired deflationary effect, a cap is set on the number of tokens that can be recovered per cycle. Therefore, if the number of burned tokens exceeds this cap, deflationary effects can still be achieved. As early as November 2020, the first protocol to implement this mechanism was Helium. Since then, this mechanism has become standard for protocols using the BME model with a capped supply. Stake-for-Access Model:
The Stake-for-Access model, also known as the work token model, requires service providers to stake native tokens to perform work for the network. Staked tokens can serve as collateral or penalize malicious participants in the nodes.
Taking The Graph (a multi-chain indexing application) as an example, the protocol requires supply-side participants (Indexers and Curators) to hold the native token (GRT) to provide indexing and query processing services for the network. The more GRT invested, the more rewards the service provider receives.
Typically, the amount of tokens staked is proportional to the amount of work the service provider can perform. This relationship creates a dynamic where service providers earn income (in the form of native tokens) based on the amount of tokens they hold. Therefore, when using the SFA model, the token price should increase with network usage. Kyle Samani, managing partner at Multicoin Capital, eloquently explains the game theory involved:
"As service demand grows, more revenue will flow to service providers. Given the fixed supply of tokens, service providers will reasonably pay more for each token to gain a share of the growing cash flow."
While the SFA model typically applies only to supply-side participants, it can also be used for demand-side protocols. Pocket Network requires not only service providers to stake for work but also demands that users stake to access the protocol's RPC (remote procedure call) services. This demand-side approach captures more value but comes at the expense of the end-user experience.
Final Thoughts
Both SFA and BME address the velocity issue and create a relationship between network usage and token price. As network usage increases, the token price should also increase. However, the downside of this relationship is that if network usage declines, the token price will also decrease. In either case, both token models align the incentives of all participants by incentivizing community participation and leveraging the network.
Kyle Samani believes the SFA model is more valuable than the BME model, but SFA cannot be applied to all protocols. The SFA model is only suitable for protocols that provide undifferentiated commodity services. For protocols where service providers do not offer pure commodities, the BME model is the most effective. The BME model allows protocols to operate like businesses, setting their own variables and pricing while also competing in areas such as business development and collaboration.
As developers continue to experiment, new variations and even new models may emerge. For a protocol's token to capture value, well-designed token economics that create fundamental value are essential. The speculative component of token prices will never completely disappear, but as more project teams focus on token appreciation, a future where token prices are driven by actual network usage seems feasible.
