Web3 Network: Limitations of Token Incentives

Web3 Network: Limitations of Token Incentives

Crypto tokens bring financial incentives to technological products. Startups and the web3 ecosystem are still studying the implications of this, including how and why it would be useful. During the experiment, one theory seemed to gain some ground— that tokens were a way to incentivize early network participants and avoid the “cold start problem.” The theory is tantalizing, but it’s worth thinking about how broad its practical application is.

Before we dive into it, let’s revisit the cold start problem – a well-known challenge for products with network effects (or “networks”), including Snapchat or Airbnb. On day 0, they have no users, so there is no utility to acquire new users.This forces them to find creative ways to reach a critical user base (or “liquidity”) and achieve a basic level of utility that can attract new users.

Tokens are seen as a way to circumvent this problem. Here’s Chris Dixon’s article on token incentives:

The basic idea is: in the early stages of the launch phase, when the network effect has not yet started, provide users with economic utility through token rewards to compensate for the lack of local utility. —Chris Dixon (a16z)

The image at the top of this article (also by Chris Dixon) shows a visual description of the theory. NFX proposes a similar idea, called network binding theory. According to this view, tokens provide early users with an economic incentive to participate in the network. The proliferation of these users will allow the network to increase its utility and achieve liquidity.

Passive Participation: When Token Incentives Work

Chris Dixon and the a16z team cite several examples of web3 networks that have successfully leveraged tokens to achieve liquidity:

  • The first is Helium, a decentralized network that provides cheap, easy internet access for IoT devices in the “wild” such as electric motorcycles and sensors. Hosts can join the network by purchasing a “hotspot” of the Helium network and connecting it to its own WiFi. Once they do, the hotspot provides internet access to the end user (or owner of the aforementioned IoT device) and rewards the host with HNT tokens.
  • The second example is Arweave, which is described as a decentralized, censorship-resistant storage network. Miners connect their unused hard drive space to the Arweave network, which end users can use to store any type of data.Miners are compensated in AR tokens as long as the data is hosted on their hard drives. Filecoin and Storj are some other similar examples.
  • Another example is the lending network Compound. Lenders deposit their crypto assets into a lending pool for borrowers to use. Lenders then earn interest on their deposit assets and are rewarded with COMP tokens for providing liquidity to the network.

In these cases, the economic advantage of the token is a strong incentive for early user registration and increased network utility. But have you noticed that these networks have one aspect in common? They all require the passive participation of users, especially the supply side of their network. Once users connect their assets or resources to the network – be it bandwidth (Helium), storage (Arweave) or crypto assets (Compound) – they continue to earn tokens. This gives them financial benefits while also increasing the utility of the network. The supply side does not need to actively interact with the network to benefit from this economic advantage.

However, there are also few passively participating networks. Most of the networks we use today require active participation—whether it’s social networks like Snapchat and WhatsApp, or marketplaces like Airbnb and Uber. If you never open Snapchat, you don’t bring any value to the network. If you’ve never taken an Airbnb reservation, you’re not adding any value to the market. Are tokens an efficient way to bootstrap these types of networks?

Active Participation: Limitations of Token Incentives

One of the most important principles to guide a network is to start with the most underserved users. Acquiring users is not enough to achieve liquidity. You also need the right type of users, those who understand the problem deeply and are willing to put up with any resistance to join your network. As you acquire these users, the network becomes more active than the application, and the network’s utility grows. As a result, the network becomes more valuable to new users. This is especially important for networks that require active user participation – as liquidity requires repeated participation, not one-time adoption.

Tokens could be tools to target this underserved niche that could attract the wrong type of users — those attracted by economic incentives rather than the short-term utility of the network. So, in the web3 version of Snapchat, the token could appeal to high school students and professionals regardless of the type of users the network needed at the time.When this happens, it becomes very difficult to achieve the desired density of the right type of users. As such, adoption has no direct impact on network utility, and the evolution of network value may resemble that shown in the following diagram:

Web3 Network: Limitations of Token Incentives

Token Guidance: Active and Passive Participation

This shows what happens when there is a disconnect between economic incentives and network utility – immediate growth followed by a painful decline. Of course, this is an extreme theoretical scenario. What would this look like in the real world? Let’s look at a few examples.

When the token encounters active participation

The most obvious example is Looksrare — a decentralized NFT marketplace launching in January 2022. It aims to be a decentralized alternative to Opensea, which dominates the space. Unlike most web3 networks, Opensea is a centralized, web2.0-style NFT marketplace with strong network effects — at least as long as demand for NFT projects remains healthy.To overcome these network effects, Looksrare performed a “vampire attack” against Opensea, which distributed (or “airdropped”) LOOKS tokens for free to a large number of Opensea users. It also rewards users for using LOOKS tokens when transacting specific collections of NFTs on Looksrare. This way of entering the market should be enough for Looksrare to solve the cold start problem and scale its network. Unfortunately, economic incentives cause user behavior to be inconsistent with network utility.

Web3 Network: Limitations of Token Incentives

Source: Dune Analysis / @hildobby

The chart above shows the true volume of Looksrare transactions – after filtering out “wash trades,” where the same NFTs are traded back and forth between the same wallets to earn more token rewards. Interestingly, as token payments normalized, the real volume started to collapse. By the end of February 2022, Looksrare’s real daily trading volume had fallen below 5% of its peak and below 3% of the daily volume of Looksrare tokens. Essentially, users are there to earn and speculate on tokens, not to interact with the network.

Many other vampire attacks have had similar results. Another NFT marketplace, Infinity, followed the same strategy with Opensea in October 2021, with even worse results. Decentralized exchange Sushiswap carried out a vampire attack on Uniswap in August 2020. The results again followed a similar trajectory, albeit perhaps less clearly (also beset by governance issues).

Decentraland, a virtual world powered by NFTs, is a less obvious example that doesn’t involve vampire attacks. Facebook’s rebranding to Meta in November 2021 sparked a gold rush for all Metaverse-oriented projects in the web3 ecosystem. This has greatly boosted demand for Decentraland’s MANA token and its virtual real estate NFTs in its virtual world. However, most buyers appear to be financially motivated, and the utility of this virtual real estate remains low — and engagement is low. That’s not to say that virtual real estate will never have any utility. It obviously can, but it requires the active participation of users – a scaling strategy using an active web2 network like Roblox rather than a passive web3 network like Helium.

Token incentives aligned with utility

By now, it should be clear that tokens are not a panacea – there are no shortcuts to building a network. Networks that only require passive participation of users can use tokens as a strategy to overcome the cold start problem. But actively engaged networks can be harder to bootstrap. In these cases, token rewards can incentivize behaviors that conflict with increasing network utility.

How do we solve this problem? At a high level, the only way to solve this problem is to link token incentives to network utility, i.e. to ensure that users receive token incentives only when they add value to the network. In other words, rewards need to be limited to specific, satisfying actions, not just adoption. Braintrust, a decentralized freelance marketplace, is a good example. Packy McCormick recently published a deep dive into Braintrust and explained how its BTRST token works.Currently, it only distributes tokens to the following users:

  • Refer clients or freelancers (rewarded referrals)
  • Screening of candidates after completion of course (curation)
  • Freelancers who complete detailed profiles, courses and jobs (core actions)

Referrals, curation and core actions are key pillars of many web2 networks – they are not unique to web3. The only difference here is that the tokens are used as a substitute for another economic incentive – which is what makes them effective. Of course, its downside is that it’s a less effective way to overcome the day 0 cold start problem – the bar for earning rewards is higher. This is a healthy tradeoff for a network that requires active participation. In fact, these types of networks may be good candidates for progressive decentralization, i.e. first building a network in the usual way and then introducing tokens for community ownership, governance and/or rewards.

All in all, tokens can play a role in building the network.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/web3-network-limitations-of-token-incentives/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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