Where does protocol revenue come from in the face of declining Liquidity? Is Token buyback and burn the answer?

Author: Joel John, Decentralised.co; Translation: Yangz, Techub News

Money dominates everything around us. When people start to discuss the fundamentals again, the market is probably in a bad situation.

This article raises a simple question: should tokens generate income? If so, should the team repurchase their own tokens? Like most things, there is no clear answer to this question. The path forward needs to be paved by honest dialogue.

Life is just a game called capitalism.

This article is inspired by a series of conversations with Ganesh Swami, co-founder of the blockchain data query and indexing platform Covalent. The content involves the seasonality of protocol revenue, evolving business models, and whether token buybacks are the best use of protocol capital. It is also a supplement to an article I wrote last Tuesday about the current state of stagnation in the cryptocurrency industry.

The venture capital and other private equity markets always oscillate between excess liquidity and scarcity of liquidity. When these assets become liquid assets and external funds continue to pour in, the industry's optimism often drives prices up. Think of various new IPOs or token issuances, this newly acquired liquidity will make investors take on more risks, but in turn will drive the birth of a new generation of companies. When asset prices rise, investors will shift funds to early-stage applications, hoping for higher returns than benchmarks like Ethereum and SOL.

This phenomenon is a characteristic of the market, not a problem.

Source: Equidam Chief Researcher Dan Gray

The liquidity of the cryptocurrency industry follows a cyclical pattern with the halving of Bitcoin block rewards as a marker. Historically, market rebounds typically occur within six months after the halving. In 2024, the influx of funds into the Bitcoin spot ETF and Michael Saylor's large-scale purchases (he spent a total of 22.1 billion USD on Bitcoin last year) have become the 'reservoir' for Bitcoin. However, the rise in Bitcoin prices has not led to an overall rebound of small altcoins.

We are currently in a period of tight capital liquidity, where the attention of capital allocators is scattered among thousands of assets, and founders who have been working on tokens for years are also striving to find the meaning of all this, 'Since launching meme assets can bring more economic benefits, why bother to build real applications?'

In the previous cycle, L2 tokens enjoyed a premium due to their perceived potential value, supported by exchange listings and venture capital. However, as more participants enter the market, this perception and valuation premium are being eroded. As a result, the value of L2 tokens is declining, limiting their ability to subsidize smaller products with grants or token revenue. Furthermore, the excess valuation in turn forces founders to pose the age-old question that troubles all economic activities: where does the income come from?

How Cryptocurrency Project Revenue Works

The diagram above explains well the typical operation of revenue for cryptocurrency projects. For most products, Aave and Uniswap are undoubtedly the ideal templates. These two projects have maintained stable fee income over the years thanks to the advantage of early entry into the market and the 'Lindy effect'. Uniswap can even generate revenue by increasing frontend fees, perfectly confirming consumer preferences. Uniswap is to decentralized exchanges as Google is to search engines.

By contrast, the revenue of Friend.tech and OpenSea is seasonal. For example, the 'NFT summer' lasted for two quarters, while the speculation craze of Social-Fi only lasted for two months. For some products, speculative income is understandable, provided that the income scale is large enough and consistent with the original intention of the product. Currently, many meme trading platforms have joined the club with fee income exceeding 100 million U.S. dollars. This income scale is usually only achievable for most founders through token sales or acquisition. For most founders who focus on developing infrastructure rather than consumer applications, this level of success is not common, and the revenue dynamics of infrastructure are also different.

During the period from 2018 to 2021, venture capital firms provided a significant amount of funding for developer tools, hoping that developers could acquire a large number of users. However, by 2024, the cryptocurrency ecosystem underwent two major shifts:

First, smart contracts achieve unlimited scalability with limited human intervention. Today, Uniswap and OpenSea no longer need to scale their teams proportionally to trading volume. 2. Secondly, the advancement in large language models (LLM) and artificial intelligence has reduced the demand for investment in developer tools for cryptocurrencies. Therefore, as an asset class, it is at a 'clearing moment'.

In Web2, the API-based subscription model works effectively because of the large number of online users. However, Web3 is a smaller niche market, with only a few applications able to scale to millions of users. Our advantage lies in the higher average revenue per user. With the characteristic of blockchain enabling capital flow, ordinary users in the cryptocurrency industry often spend more money at a higher frequency. Therefore, in the next 18 months, most companies will have to redesign their business models to directly generate income from users in the form of transaction fees.

Of course, this is not a new concept. Initially, Stripe charged fees per API call, while Shopify charged a flat fee for subscriptions, but later both platforms switched to charging based on a percentage of revenue. For infrastructure providers, the API charging method of Web3 is relatively simple and straightforward. They eat away at the API market by competing to lower prices, and even offer free products until reaching a certain transaction volume, before starting to negotiate revenue sharing. Of course, this is an ideal scenario.

As for how things will actually turn out, Polymarket is a prime example. Currently, tokens from the UMA protocol are tied to disputed cases and used for dispute resolution. The more prediction markets there are, the higher the probability of disputes, thereby directly driving demand for UMA tokens. In the trading model, the required margin can be a very small percentage, such as 0.10% of the total bet amount. For example, if $1 billion is wagered on the outcome of a presidential election, UMA can earn $1 million in revenue. In the hypothetical scenario, UMA can use this revenue to buy and burn its own tokens. This model has its advantages but also faces certain challenges (which we will discuss further later on).

Apart from Polymarket, another example of a similar model is MetaMask. Through the embedded exchange function of the wallet, there is currently about 36 billion US dollars in transaction volume, and the revenue from exchange business alone exceeds 3 billion US dollars. In addition, a similar model also applies to staking providers like Luganode, which can charge fees based on the amount of staked assets.

However, in a market where API call revenue is decreasing, why do developers choose one infrastructure provider over another? And why choose one oracle service over another if revenue sharing is needed? The answer lies in network effects. Providers that support multiple blockchains, offer unparalleled data granularity, and can index new chain data faster will become the preferred choice for new products. The same logic also applies to categories such as intent or gasless exchange tools. The more blockchains are supported, the lower the cost and the faster the speed, the more likely they are to attract new products, as marginal efficiency helps retain users.

Token Repurchase and Burn

Linking token value to protocol revenue is not something new. In recent weeks, some teams have announced mechanisms to buy back or burn native tokens based on revenue ratios. Among them, Sky, Ronin, Jito, Kaito, and Gearbox are worth noting.

Token buyback is similar to stock buyback in the US stock market. Essentially, it is a way to return value to shareholders (token holders) without violating securities laws.

In 2024, the funds used for stock repurchases in the US market alone reached approximately $790 billion, compared to only $170 billion in 2000. Prior to 1982, stock repurchases were considered illegal. In the past decade, Apple alone has spent over $800 billion repurchasing its own stocks. Although the sustainability of this trend remains to be seen, we observe a clear divergence in the market between tokens with cash flow and a willingness to invest in their own value, and those without.

Source: Bloomberg

For most early protocols or dApps, using revenue to repurchase their own tokens may not be the most optimal capital deployment strategy. One feasible approach is to allocate sufficient funds to offset the dilution effect caused by the issuance of new tokens, which is exactly the explanation given by the founder of Kaito regarding their token repurchase method. Kaito is a centralized company that incentivizes its user base with tokens. The company obtains centralized cash flow from corporate clients and uses part of this cash flow to repurchase tokens through market makers. The amount of repurchased tokens is twice the number of newly issued tokens, thereby putting the network in a deflationary state.

Unlike Kaito, Ronin adopts a different approach. The chain adjusts fees based on the number of transactions in each block. During peak usage, some network fees will flow into the Ronin treasury. This is a way to monopolize asset supply without token buybacks. In both cases, the founders have designed mechanisms to peg value to economic activity on the network.

In future articles, we will delve into the impact of these actions on the prices of tokens participating in such activities and on-chain behavior. But for now, it is obvious that with the decline in token valuation and the reduction in venture capital inflows into the cryptocurrency industry, more teams will have to compete for marginal funds flowing into our ecosystem.

Considering the core attributes of the blockchain 'currency track', most teams will switch to a revenue model based on trading volume percentages. When this happens, if the project team has already launched tokens, they will be motivated to implement a 'buyback and burn' model. Teams that are able to successfully execute this strategy will become winners in the liquid market, or they may purchase their own tokens at a very high valuation. The outcome of everything can only be known afterwards.

Of course, one day, all discussions about prices, profits, and revenues will become irrelevant. We will continue to invest money in various 'dog Memecoins' and purchase various 'monkey NFTs.' But look at the current market situation, most founders who are concerned about survival have begun to engage in in-depth discussions around income and token destruction.