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Adjusting ecosystem incentives

This video discusses how we make ecosystem incentives sustainable.

Today Web3 businesses are issuing tens of millions of dollars worth of tokens to grow. These ‘ecosystem incentives’, such as liquidity mining rewards, are a major cost as Web3 projects scale. Adjusting these ecosystem incentives downwards — “turning off the money printer” — is necessary to make Web3 business models sustainable. These adjustments move a Web3 business beyond bootstrapping.

Revenues and costs

We can think about business model sustainability in terms of revenue and costs.

Sustainable businesses need revenue. For a defi project, potential revenue sources are portions of trading fees or returns on treasury investments. As projects find product-market fit, and their user base grows, hopefully their revenue grows too.

Some of that revenue will likely go into a collective treasury. Governance might reinvest that revenue into further growth opportunities, such as building out new products. Alternatively, projects might pay out some cash dividends, or implement buyback-and-burn mechanisms.

But let’s put revenue to the side for a moment — imagine that revenues are flowing in. For sustainability, you also need to reduce costs. So, what is the cost of acquiring that revenue?

In Web3, a major cost is ecosystem incentives. These rewards, as Lucas Baker and Nihar Shah describe, can help to bootstrap a project:

During the bull market, too many protocols, almost by default, used their tokens for one overriding purpose: to solve the “cold start” problem of usage and awareness. In doing so, these protocols offered high (and at times outrageous) rewards without considering whether this was sustainable or in its long-term interests.

Indeed, tokens can attract the hard side of your market, attack your competitors and build a base of decentralised ownership.

But the cost of incentivising your users over a long enough time frame is unsustainable. We know this from Web2, where many platforms heavily subsidised sides of their market (e.g. rideshare fares, bonus returns). But eventually that incentive tap needs to be turned off.

Grow Rapidly and scale icon Too many incentives for too long can mask whether a business has found product-market-fit. Are your customers there because they like your product, or because you’re paying them? Be wary of the endless line of competitors who will incentivise their customers more.

In Web3, the sustainability problem for incentives is even deeper. The challenge is that incentives aren’t paid in cash but are paid in tokens. This is more like paying your customers equity rather than cash. And, importantly, your tokens will eventually run out (at least for fixed supply tokens), so you need a solution.

Adjusting ecosystem incentives

How do we navigate the process of reducing incentives? There are several complex factors to consider.

When should incentives be adjusted?

A Web3 business should have confidence that there is a sufficient and sticky underlying network of users.

Unfortunately, turning off incentives might also reveal that you do not have a moat around your project. The harsh reality is that your sides of the market were there because you paid them in tokens to be there.

Adjusting incentives too early can lead to different sides of your market flocking to competitors. For instance, after Uniswap reduced its rewards for liquidity provision, liquidity providers “quickly migrated in search of higher rewards” from competitors.

How to change incentives?

Your ecosystem incentives don’t have to go to zero. The design space is much wider than that.

SushiSwap, for instance, has invested in optimising their incentives. Curve has a set level of incentives that enable the community to decide where incentives should flow through now-popular vote escrow dynamics, which you can learn more about here and here. This is a decentralised bottom-up approach to incentive optimisation.

Maybe you have even more elaborate plans, like using revenues to buyback tokens, and then redistributing them as rewards.

How will your community react?

Decisions about adjusting incentives happen when Web3 projects have communities. It’s worthwhile considering how different groups might react to changes in ecosystem incentives. Consider how groups can perceive this as a benefit or loss.

Your case will often have to be made to a community. As referenced earlier in this article Synthetix recently voted on a proposal to “turn off the money printer”. The aim of this proposal was to move away from the inflationary tokenomics of the project.

You probably don’t have to deal with these challenges yet. But these are an inevitable part of building a mature Web3 business. It’s worthwhile considering how and when this might happen before your treasury runs out of tokens.

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Doing Business in Web3

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