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

Authored by: Joel John, Decentralised.co

Compilation: Yangz, Techub News

Money rules everything around us. When people start to talk about fundamentals again, the market is probably in a bad place.

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

Life is just a game called capitalism

The inspiration for this article comes from 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. This is also a supplement to the article I wrote last Tuesday about the current stagnation of the cryptocurrency industry.

The venture capital and other private equity markets are always swinging between excess liquidity and scarcity of liquidity. When these assets turn into liquid assets and external funds continue to pour in, the industry's optimism often drives prices up. Think of various new IPOs, or token offerings, this newly acquired liquidity will make investors take on more risks, but in turn, it 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 in the cryptocurrency industry follows a cyclical pattern marked by the halving of Bitcoin block rewards. Historical data shows that market rebounds typically occur within six months after the halving. In 2024, the inflow of funds into Bitcoin spot ETFs and Michael Saylor's large-scale purchases (who spent a total of 221 billion USD on Bitcoin last year) will become the "reservoir" for Bitcoin. However, the rise in Bitcoin prices has not spurred a general rebound in small-cap altcoins.

Currently, we are 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 developing 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 the support of exchange listings and venture capital, as they were considered to have potential value. However, as more and more participants enter the market, this perception and the valuation premium are being eroded. As a result, the value of L2 tokens is declining, restricting their ability to subsidize smaller products with grants or token revenue. In addition, the excess valuation in turn forces founders to pose the age-old question that plagues all economic activities: where does the income come from?

The operation mode of cryptocurrency project revenue

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

In contrast, the revenue of Friend.tech and OpenSea projects is seasonal. For example, the 'NFT summer' lasted for two quarters, while the speculation frenzy 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 product's original intention. Currently, many meme trading platforms have joined the club with fee revenues exceeding 1 billion U.S. dollars. This scale of income is typically only achievable for most founders through token sales or acquisitions. For most founders focusing on developing infrastructure rather than consumer applications, this level of success is not common, and the revenue dynamics of infrastructure also differ.

During the period from 2018 to 2021, venture capital companies provided a large 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 transformations:

First, smart contracts have achieved unlimited scalability with limited human intervention. Today, Uniswap and OpenSea no longer need to scale their teams proportionally based on trading volume.

Secondly, advances in large language models (LLMs) and artificial intelligence have reduced the demand for investment in developer tools for cryptocurrencies. Therefore, as an asset class, it is at a 'liquidation moment'.

In Web2, the subscription model based on API works effectively because of the large number of online users. However, Web3 is a smaller niche market, and only a few applications can scale to millions of users. Our advantage lies in the higher average revenue per user. Due to the nature 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 revenue from users in the form of transaction fees.

Of course, this is not a new concept. Initially, Stripe charged by API calls, 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 compete by undercutting prices in the API market, even offering free products until a certain transaction volume is reached, and then negotiate revenue sharing. Of course, this is an ideal scenario.

As for how things will actually turn out, Polymarket is an example. Currently, tokens of the UMA protocol are tied to disputed cases and used to resolve disputes. The more prediction markets there are, the higher the probability of disputes, directly driving demand for UMA tokens. In the trading model, the required margin can be a very small percentage, for example, 0.10% of the total bet amount. Assuming a $1 billion bet on the presidential election result, UMA could generate $1 million in revenue. In the assumed 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).

In addition to Polymarket, another example of a similar model is MetaMask. With the wallet's embedded exchange function, there is currently approximately $36 billion in trading volume, with revenue from exchange services alone exceeding $3 billion. Furthermore, a similar model also applies to staking providers like Luganode, which can charge fees based on the amount of assets staked.

However, in a market where API call revenues are decreasing, why do developers choose one infrastructure provider over another? If revenue sharing is needed, why choose this oracle service over another? The answer lies in network effects. A data provider that supports multiple blockchains, provides unparalleled data granularity, and can index new chain data faster will be the preferred choice for new products. The same logic also applies to categories such as intent or gas-free exchange tools. The more blockchains supported, the lower the cost, the faster the speed, the more likely 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, the notable ones include Sky, Ronin, Jito, Kaito, and Gearbox.

Token buyback is similar to stock buyback in the U.S. stock market, essentially 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 amounted to about $790 billion, compared to only $170 billion in 2000. Before 1982, stock repurchases were considered illegal. In the past decade, Apple alone has spent over $800 billion repurchasing its own stock. Although the sustainability of this trend remains to be seen, we see 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 buy back their own tokens may not be the most optimal way to utilize capital. One feasible approach is to allocate sufficient funds to offset the dilution effect caused by the issuance of new tokens, and this is exactly the explanation that the founder of Kaito recently provided for their token buyback method. Kaito is a centralized company that incentivizes users with tokens. The company obtains centralized cash flow from corporate clients and uses part of the cash flow to buy back tokens through a market maker. The number of tokens repurchased is twice the number of newly issued tokens, thereby putting the network into 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, founders have designed mechanisms to tie value to economic activity on the network.

In future articles, we will delve into the impact of these operations on the prices of tokens participating in such activities and on-chain behavior. However, for the time being, it is obvious that with the decrease 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 orbit', most teams will instead adopt a revenue model based on the percentage of trading volume. When this happens, if the project team has already launched tokens, they will be motivated to implement a 'buyback and burn' model. Teams that can successfully execute this strategy will become winners in the liquid market, or they may buy back their tokens at a very high valuation. The results of all this 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 worried about survival have begun to engage in in-depth discussions around revenue and token destruction.