Web3 Operating Metrics: Fees, Revenue, and Profitability of Protocols

Introduction

There is widespread confusion in the Web3 space with some core protocol metrics and people speak about protocol fees, revenue, and profitability interchangeably. This is far from the truth given the different designs and value accrual structures of each protocol. Most protocols function as two-sided platforms which match supply to demand, these metrics have a more profound impact in DeFi than in other areas. This article focuses on operational metrics, not valuation metrics like market capitalization, TVL, etc. These operational metrics are important to understand as they ultimately inform protocol valuations.

Fees and Revenue

Fees and revenue are two KPIs measuring distinctly different measures of economic activity. A decentralized exchange like Uniswap generates transaction fees by matching supply and demand, all its fees are delivered to its liquidity providers while its treasury and token holders get no fee, hence they are high fees yielding but zero revenue producing.

Other protocols like GMX split their fees between liquidity providers and “stakers” while protocols like dYdX accrue all fees to the parent company’s treasury making it a high revenue-generating protocol. The protocol’s revenue accrual percentage is called the “take rate”. PancakeSwap has a 33% take rate while Uniswap has 0%.

Protocols like ENS have the potential to generate high-quality revenue i.e., ARR (Annual Recurring Revenue) provided Ethereum users continue to show demand for using unique addresses. Each unique domain address is an NFT and users pay rent for access and usage. ENS must control the churn, make it attractive for users to hold these addresses and maintain steady demand. In these circumstances, its revenue mirrors a good business model.

Revenue and fee must not be confused with metrics like TVL (Total Value Locked), TVL is analogous to the balance sheet of a protocol that the protocol monetizes via the liquidity supplied by participants. The revenue and fee generation may not reflect on token prices in the short-term given their tokenomics factors, however it is important for long-term viability of the protocol.

Profitability

A protocol’s profitability is a different metric from revenue and fees. It has distinct levers like token-driven incentives for growth and usage of platforms. Profitability is typically computed as the difference between costs and revenue, in Web3 the cost to issue new tokens is only the gas fee. However, issuing new tokens dilutes the existing token holders and the treasury resulting in two distinct phenomena i.e., lower revenue accrual and added sell pressure lowering profitability.

However, in their initial days, protocols drove adoption through higher token-based incentives offsetting revenue (higher burn rate for a startup). As adoption picks up, protocols should (not always do) reduce token incentives like grants, airdrops, etc. to skew the ratio of value accrual toward revenue. Many protocols could not gain the adoption levels they had promised and continue to dilute their token holders sacrificing revenue and taking low to negative profitability creating an unsustainable spiral. The only alternative for protocols to sustain in this mode is to raise funds again and dilute their token holders again if the execution to adoption is improper. This is the vicious cycle many projects are likely to be trapped in this bear market of 2022.

The Layer 1 Model

L1s sell limited on-chain block space, and higher demand generates higher fees. These block spaces are immutable, decentralized, and permissionless and without these attributes, the blockchain is a dumb and inefficient database.

The principle of Layer 1 protocols remains like other protocols; however, they entail costs like paying validators (or miners) and on-chain storage costs, they may charge users for it e.g., Solana’s rent per-byte/per-year is 0.00000348 (at $14 priced SOL), the price is approx. $50K yearly. This can affect the profitability levels of the protocol and high prices could discourage adoption. Layer 1 protocols have gas fees collected from transactions split with their ecosystems and staking revenue received. Hence Profit = (Gas Fees+ Staking Rewards) – (Validator Fees+ Storage Costs, etc.)

Many of these protocols have been “paying” users, developers, and customers through token incentives, yet not gaining the escape velocity on adoption. So far, they have offset this by raising large rounds of venture capital money without delivering returns to investors other than speculation around future adoption. Many of these negative revenue-generating protocols are unlikely to survive if their rate of adoption cannot beat their inflation rates by a significant margin. The levers around raising several rounds of VC money and throwing tokens at the community to dilute token holders will not last forever, both factors have heavy headwinds in the bear market.

Ethereum Example

In its PoW (proof-of-work) days, Ethereum issued approx. 4% (32m ETH per day) of tokens to its miners as a block reward, required to keep miners interested, validate transactions, and keep the network secure. Ethereum was unprofitable for a long time, but things changed with the merge (migration to proof-of-stake) reducing the issuance by approx. 90%.

Ethereum’s revenue is demand dependent and ranged between $4m and $80m per day over the past 12 months (an average of approx. $15m per day). The merge brings Ethereum’s issuance costs to about $3m per day offsetting electricity and expensive miner costs adding nearly 75% in operating margin and making it a highly profitable blockchain.

Concluding Thoughts

As the Web3 and crypto markets mature, these fundamental metrics will be important to retail and institutional investors. Protocols failing to inject good fundamentals into their chains will be quickly abandoned.

Many protocols also get away with rewarding one side of the ecosystem for the other, this will also have to change with tighter linkages between equitable fee distribution, revenue, and profitability coming under scrutiny. The nuances and underlying economic logic of each protocol design and its advantage to the community, users, token holders, liquidity providers, etc. will also need to be transparent and maybe standardized to a degree.

The critical vector here remains adoption rates and multiple KPIs being a manifestation of adoption.

References

Messari Stats

Andre Cronje’s Medium Post

Avi Gupta’s Mirror Article (Eth Data)