Funding the network, protocol and application layers

Exploring the differences that can be considered when funding different layers of a Web3 ecosystem

Network layer

The network layer includes any blockchain or distributed ledger ecosystem. Bitcoin, Ethereum, Solana, Cardano and Polkadot are all networks. Protocols and applications can be built on top of these networks.

Complexities

• Project tokens only have partially aligned incentives - Protocols or applications that are building on top of a network don’t have fully aligned incentives to maintain the network itself. Instead the incentives are only partially aligned as although they do benefit from improvements to the network they also have an opportunity cost in situations where they can simply migrate to another network. A project building on top of the network has no obligation to pay for any contribution efforts that maintain and improve the network.

• Importance of self sustainability - A network that relies on donations from community members or from projects building on top of the network is at a higher risk of stagnation if it fails to generate enough income to pay for necessary contribution efforts to maintain and improve the network.

Idea token vs network funding

Blockchain and distributed ledger networks already have their own coin that is used to pay for node operation through fees. This same coin can be used for generating income for the network. Similar to protocols and applications the network layer could generate income to maintain and improve itself through fees. Transactions fees could represent a long term approach for generating income for the network that can then be used for funding different initiatives. Projects building on top of the network don’t have fully aligned incentives to pay for network maintenance and improvements. Donations are more of a good will gesture than an obligation. A network generating income to fund its own development is the most obvious sustainable long term approach.

Protocol layer

The protocol layer includes any smart contracts that are developed for the wider ecosystem to use. Protocols often focus on implementing a specification to solve a specific problem. Protocols could focus on token swapping, borrowing & lending, derivatives, social messaging, game engines or many other areas.

Complexities

• Long term token use cases - Protocols that use their own token have a risk that when the protocol matures there might be less ongoing contribution effort needed. If the protocol rarely needs to be updated and maintained there is an opportunity to remove the fees and token attached to that project and make a new deployment that has no fee to reduce the costs for the end user of that protocol. Everyone in the ecosystem can benefit from having a number of free to use protocols.

• Fast changing environment - It can be difficult to predict exactly how a protocol is going to be used and how it might need to evolve over time to become an effective protocol for its targeted use case. A changing environment could introduce new use cases that change what is required and preferred.

• Importance of open source - If protocols are intended as a public good benefit for the ecosystem it is beneficial for the developers who are integrating that protocol into their own solutions to be able to verify and review the code themselves and ensure it meets their requirements and verify it’s secure and trustworthy.

• Ownership is often not desirable - Similar to internet protocols like TCP/IP, HTTP, SMTP and many others, it is often not desirable for these protocols to be owned by a single company or small group of people that are seeking to generate profit from the users of that protocol. A large part of the value of these protocols is they have been created and provided as public good for the benefit of society. Anyone is able to use these protocols however they wish to do so. Contributors who are funded as stewards for these protocols can help to maintain and improve them over time. These contributors are often sponsored by stakeholders that are interested in the maintenance and progression of these protocols. Sometimes existing companies contribute the time of their own employees to support these protocols. Web3 ecosystems could highly benefit from this same approach of making protocols that are for the benefit of the community. Protocols do not need to be privately owned or controlled by a small number of people or subset of the community. Web3 ecosystems have the opportunity to fund contributors on an ongoing basis to help with the maintenance and improvement of these emerging protocols.

• Preventing misuse and theft - If a token is introduced to a protocol there is a concern about what those token holders are able to do with any controlling ownership amount. Concerns could emerge around the use of kill switches or parameter changes if owners can stop or alter the usage of a protocol.

Idea token vs network funding

Some of the issues with introducing a token for a protocol are how the environment could change over time and how the long term use cases of the token may not be sufficient to justify the token. A token can also introduce a situation where the is a small number of actors or a subset of the community who has control and influence over a protocol that was intended to be a benefit to the wider ecosystem. If these owners are able to misuse or abuse their influence over the protocol this could be adding an unnecessary risk that is not beneficial to the ecosystem's stability. Issuing a token for a protocol could end up increasing the amount of competition between different projects due to the need for them to maintain and grow the value of their own token so they can sustain themselves. This could come at the cost of reduced collaboration across the ecosystem if projects are not effectively identifying shared problems and collaborating on potential solutions. Protocol token funding could be effective in some use cases however it is preferable to avoid the usage of a token if the protocol development can be funded in another way sustainably. Network funding could be effective for funding protocol development if the network is able to generate enough income over the long term to pay for these efforts.

Application layer

The application layer focuses on end user solutions such as web or mobile applications. Applications can integrate network and protocol functionality and any libraries available to make solutions that can be useful to community members. Example applications could be social and finance applications or online games.

Complexities

• Long term token use cases - Adding a separate token to fundraise for an application might be problematic unless there is long term utility in the token. Some examples of where a token could make sense could be for loyalty or reward points in an e-commerce platform or in-game currencies in an online game. In other situations the application may benefit from simply charging a fee with the network coin itself rather than making another token. Application development could be funded by community investment using the network's own coin or be funded by the network itself.

• Open source vs closed source - Applications could go down a closed source route where they charge some form of fee to use their application and then want to protect their code from being copied and deployed for free. Another approach could be that application development is supported by network funding and the code is open source from the start and the community can freely deploy and edit this application as they want to. Both open source applications and closed source applications could be sustainable over the long term however closed source would have increased competition in this environment as the open source solutions would be free and openly available to use. Closed source applications would need to provide a better or more tailored experience for end users to justify any one-off or ongoing cost to use that application.

• Preventing misuse and theft - An ongoing risk for end users with applications is if those applications mislead the user into performing an action that results in a loss of funds. If the application is closed source then there is an increased reliance that the wallets and transaction signing interfaces that people are using can help with identifying applications that are attempting to do something malicious. These problems can be more easily checked and verified if the codebase was open source.

Idea token vs network funding

Some applications could benefit from the usage of a token over the long term. Other applications may be more suitable for generating income through fees to use the application. Network funding could be another approach that is effective for developing many open source applications that can then be modified and used by anyone freely. There are many different ways that an application developer could compose the available protocols and network functionality together into a user experience. This variety of ways that an application could be built for general and niche use cases can increase the opportunity that a multitude of sustainable funding approaches could be effective. Open source applications are still a highly desirable outcome so that the code can be checked and verified as it gets updated over time.

Open source software libraries

Open source software libraries could be created for any of the network, protocol or application layers. Libraries could help with math, cryptography, data processing and formatting, compression, data storage, transaction building, scalability and many other areas. Some of these libraries could be used across all of the network, protocol and application layers.

Software libraries such as these do not necessarily need to have a business model to be sustainably funded. Network funding could play an important role in ensuring these types of initiatives are supported over the long term.

Idea token vs network funding

Ecosystems without much network funding available could become more reliant on projects building on top of the ecosystem to lead and support the development of open source libraries. The main issue with this approach is that the projects would only have partially aligned incentives to support these open source initiatives. If they support these initiatives more than other projects in the ecosystem they could be putting themselves into a weaker financial position than the competition. Projects are incentivised to succeed, this incentive can conflict with using their capital to support initiatives that aren’t fully aligned with increasing their own chances of success. Network funding does not face this partially aligned incentive problem as any funding that comes from the network can be directed towards any high impact open source initiative that improves the ecosystem. Network funding has more fully aligned incentives to repeatedly identify and support the most impactful open source initiatives.

Key takeaways

• Network treasury funding is at its highest importance for maintaining and improving the network itself - The most reliable way to sustainably fund the contribution efforts needed to maintain and improve the network will likely be from network transaction fees. It is of the highest importance that any code developed to maintain and improve the network itself is open source so it can be verified and audited by the wider community.

• Network treasury funding is highly preferable for protocol development - Similar to Web2 protocols there is a massive benefit for the community when protocols are developed as a public good that is for the benefit of the ecosystem. Some protocols may require a token to function more effectively however when in doubt it is more beneficial for the protocol to remain open source and be owned by the community. Protocols that are responsible for a growing amount of ecosystem assets can benefit from having a similar level of verification and auditing as network changes would.

• Network treasury funding could be the most effective for application development - Applications could create revenue models in a number of ways and some applications may benefit from a token over the long term. Network treasury funding is still a highly promising approach that could prove to be one of the most effective due to the more fully aligned incentives it creates for projects to open source their code from the start. More experimentation will be needed to find out which funding approaches are the most effective for different types of applications.