Thanks to @montez and @snormore for the edits

Goal

Identify the problems with using a speculative project token for web3 project user actions. Use Arweave’s $AR token as an example.

Introduction

Enthusiasm for crypto projects drives speculative market activity for project tokens. If tokens are used to pay for project actions (i.e., payment tokens), then the price of project actions increases along with token value. In this way, token speculation levies an implicit cost on web3 product users—ultimately leading to self-enforced limits on product growth.

How should we solve this problem? Alternatives are unsatisfying and require real tradeoffs. The problem is admittedly complicated by the desire to build utility for project tokens.

Web3 user actions

Web3 products are open access and lack permissions. The interfaces are open and composable, and everyone is free to use them. The lack of permissions is a defining characteristic of web3, and sets it apart from its predecessor web2 technologies.

Openness brings many advantages, but leaves the product vulnerable to spam, which at scale can take the product offline making it unusable for everyone.

To prevent spam, users must pay per action or account.

Can I pay for web3 user actions with my credit card?

Web3 project designers choose how users pay for actions and accounts. Fiat currencies are not digitally native, and thus historically have not been viewed as a good choice for denominating web3 actions.

Instead, crypto projects mint digitally native tokens that can be used to pay for actions. We call these tokens, payment tokens.

The tokens in circulation are the monetary base of the project’s ecosystem, and the project effectively takes on the role of monetary authority, just like the U.S. Federal Reserve or the Monetary Authority of Singapore. This is not an easy job.

The big problem with payment tokens: volatility

Volatility represents the annualized standard deviation of returns of an asset relative to a base asset—typically $USD. Volatility represents uncertainty. A highly volatile payment token that is used for product actions introduces uncertainty for product users.

So, we want to minimize the volatility of payment tokens, or choose payment tokens that exhibit low volatility.

For example, the volatility of USD against a basket of major fiat currencies is 0.38%, which is much lower than the volatility of web3 payment tokens against USD:

Selecting a high volatility payment token leads to two unfortunate outcomes for web3 projects:

• Limits medium-to-long-term network adoption

• Uncertainty for developers and users

Limits medium-to-long-term network adoption

As well-intentioned as payment tokens are, the existence of payment tokens provides a way for people around the globe to speculate on web3 projects with minimal friction—tokens are simply data that can be updated at the speed of the internet 24 hours a day, seven days a week, all year long, currently without much regulation.

Speculation exists in all markets, and its existence is healthy for trading volumes (i.e., liquidity). And trading volume is required for the efficient discovery of asset price equilibrium.

But, speculation is one of the primary use cases in web3 to-date, and cycles of excessive speculation are a theme.

Excessive speculation isn’t a feature we want for payment tokens. We can see the impact of excessive market speculation on the Arweave payment token in the charts below.

Arweave is a network of data storage providers that are incentivized by the protocol to make hard disk space available to users.

Figure one:

In the last nine months, the cost to store a few GB of data on Arweave is consistently around 1 $AR.

Figure 2:

But, the price of $AR in comparison to $USD has increased substantially

Figure 3:

The token valuation may be justified, as Arweave usage has also increased

Figure 4:

But, the unsurprising result is concerning: As $AR/$USD rises, so does the cost of storage in $USD terms. When $AR was trading for ~$37 on March 14th, it cost end users ~$40 to store a GB of data.

AWS S3 storage is currently $0.023 per GB per month. The Arweave protocol is designed for users to pay once to store forever, but you would have to live another 145 years to make it economical to store a GB of data on Arweave over S3.

There are real guarantees offered by a decentralized network, like Arweave that AWS cannot offer. However, the economics are currently too imbalanced for decentralized crypto networks to win out over their web2 predecessors.

Internet service provider tokens - thought experiment

It isn’t hard to imagine other real world examples of payment token shortcomings. If a successful ISP launched a speculative project token for customer billing payments, the cost of the provider’s internet service would go up as speculators gobbled up the project tokens during good times. Service cost inflation would act as a self-enforced limitation on service growth, as customers would switch to competitor providers in direct proportion to the ISP’s own success.

Hmm, wouldn’t the price of the web3 service adjust downward in response to token/$USD increases?

We might expect prices to adjust down as the payment token appreciates against fiat. But this is not the case. In fact, prices tend to rise along with the token.

Uncertainty for developers and users

The second unfortunate outcome of payment token volatility is that it introduces uncertainty for product customers. Developers and users want to know their costs with some level of certainty. Anecdotally, in figure 4 above, we can see that $AR/$USD introduces a considerable amount of cost uncertainty. For those holding $USD on January 13th, a GB of data storage cost less than $10. Just two months later in March that same user holding $USD had to pay 4x more for the same GB of data storage.

Token infrastructure

Web3 payment tokens themselves require token infrastructure: if it is a non-native token it requires a contract on a settlement chain with high security guarantees, deep access to liquidity for swapping (onchain/offchain), secure bridging options, and consideration of applicable tax rules on token transfers.

Token infrastructure designs determine the level of friction placed on developers and users when swapping in/out of the project’s payment token for project use. If a project introduces a payment token without well-developed token infrastructure, unnecessary frictions will inevitably sap product growth.

Protocol infrastructure provider preferences

The majority of protocol infrastructure providers are professional operators that work across many open protocols. They are interested in earning project tokens from protocol rewards for their service. They also earn fee income from user payments for product actions. If both rewards and payments are denominated in project tokens, their income will be highly unpredictable. Provider income can be made more predictable by denominating user payment in a low volatility token.

Exchange rate risks

The majority of rollup chains are operated by project teams. These teams pay the operational costs of the rollup on behalf of users and developers. The biggest costs are consensus and data availability fees paid to the settlement chain and the data availability chain. The denomination of these costs may be different from the denomination of fees collected from user payments. This currency mismatch introduces uncertainty for operators—there can be no guarantee the amount of fees collected at user payment time will be sufficient to pay for rollup operating costs, as the relationship between the two different currencies is continuously changing.

Why do teams choose to use a payment token?

Early web3 projects, such as Arweave thought of their ecosystem as an independent economy with its own monetary system.

The main benefits of an independent monetary system are (1) monetary premium, and (2) token supply control.

Monetary premium

In finance, an asset is valued at a premium when it is trading above its intrinsic value. A monetary premium refers to money-like assets that are valued at a premium to their intrinsic value. Fiat money is a typical example—society swaps time, energy, and goods for fiat money, despite the money instrument not being redeemable for anything from the authority that issued it.

In web3, monetary premiums can drive token prices above their intrinsic value, which means project treasuries have more money to spend on the project.

But, there is a real cost for project development companies to build sufficient token liquidity necessary for monetary premium. Market makers (LPs and professional traders) need compensation to form and contribute to a liquid market. To start, this must be paid by the project in the form of incentives for DEX liquidity providers, contracts with professional traders, and contracts with CEX for token listing. Sustaining monetary premium requires the broader social layer to coordinate around the use of the token as the standard medium of exchange.

Supply control

Supply control means the team can mint payment tokens for developer integrations or users to make the service free for some period of time. However, token incentives for adoption are unsustainable, and likely bad monetary policy given the ruthlessness of token farmers.

All costs can be passed on to the end user, but the objective should be to remove frictions for users, not introduce more friction in order to support token values.

Web3 user action problems

There are many problems we must solve for web3 user action payments that are aside from the problems introduced by project payment tokens.

As web3 product designers, we should try to address these problems and simplify user experience in order to drive value to our products. We often do the opposite—favoring token utility designs that drive value to the token instead of the product.

Alternatives to project payment tokens

Designers that choose to use the project’s token as the payment token are stating: I can do better than available stablecoins and existing internet native currencies, such as $DAI and $ETH. This is ambitious, and detracts from other product priorities. Building internet native money standards that support—rather than hinder—product growth requires significant investment in both monetary policy and token infrastructure.

So, what options exist for web3 product designers?

Stablecoins

A low volatility asset like $USD (and other fiat currencies) stablecoins can be a good choice for payment tokens. Stablecoins, although not without risk, are the only tokens unaffected by web3 project speculation cycles.

This is the path chosen by Gnosis Chain, which uses bridged $DAI ($xDAI) as the chain’s payment token.

Stablecoin risks - intermediary risk and smart contract risk

Some stablecoins, like $USDT and $USDC require a trusted intermediary, which issues stablecoins for user collateral deposits. Stablecoin intermediaries invest the deposited user collateral in order to earn a yield on the deposits for themselves. All yield opportunities require risk. As in most financial intermediary cases, the users directly bear the full extent of the risk. The only risk insurance available to users would be on fiat collateral held in insured bank accounts, which is minimal.

Permissionless stablecoins, such as $DAI do not require a centralized intermediary. Instead, a smart contract protocol on Ethereum acts as a monetary authority issuing $DAI loans on collateral placed into smart contract vaults. A large portion of the collateral requires an intermediary, and some of these risks are transferred to $DAI holders.

Largely disintermediated stablecoins, like $DAI are also not without risk. Smart contract bugs can lead to a loss of collateral and an equivalent loss of value for the stablecoin.

Stablecoins are a good option for denominating user actions, since the monetary policy is set by global monetary authorities with demonstrated experience in maintaining price stability. Monetary policy is a globally researched problem, the history of which spans centuries. It needs constant debate and maintenance, as the primary goal of any monetary policy is to provide the appropriate level of liquidity to the evolving economy while keeping prices in check. Like many things in nature, economies are cyclical. Monetary policy must be constantly updated to follow the market’s nature.

Stablecoins also have strong token infrastructure and are widely used as a medium of exchange. However, intermediary risk and smart contract risk must be considered.

Designers that choose a stablecoin as the monetary base for their project are stating: global monetary authority policy setting is more sound than the monetary policies of existing internet native money or my own.

Use an existing internet native money standard

$ETH is becoming a likely social standard for internet native money. Ethereum has proved it can both curate world class research and deliver seamless upgrades. The Ethereum research community, shepherded by the Ethereum Foundation Robust Incentives Group has continually pushed the industry forward, leading to an incredible amount of value accrual in the ecosystem and the ubiquity of $ETH across blockchain ecosystems.

$ETH is a good choice for denominating user actions. This is especially true on rollup chains that settle to Ethereum—since the rollup costs are also denominated in $ETH. There is no disagreement that $ETH token infrastructure is the most well developed among internet native currencies, and it is widely used as a medium of exchange.

Designers that choose $ETH as the monetary base for their project are stating: Ethereum monetary policy is more sound than global monetary authorities or my own.

Conclusion

This blog delves into the intricacies of web3 user actions and the necessity of fees within permissionless web3 projects. By introducing digitally native payment tokens, web3 projects aim to streamline transactions and minimize reliance on traditional financial infrastructure. However, the adoption of speculative, high-volatility payment tokens poses challenges, such as limiting network adoption and fostering uncertainty among developers and users. Moreover, the burden of payment token volatility falls on infrastructure providers, developers, and users alike. Considering the significant investment of time and resources required to navigate these challenges, exploring alternatives like stablecoins or adopting existing internet-native money standards may offer more sustainable paths forward for product designers.