Source: Chris Dixon / a16z (and slightly tweaked)

Crypto tokens introduce financial incentives to technology products. The startup and web3 ecosystem are still working out the implications of this, including how and why this can be useful. During this period of experimentation, one theory appears to have gained some steam — tokens are a way to incentivize early network participants and avoid the “cold start problem”. This theory is tempting, but it is worth thinking through how widely applicable it actually is.

Before we dive in, let’s revisit the cold start problem — a well-known challenge for products with network effects (or “networks”), including Snapchat or Airbnb. On these products, the addition of a user makes the product more useful for all users. But on day 0, they have no users and, therefore, no utility to offer new users. This forces them to find creative ways to reach a critical mass of users (or “liquidity”) and achieve a base level of utility that can then attract new users.

Tokens are viewed as a way to circumvent this problem. The following quote is from Chris Dixon’s post on token incentives:

The basic idea is: Early on during the bootstrapping phase when network effects haven’t kicked in, provide users with financial utility via token rewards to make up for the lack of native utility.

- Chris Dixon (a16z)

The image at the top of this post (also via Chris Dixon) shows a visual depiction of this theory. NFX has proposed a similar idea called network bonding theory. According to this school of thought, tokens give early users a financial incentive to participate in a network. The addition of those users then allows the network to increase its utility and reach liquidity.

Passive Participation: When Token Incentives Work

Chris Dixon and the a16z team have cited a few examples of web3 networks that successfully leveraged tokens to reach liquidity:

1.The first is Helium, a decentralized network that provides cheap, easy internet access to IoT devices “in the wild” — like e-scooters and sensors. Hosts can join the Helium network by buying its “hotspot” and connecting it to their WiFi. Once they do that, the hotspot provides internet access to end-users (or owners of the aforementioned IoT devices) — and rewards hosts with HNT tokens.

2.The second example is Arweave, which is described as a decentralized, censorship-resistant storage network. Miners hook up their unused hard drive space to the Arweave network, which can then be used by end-users to store any type of data. Miners are compensated in AR tokens as long as data is hosted on their hard drives. Filecoin and Storj are other, somewhat similar examples.

3.Another example is Compound, a lending network. Lenders deposit their crypto assets into a lending pool for borrowers to access. Lenders then earn interest on their deposited assets and are rewarded with COMP tokens for providing liquidity to the network.

In each of these cases, the financial upside of the token was a strong incentive for early users to sign up and increase the utility of the network. But have you noticed the one facet that these networks have in common? They all require passive participation from users, particularly from the supply-side of their network (not very different from the concept of passive crowdsourcing in data networks). Once users connect their assets or resources to the network — whether that is bandwidth (Helium), storage (Arweave), or crypto assets (Compound) — they continue to earn tokens. That gives them financial upside and increases the utility of the network at the same time. The supply-side does not need to actively engage with the network to benefit from this financial upside.

However, networks with passive participation also tend to be rare. Most of the networks we use today require active participation — whether they are social networks like Snapchat and WhatsApp or marketplaces like Airbnb and Uber. If you never open Snapchat, you add no value to the network. If you’ve never accepted bookings for your Airbnb listing, you add no value to the marketplace. Are tokens an effective way to bootstrap these types of networks?

Active Participation: The Limits of Token Incentives

One of the most important principles of bootstrapping a network is to start with the most underserved users. Acquiring users is not enough to reach liquidity. You also need the right type of users, i.e. those who feel the problem most deeply and would put up with any amount of friction to engage with your network. When you acquire these users, activity outpaces adoption and the utility of the network grows. As a result, the network becomes significantly more valuable for newer users. This is especially important for networks that require active participation from users — because liquidity requires recurring engagement, not just one-time adoption.

Tokens can be a blunt instrument to target this underserved niche because they can attract the wrong type of users — those drawn to financial incentives, and not the near-term utility of the network. So on a web3 variant of Snapchat, tokens could attract high schoolers and also working professionals, irrespective of the kind of users the network needs at that point in time. When this happens, it becomes very difficult to reach the required density of the right kind of users. As a result, adoption does not have a direct impact on network utility and the evolution of network value can look something like the visual below:

Token Bootstrapping: Active vs. Passive Participation

This shows what happens when there is a disconnect between financial incentives and network utility — instant growth out of the gates, followed by a painful decline. Of course, this is an extreme, theoretical scenario. What would this look like in the real world? Let’s take a look at a few examples.

When Tokens Meet Active Participation

The most obvious example here is Looksrare — a decentralized NFT marketplace that launched in January 2022. It was meant to be a decentralized alternative to Opensea, which dominates the space. Unlike most web3 networks, Opensea is a centralized, web 2.0-style NFT marketplace with strong network effects — at least as long as demand for NFT projects remains healthy. To overcome these network effects, Looksrare executed a “vampire attack” on Opensea, i.e. it distributed (or “airdropped”) LOOKS tokens for free to high volume Opensea users. It also rewarded users with LOOKS tokens for trading certain NFT collections on Looksrare. This go-to-market (GTM) approach should have been enough for Looksrare to beat the cold start problem and scale its network. Unfortunately, financial incentives led to user behaviors that weren’t aligned with network utility.

Source: Dune Analytics / @hildobby

The chart above shows the genuine volume of NFTs traded on Looksrare — after filtering out “wash trading”, i.e. the same NFTs traded back and forth between the same wallets to earn more token rewards. Interestingly, genuine trade volumes began to collapse as token payouts normalized. By the end of February 2022, Looksrare’s daily genuine volumes had dropped to <5% of its peak and <3% of the daily trading volume of LOOKS tokens. In essence, users were there to earn and speculate on tokens, not to engage with the network.

Many other vampire attacks have led to similar results. Another NFT marketplace, Infinity, attempted the same tactic against Opensea in October 2021 with even more subdued results. Sushiswap, a decentralized exchange, executed a vampire attack on Uniswap in August 2020. The results, again, followed a similar trajectory although perhaps less stark (and also plagued by governance issues).

Decentraland, a virtual world powered by NFTs, is a less obvious example and one that doesn’t involve vampire attacks. Facebook’s rebrand to Meta in November 2021 triggered a gold rush for all metaverse-aligned projects in the web3 ecosystem. This dramatically drove up demand for both Decentraland’s MANA token and virtual real estate NFTs within its virtual world. However, most buyers appeared to be financially motivated, and the utility of this virtual real estate remains low — as does engagement. This isn’t to say that virtual real estate will never have any utility. It clearly can, but it will require active participation and engagement from its user base — with scaling tactics that are more likely to resemble active web2 networks like Roblox, rather than passive web3 networks like Helium.

Aligning Token Incentives With Utility

By now it should be obvious that tokens aren’t a magic bullet — there are no shortcuts to building a network. Networks that just need passive participation from users can use tokens as one tactic to overcome the cold start problem. But networks with active participation can be harder to bootstrap. In these cases, token rewards can incentivize behavior that conflicts with increasing network utility.

How do we fix this? At a high level, the only way to address this problem is to link token incentives to network utility, i.e. ensure that users can only receive token incentives if they add value to the network. In other words, rewards need to be restricted to specific, desirable actions, not just adoption. Braintrust, a decentralized freelance marketplace, is a good example of this. Packy McCormick recently published a deep dive into Braintrust and explains how its BTRST token works. Currently, it only distributes tokens to users who:

1. Refer clients or freelancers (incentivized referrals)
2. Screen candidates after completing courses (curation)
3. Freelancers who complete detailed profiles, courses, and jobs (core action)

Referrals, curation, and the core action(s) are key pillars for many web2 networks — they’re not unique to web3. The only difference here is that tokens are being used as an alternative to another financial incentive — and that is exactly what makes them effective. The downside, of course, is that this is a less effective hack to overcome the cold start problem on day 0 — the bar for earning rewards is higher. That’s a healthy trade-off for networks that require active participation. In fact, these types of networks may be good candidates for progressive decentralization, i.e. build a network the usual way first and introduce tokens for community ownership, governance, and/or rewards later.

To summarize, tokens can certainly play a role in building a network, but they are not a GTM motion in themselves. Pay attention to the kind of network you’re building and how token incentives interact with network utility before relying on them as a bootstrapping solution.