a16z: When will the Blockchain protocol and products turn on the fee switch?

Source: a16z crypto; Compiled by Golden Finance

Pricing is a common challenge faced by market makers. Many markets heavily subsidize user activity to promote initial growth and liquidity—offering products or services for free (or at a significant discount). However, this practice is not sustainable: at some point, if builders want the value of the network to match the business it generates, the network must start charging substantial fees.

Turning on the "charging switch" may seem concerning, as usage will almost certainly decline when a market starts charging for something that was previously free, at least in the short term. However, it is important to remember that while raising prices may drive away some customers, it also means earning more profit from the users who remain. Even if the number of end users ultimately decreases, the fact that these users are paying can actually enhance the value of the network.

The issue is not whether to turn on the switch, but when to turn it on.

This article will discuss the logic behind the answers. The result is that many businesses take too long to charge or price too low.

But first, what is the fee switch?

The "fee switch" in the market refers to the compensation that the market receives for facilitating and supporting transactions. The fee switch is "on" when the market itself earns significant revenue from transactions (commonly referred to as "rake," "commission," or "commission rate").

In blockchain protocols, this is typically achieved through a literal fee switch - a programmatic feature that, once activated, charges fees on every transaction. For example, in DeFi protocols, the fee switch is a mechanism that allows a portion of the transaction fees (such as those generated by DEX) to be directly allocated to the protocol's treasury or stakeholders.

After activation (with the fee switch "on"), a portion of the fees will be accumulated into the protocol's network tokens—either through a slight increase in the total fees or by redirecting some fees that were previously allocated to other stakeholders.

Why do protocols charge fees?

Costs are necessary because the agreement needs to cover operational expenses. This seems basic, but it's worth mentioning. Any business—be it a gardener, an internet retailer, or a blockchain protocol—cannot last long if it cannot cover its costs.

But in a decentralized blockchain network, there is a turning point: fees are not only used to cover the costs themselves but also to reward those who have contributed to the health of the network over the long term.

Owning the protocol incentivizes token holders to create value by contributing to the network. This is the superpower of blockchain: market participants holding tokens are your partners. Reasonable market pricing can strike a balance between subsidizing liquidity, ensuring smooth operations, and coordinating long-term incentives. The fee switch is a key mechanism to achieve this goal.

How to Consider Timing

The decision on when to turn on the fee switch boils down to a demand issue: when is the demand strong enough that a slight increase in price will not drive users to competing protocols (or lead them to abandon the market altogether)?

Businesses that rely on network effects (think: most, if not all, of your favorite online marketplaces) typically avoid charging high fees in the early stages of development because they need the network effect to be large enough to suppress participants' willingness to switch. For example, think about how Amazon has subsidized customers over the years, foregoing dividends to maintain and grow its network and secure its competitive position.

It seems that interoperability in blockchain is conducive to switching to competitive protocols—in other words, because user activities are easily portable—blockchain networks may have longer wait times than traditional platforms. But tokens disrupt this logic: by sharing ownership through tokens, protocols transform users into partners and create network effects that drive the success of the protocol through their shared incentive mechanisms.

To enable the network effect of this token to take effect, token holders must have reasonable expectations that their rights in the network can appreciate. Therefore, blockchain protocols may wish to charge fees earlier than traditional protocols. Conversely, shared ownership achieved through governance can buffer the high fees we see in Web2.0 enterprises.

When to turn on the fee switch

There may be legal or operational reasons for turning on the fee switch, but from an economic perspective, the logic is simple: when the network of the protocol is strong enough, it should turn on the fee switch so that fees do not drive too many users to other protocols (or completely exit the market), thereby significantly reducing the value of the network.

It's easy to say, but what reasons can prove this point? Under what circumstances would a protocol lose participants without losing value? If the services provided by the protocol are practical, and have network effects and embeddeness, then in a state of equilibrium, any competitor with the same cost structure cannot provide the same service at a lower cost. In short: when a protocol is both practical and widely used, other protocols facing the same cost structure cannot offer the same product or service at a lower cost while maintaining sustainability.

The protocol can also infer through price experiments: how many users will be driven away by increasing fees? In industrial organization analysis, this is referred to as the churn rate. To get a rough understanding of the churn rate, you can look for "natural experiments" caused by external shocks, which affect the effective cost that users pay for your service—meaning when certain factors beyond your control make your service more expensive for users. Take the change in gas fees as an example: how much will the demand for your application decrease when gas fees spike? Similarly, the protocol may be able to estimate the churn rate based on fluctuations in token prices. This analysis is only directional—and it's important to consider sensitivity—but it's certainly better than doing nothing, guessing, or not charging fees at all.

Lastly (perhaps most importantly), you can also infer the price from basic principles: how much value do people derive from this service? Take an extreme example: if a customer derives $1 million in value, then the protocol could potentially afford a fee of $5.

If you follow the analysis here and conduct some experiments, you will be able to determine the best time to press the switch. To quickly memorize the logic, here is the essence of the haiku:

Achieve value-added, Enhance network strength, The fee switch is turned on.