New Paradigm for Software Monetisation
In the preceding article, we examined how crypto protocols mirror businesses with diverse revenue models.
This piece provides context to protocol cash flows, delving into the brief history of open-source software, its challenges, and the revolutionary role of crypto in coordinating and creating value for open-source projects.
Further, we analyse the cash flow dynamics by tracing the value through the theoretical "income statement" for the previously discussed examples: Ethereum, Uniswap, and Lido.
Open vs. closed-source software
In today’s tech industry dominated by trillion-dollar giants like Microsoft, Apple, Google and Amazon, closed-source software reigns supreme. These companies’ playbook has involved recruiting top talent, creating proprietary products, safeguarding the intellectual property, and perpetuating network effects for healthy monetisation – a well-established formula for industry dominance.
Venturing into the perhaps less glamorous annals of tech, we find the open-source movement. Here, developers take a collaborative approach to creating software. The source code is made available to the public; anyone can view, use, modify and distribute the code.
The open-source movement gained momentum post the invention of Unix – a multiuser, multitasking operating system developed by Bell Labs in the 1960s. Many projects sought to scale Unix or Unix-like operating systems. Contenders included projects like BSD (Berkeley Software Distribution), System V Release 4 (by AT&T and Sun Microsystems), Xenix (by Microsoft) and GNU (Gnu’s Not Unix started by Richard Stallman, founder of the Free Software Foundation).
Many of these initiatives succumbed to the passage of time. But one not only survived, but thrived to become one of the most popular operating systems in the business server market today. This project was Linux, started by a Finnish software engineer named Linus Torvalds in 1991. So how exactly did Linux take off? What was the magic behind Torvalds’ success?
Richard Stallman (left) and Linus Torvalds (right)
Linux’s history and lessons from its ascent are well documented in Eric Raymond’s book The Cathedral and the Bazaar. In a nutshell:
Linus was not just a developer, but a masterful community builder.
His leadership defied conventional power dynamics, emphasising open communication and collaboration across a global community of programmers. He established a set of cooperative customs, fostering an environment where developers were inspired to attract co-developers.
The timing aligned perfectly with the advent of the World Wide Web, which expanded Linux’s reach to tap into the global pool of talent.
In studying the story of Linux, we observe two major benefits to open-source software:
Many eyeballs tame complexity. If enough people care about the project, errors in the code could be easily spotted and questions quickly solved. Transparency allows any developer to review and scrutinise the code, resulting in quality, reliable software.
Reduction of development cost. With public code, developers can stand on the shoulders of giants. They don’t have to build everything from scratch. The result is a lower cost of iteration and innovation.
Issues with open source – no $$$
Despite the advantages of open-source software, its limited monetisation options have led the developer talent to skew to closed-source. Eric Raymond writes:
“…Hackers cannot be pursuing anything very closely analogous to material wealth (e.g. the accumulation of scarcity tokens). There is one way that open-source activity can help people become wealthier… Occasionally, the reputation one gains in the hacker culture can spill over into the real world in economically significant ways. It can get you a better job offer, or a consulting contract, or a book deal. This kind of side effect, however, is at best rare and marginal for most hackers… they’re doing what they do, not for money but out of idealism or love.”
Making money as an open-source contributor was tough. For instance, Linux had no easy way of directly capturing value and systematically sharing that value with its contributors. Companies like Red Hat that sold services around Linux did better, though key contributors like Torvalds et al were hardly the main beneficiaries (Torvalds reportedly received ~$1m in Red Hat stock at the IPO in 1999).
With open-source being a financially unattractive proposition, it is unsurprising that the tech industry evolved to favour companies monetising proprietary software and offering lucrative salaries to top talent.
But what if the so-called “scarcity tokens” became real?
Crypto is changing the game for open-source software
What makes crypto so exciting is that open-source projects finally have a way to coordinate and generate value, thanks to blockchains that secure internet users’ digital property rights. Hackers don’t have to be poor and altruistic. Conceptually, tokens bring:
A funding mechanism: token sales to investors allow more projects to get started
An incentive mechanism: token rewards to contributors help attract and retain talent
A payment mechanism: internet-native money lowers friction for monetising through global retail micropayments
An engagement mechanism: global public markets for tokens raise and sustain interest in the project
A value accrual and retention mechanism: tokens are the vessel for accruing and retaining the tangible value created by monetising the protocol and the intangible value created by the community.
Having said the above, how tokens are implemented in each project varies significantly in practice. Important aspects that tokens investors must consider are 1) the alignment between project contributors and the token and 2) how the token gains economic value. Let’s explore the different models using Ethereum, Uniswap and Lido as examples.
Ethereum: The non-profit foundation model
The Ethereum blockchain is an open-source project that is driven by the core team at the Ethereum Foundation (“EF”), as well as many other independent contributing entities (e.g. Consensys and Nethermind). The EF is a non-profit organisation that housed the founding team and received an allocation of 12m ETH (20% of the total initial supply) during the 2014 Initial Coin Offering (ICO). Presently, the EF holds 0.26% of the total ETH supply (~$650m) in its treasury.
The strength of the Ethereum community’s structure is that the core developers are wholly aligned with the value appreciation of ETH, as it constitutes a significant portion of the Foundation’s treasury. However, a potential vulnerability is that the non-profit nature of the Foundation necessitates prudent management of its treasury to sustain essential R&D endeavours.
Income statement: Below is a theoretical income statement for Ethereum, using accounting language that most will be familiar with.
The Ethereum blockchain generates “revenues” from processing user transactions, for which it charges gas fees. Gas fees, denominated in ETH, are made up of base fees and tips.
Tips are passed onto the Ethereum validators who provide the transaction processing service. This is essentially the cost of providing the service.
Base fees are kept by the protocol as “gross profit”.
Operating expenses, including people/R&D costs, are covered by the EF and other for-profit entities that develop and monetise products and services that enrich the Ethereum ecosystem.
Token holders benefit from retained base fees, which automatically reduce the token supply through burning. Countering the deflationary impact is formulaic ETH issuance paid out to the validators.
In summary, the value to Ethereum token holders is clear: ETH appreciates through increased user gas fees and the burning of base fees. Additionally, core contributors’ alignment with the token is strong as the EF relies on ETH’s value appreciation as a necessity to sustain itself.
Uniswap: The for-profit company + DAO + Non-profit foundation model
Uniswap is the largest decentralised exchange built on Ethereum, with over $1.7 trillion of cumulative volumes traded since its inception in 2018. The protocol is supported by an ecosystem of contributors organised around 3 main entities:
Uniswap Labs, a for-profit US C-corp, where the core development team of the Uniswap protocol sits
The Uniswap DAO governed by $UNI token holders, who submit and vote on proposals related to the Uniswap protocol, including protocol monetisation (“fee switch”)
The Uniswap Foundation, a non-profit organisation that supports ecosystem growth through a grants program
The key distinction with Uniswap is that the core development team sits inside a for-profit company. Uniswap Labs has raised funding from equity investors who represent an overlapping but separate constituency as the token holders of the Uniswap DAO. This has both positive and negative implications.
While the equity raise ($165m raised in October 2022) provides the core team good runway for protocol enhancement, it introduces potential conflicts of interest between equity and token holders. Uniswap Labs pursues a dual mission of building the protocol and creating monetisable products for equity holders. This means the success of the $UNI token is not the only consideration for the core team.
For instance, a notable conflict involving Uniswap Labs was its recent implementation of a 15bps fee on trades executed through the Uniswap website. As a primary access point to the Uniswap protocol, the website, owned by Uniswap Labs, currently handles approximately 40% of the total traffic. The unilateral decision to introduce fees for trades on the Uniswap website faced significant criticism from $UNI token holders, who had yet to reach a consensus on whether/how to monetise the protocol due to legal and regulatory considerations. The 15bps fee competes with token holders’ interests: if a Uniswap user is willing to pay x% fees, the fee opportunity for token holders may have diminished to (x-0.15)%.
Income statement: Despite the intricacies of organisational structures within the Uniswap ecosystem, the Uniswap protocol stands out as one of the select crypto applications to have achieved product-market fit. While the DAO has not yet voted on a "fee switch," one can conceptualise the theoretical token value accrual as illustrated below.
Protocol revenues result from trading volumes multiplied by the take rate (i.e. commission on trades). In 2022, Uniswap's total trading volumes amounted to $742 billion, compared to Coinbase's $830 billion. The DAO is yet to agree on the take rate, but for context Coinbase charges between 0.05% and 0.60% based on pricing tiers.
Liquidity in DEXs is provided by Liquidity Providers (LPs), who are compensated with a share of the trading fees. Average pool fees stand at ~15bps.
Operating expenses are zero, as Uniswap Labs covers these costs.
The total value to token holders remains uncertain as the full protocol fees have not been activated. However, upon activation, one can envision the value being returned to token holders through mechanisms such as token burns.
In summary, the value for $UNI token holders hinges on protocol trading volumes and the fee activation. While the core team is aligned with $UNI success (they received 21% of total supply at token genesis), their equity in Uniswap Labs introduces a potential misalignment, posing risks to token holders.
Lido: The simple DAO model
Lido is the largest liquid staking protocol for Ethereum. It helps users easily stake their Ether (i.e. lock up their Ethereum to secure the blockchain in return for rewards) by outsourcing the technical aspects of staking to a third-party called node operators.
The protocol is developed and maintained by the Lido DAO (Decentralised Autonomous Organisation), a fully virtual, blockchain-native entity operated by contributors. The DAO is governed by the $LDO token holders who vote on the strategic decisions of the project.
The DAO operates as a self-sustaining entity, collecting fees from protocol users to cover contributor compensation and other operating expenses. Real-time insights into its "income" and "balance sheet" are accessible through blockchain data, viewable for instance on the Dune Dashboard provided by Steakhouse Financial.
The DAO model is simple, transparent and aligned. However, a potential drawback lies in the lack of a legal framework for DAOs and their inherent inefficiencies in decision-making compared to traditional corporations. Additionally, issues such as voter concentration or apathy may lead to a centralisation of decision-making.
Income Statement: Lido has a clear fee model.
10% of user’s Ethereum staking rewards (currently around 3.5% yield) are shared equally between the DAO and the Lido node operators who provide the staking service
“Gross profit” is therefore 5% of user’s Ethereum staking rewards.
Opex is assumed by the DAO. The big item is people cost for ongoing R&D.
The DAO is currently at around breakeven. Future surplus could be returned to token holders for instance via token burns.
Conclusion
The World Wide Web effectively solved the coordination challenges of open-source development, catalysing projects like Linux to be an enduring success. But despite inherent advantages, open-source software struggled to achieve mainstream adoption, largely due to a lack of mechanisms for rewarding developers and capturing value.
Crypto heralds a transformative paradigm for open-source software by establishing an internet-based financial and incentive system. We’ve seen how various projects and contributors have begun to organise themselves, utilising tokens as instruments for coordination and value creation.
Certainly, the harmonisation of legal frameworks and regulatory considerations for this emerging global asset class is a gradual process expected to unfold over several years. Nevertheless, my hope is that the readers can appreciate innovation underlying crypto merits more recognition than a reductionist label of “speculation”.
Bonus: Eric Raymond’s two cents on when to go open-source
If the hints through the article were not enough, I strongly recommend Raymond’s book. It’s an oldie but a goodie. Reinterpreting Raymond’s reflections on when to go open-source, I think projects with the below characteristics could consider leveraging open-source + crypto:
“
The following discriminators push towards open source:
Reliability/stability/scalability are critical
Correctness of design and implementation cannot readily be verified by means other than independent peer review
The software is critical to the users’ control of his/her business
The software establishes or enables a common computing and communication infrastructure
Key methods (or functional equivalents of them) are part of common engineering knowledge
“
Source: Raymond, Eric S. The Cathedral and the Bazaar: Musings on Linux and Open Source by an Accidental Revolutionary. O'Reilly Media, 1999.