Source: a16z crypto; Translation: Jinse Finance
Pricing is a common challenge faced by market builders. Many markets heavily subsidize user activity to promote early growth and liquidity—offering products or services for free (or at a significant discount). But this practice is unsustainable: at some point, if builders want the network's value to match the business it generates, the network must begin to charge substantial fees.
Turning on the 'fee switch' may seem concerning because when a market begins to charge for something that was previously free, usage will almost certainly decline, 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 those who remain. Even if the end users decrease, the fact that these users are paying can actually enhance the value of the network.
The question is not whether to turn on the switch, but when to turn it on.
This article will explore the logic of the answer. The result is that many businesses charge for too long or price too low.
But first, what is a fee switch?
The 'fee switch' in the market refers to the market receiving compensation for its work in facilitating and supporting transactions. When the market itself receives substantial revenue from transactions (often referred to as 'the cut', 'commission', or 'commission rate'), the fee switch is 'on'.
In blockchain protocols, this is often 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 transaction fees (such as fees generated by DEX) to be directly allocated to the protocol's treasury or stakeholders.
Once activated (the fee switch is 'on'), a portion of the fees will accumulate to the protocol's network tokens—either through a slight increase in total fees or by redirecting some fees that were previously allocated to other stakeholders.
Why should the protocol charge fees?
Fees are necessary because protocols need to cover operational costs. This seems fundamental, but it is worth mentioning. Any business—whether a gardener, an online retailer, or a blockchain protocol—cannot last long without covering costs.
But in a decentralized blockchain network, there is a twist: fees are not only used to cover costs but also to reward those who have contributed to the health of the network over a long period.
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 operation, and coordinating long-term incentives. The fee switch is a key mechanism to achieve this.
How to consider timing
The decision of when to turn on the fee switch boils down to a demand question: when is the demand strong enough that a slight increase in price won't drive users to competing protocols (or cause them to abandon the market altogether)?
Businesses that rely on network effects (think: most, if not all, of your favorite online marketplaces) often avoid charging high fees in the early stages of development because they need that network effect to be large enough to suppress participants' willingness to switch. For example, think about how Amazon subsidized customers for years, foregoing dividends to maintain and grow its network and lock in its competitive position.
It appears that blockchain interoperability favors switching to competing protocols—in other words, because user activity is easily transferable—blockchain networks may wait longer than traditional platforms. But tokens disrupt this logic: by sharing ownership through tokens, protocols turn users into partners and create network effects through their shared incentives, driving the success of the protocol.
To make this token network effect work, token holders must have reasonable expectations that their stakes in the network will appreciate. Therefore, blockchain protocols may wish to start charging fees earlier than traditional protocols. Conversely, shared ownership achieved through governance can buffer the high fees we see in Web 2.0 companies.
When to turn on the fee switch
Turning on the fee switch may have legal or operational reasons, 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 out of the market), significantly reducing the network's value.
It's easy to say, but what reasons can prove this point? Under what circumstances does a protocol lose participants without losing value? If the services provided by the protocol are practical and also have network effects and embedment, then in an equilibrium state, 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 provide the same product or service at a lower cost while maintaining sustainability.
Protocols can also reason through price experiments: how many users will be driven away by raising fees? In industrial organization analysis, this is called the churn rate. To get a rough idea of the churn rate, you can look for 'natural experiments' caused by external shocks that affect the effective cost users pay for your service—that is, when certain factors outside your control make your service more expensive for users. Take changes in gas fees as an example: how much does demand for your application drop when gas fees spike? Similarly, protocols may be able to estimate churn rates based on fluctuations in token prices. This analysis is directional only—and it is important to consider sensitivity—but it is certainly better than doing nothing, guessing, or not charging fees at all.
Finally (or perhaps most importantly), you can infer prices from basic principles: how much value do people derive from this service? To give an extreme example: if a customer derives $1 million in value, then the protocol might afford a fee of $5.
If you follow the analysis here and conduct some experiments, you can determine the best time to press the switch. To quickly remember the logic, here is the essence in a haiku:
Realizing value-added, enhancing network strength, and turning on the fee switch.