When to flip the fee switch

Pricing is a common conundrum for marketplace builders. Many marketplaces heavily subsidize user activity to bootstrap initial growth and liquidity — giving their product or service away for free (or at a steep discount). But that’s not sustainable: At some point, if builders want a network to be valued for the business it generates, the network has to start taking meaningful fees.

Flipping the “fee switch” can seem scary because when a marketplace starts charging for something that was previously free, usage is virtually guaranteed to decrease, at least in the short run. Nevertheless, it’s important to remember that while raising prices is likely to divert some customers away, it also means making more money from those who stay. Even if you end up with fewer users, the fact that those users are paying can actually increase the value of the network.

The question isn’t whether to flip the switch, but when.

This article works through the logic of the answer. The upshot is that many businesses wait too long to charge fees — and/or they set prices too low. 

A “fee switch” in a marketplace is a metaphor for the idea of the marketplace being paid for its work in enabling and supporting transactions. The fee switch is “on” when the marketplace itself earns meaningful revenue from transactions — often referred to as the “rake,” “take,” or “take rate.”

In blockchain protocols, this is often implemented through a literal fee switch — a programmatic function that, once activated, results in charging a fee for each transaction. For example, in the context of decentralized finance (DeFi) protocols, the fee switch is the mechanism that allows a share of trading fees — for example, those generated by decentralized exchanges (DEXs) — to be directed to the protocol’s treasury or stakeholders. 

After activation (fee switch “on”), a share of fees accrues to the protocol’s network token — either through a marginal increase in total fees, or by redirecting some fees that would previously have been allocated to other stakeholders.

Why do protocols have to charge? 

Fees are necessary because a protocol needs to cover the costs of doing business. This may seem basic, but it’s worth spelling out. If any business — whether it’s a landscaper, an internet retailer, or a blockchain protocol — doesn’t cover costs, it won’t last. 

But in decentralized blockchain networks, there’s a twist: The fees aren’t just to cover costs per se but also to reward those who have contributed to the health of the network over time. 

Possessing an ownership stake in a protocol incentivizes token holders to add value by contributing to the network. This is a superpower of blockchains: Token-holding marketplace participants are your partners. Proper marketplace pricing balances the tradeoffs among subsidizing liquidity, ensuring smooth operations, and aligning incentives for the long-term. A fee switch is a key mechanism for doing so.

The decision about when to turn on the fee switch comes down to a question of demand: When is demand robust enough that a small increase in price won’t send users to a competing protocol (or cause them to abandon the market entirely)? 

Businesses that rely on network effects (think: most, if not all, of your favorite online marketplaces) typically avoid charging substantial fees early in their development because they need those network effects to get large enough that participants are disincentivized from switching. Think, for instance, of how Amazon.com subsidized customers for years, eschewing dividends to maintain and grow its network and lock in its competitive position.

It might seem that because blockchains’ interoperability facilitates switching to competing protocols — in other words, because user activity is easily portable — a blockchain network might want to wait even longer than a traditional platform. But tokens flip this logic: By sharing ownership through tokens, protocols turn users into partners and create a network effect out of their shared incentive to see the protocol succeed. 

For such token network effects to work, tokenholders have to have a reasonable expectation that their stake in the network could accrue value. Thus, blockchain protocols may want to take fees earlier than their more traditional counterparts. And quasi-conversely, shared ownership — via governance — can provide a buffer against the extractively high fees we see in web2 businesses.

There may be legal and even operational reasons to turn on the fee switch, but from an economic perspective, the logic is straightforward: A protocol should turn on a fee switch when its network is strong enough that the fee will not divert so many users to other protocols (or out of the market entirely) as to substantially reduce the value of the network. 

Easy enough to say, but what are some reasons this could be true? When can a protocol lose participants but not lose value? If the protocol provides a useful service compounded by network effects and embeddedness, no competitor with the same cost structure will be able to provide that same service at a lower cost in equilibrium. Put simply: When a protocol is both useful and widely used, others facing the same cost structure simply can’t offer the same product or service more cheaply while still being sustainable.

Protocols can also reason through a price experiment: How many users will raising fees drive away? In industrial organization analysis, this is known as the diversion ratio. To get a back-of-the envelope idea of your diversion ratio, you might be able to look for “natural experiments” induced by exogenous shocks to the effective cost that users pay for your service — that is, when something outside your control makes your service more expensive to users. Take for example changes in gas fees: How much does demand for your app fall when gas fees spike? Similarly, protocols may be able to estimate the diversion ratio from fluctuations in token price. This analysis is only directional — and it’s important to take sensitivities into account — but it is certainly better than nothing, or guessing, or never taking fees at all. 

Finally (or perhaps primarily), you can also reason about price from first principles: How much value are people getting from the service? For an extreme example: If a customer is getting $1m in value, then the protocol can probably afford to add a $5 fee. 

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If you follow the analysis here and run some experiments, you can determine when it’s the right time to flip the switch. And for a quick mnemonic for the logic, here’s the essence in haiku:

Value-add achieved,
complementing network strength,
the fee switch turns on.

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Acknowledgments: Many thanks to Tim Sullivan, Sonal Chokshi, Robert Hackett, Tim Roughgarden, Kate Dellolio, Miles Jennings, Eddy Lazzarin, Ross Shuel, Shai Bernstein, Michael Crystal, and Liang Wu.

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Scott Duke Kominers is the Sarofim-Rock Professor of Business Administration at Harvard Business School, a Faculty Affiliate of the Harvard Department of Economics, and a Research Partner at a16z crypto. He also advises a number of companies on web3 strategy, as well as marketplace and incentive design; for further disclosures, see his website. He’s also the coauthor of The Everything Token: How NFTs and Web3 Will Transform the Way We Buy, Sell, and Create.

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