Web3 gaming evolution and 5 economic challenges (Part II)

By: Alexandra Takei and Sophia Weng

In the last piece, Alexandra and I wrote about the evolution of web3 games. Read part I here. Now, we explore some of the challenges and solutions of web3 game economies and future paths of this genre.

Web3 Gaming: Economy Challenges

Poor economy design and unsustainable incentives attracting the wrong users are the biggest contributors to the fall of early web3 games, such as Axie Infinity. Compared to web2 games, web3 game economies are easily impacted by outside factors (e.g., general market crash). Early web3 game economies were modeled after DeFi projects, which offered large incentives for participation. “Play-to-Earn” games attracted many income-seeking stakeholders who drove up the demand and price of tokens. Income-seeking participants (net extractor of money) typically outnumber fun-seeking players (net contributor of money). These projects were not designed with the right market levers and eventually (explained in the next section), the game economies reached a tipping point and user growth and prices crashed.

Below is a list of 5 (non-exhaustive) economic challenges web3 games face.

1. Inflation / Speculative Growth
2. Monetary Participation Gate
3. Capital Flight
4. Speculator Hogging
5. Liquidity Management

1. Inflation / Speculative Growth

Many web3 games are modeled after the most successful web3 game, Axie Infinity. Axie founders admitted to accidentally pioneering the play-to-earn model when players started trading its soft token, SLP, on decentralized exchanges. However, Axie Infinity was not set up for an open economy and viral growth. Specifically, its soft token, SLP, and Axie NFTs were designed with little demand/supply levers (no supply cap) and often reinforced each other’s growth. As players made money from farming and cashing out SLPs, more people wanted to join the game, either to breed and sell Axies, assets required to play the game, or farm SLP, input required to breed Axies. Demand for new Axies led to increased 1) breeding frequency, 2) cost of Axies and 3) SLP prices. Growth was a positive feedback loop and the increase in soft token and NFT prices attracted more players. In the beginning, capital investment from new users was enough to pay existing Axie breeders and SLP farmers. Once the new user growth stalled (because no one can afford Axies anymore), the economy crashed and SLP and Axie NFT prices sank by more than 75%.

Other web3 companies that modeled their game after Axie Infinity’s economy and breeding mechanism, such as Pegaxy and Thetan Arena, experienced rapid growth and hyper inflation as their token supplies outpaced the value generated from the game. The prices crashed when players could no longer afford the entry ticket. These economies were unsustainable because growth was derived entirely from revenue generated from new players (some compare this to a ponzi scheme).

Newer web3 games recognize the inflation and speculative growth issues and have employed some of the below mechanisms to manage supply growth of tokens and NFT.

• More Sinks (Ways to Spend): Increasing ways to spend money is one of the most effective and long-term solutions to reduce token supply. However, developers must release new gameplay and features alongside new ways of spending and cannot arbitrarily introduce currency sinks.
• Burning Mechanisms: Companies can burn their tokens and NFTs to reduce supply. Some companies are actively burning soft tokens to reduce supply. A new crypto game (“move-to-earn”), STEPN, announced it will repurchase $26 million worth of GTM soft tokens to burn, starting in April 2022. The burning has been effective in reducing short-term supply but does not solve the viralious supply generation problem, which comes from players wanting to max out earnings. In fact, it may perpetuate the perverse expectation that the company will continue to repurchase and stabilize token prices. Other games such as Crypto Raiders introduced an opt-in perma-death feature where NFTs can be rendered useless upon death for some events / dungeons. However, this is a slow supply lever because most players are wary of losing their NFTs and less likely to participate.
• Limit Return on Asset: Companies have also obfuscated the earning of ROI-generating assets to reduce farming behavior and value from leaving the economy. They are 1) time-gating asset production (e.g., once a day), 2) implementing marginal return on play (e.g., less earning for playing an additional hour) 3) making earning less “grindy” and predictable (e.g., complete a quest to maybe get rewards) and 4) making earning more social (compete in guild tournaments). In late 2021, Axie Infinity removed SLP earnings from daily quests to reduce supply generation after a period of hyperinflation. In Mini Royale: Nations, players cannot earn soft tokens from merely completing daily quests. Both mechanisms reduce the supply generation, making earning secondary to the gameplay experience. Axie faced a big backlash since the majority of its players joined to make money. Mini Royale: Nations has yet to launch its soft token, but players are well aware of the difficulty of earning soft tokens.
• Repair and Decay Mechanisms: Many games also include repair and decay mechanisms in their product roadmap. These features mimic real world asset production and can reduce the earning potential of assets and serve as a sink for governance and soft tokens.

2. Monetary Participation Gate

Many web3 games require NFT ownership (e.g., Access NFTs) to play. Access NFTs are used for 2 reasons: 1) provide initial capital for the team to develop the game and 2) pure copycat behavior of earlier web3 games such as Axie Infinity. Web3 gaming companies typically sell genesis NFTs at a modest cost (comparable to the box cost of a traditional game of $60). However, if the game becomes popular, the NFTs shoot up in value and become a barrier to entry for most players. It becomes more problematic when players, not game developers, control the supply growth of the Access NFTs, since players breed and sell the majority of the new Access NFTs. An average Axie cost $800 USD at its peak. Secondly, Access NFTs reward early adopters and the high return encourages risk taking. The crypto market is largely unregulated and many investors lost $2.8 billion from rugpulls (developers collect initial investment and disappear) and scams in 2021. Below are the 2 levers companies employ to reduce barriers to entry.

• Rental Model: Some games have created an NFT rental market or a scholarship model. NFT owners, typically guilds, can rent their assets to players (also colloquially known as scholars amongst Discord and Reddit communities), who can’t afford the NFTs, at a 70/30 revenue split of the soft token, with 30% going to the owner. This model was made popular by Axie Infinity. Sponsored by guilds such as Yield Guild Game, millions of Filipinos became full time Axie Infinity scholars in 2021 to make a living as the country suffered from economic depression. However, the scholarship model reinforces more speculative ownership because each asset investment guarantees a level of daily earnings (pending on price of soft token). It has also been compared to modern day indentured servitude where scholars “farm soft tokens” to enrich the owners.
• Free-to-play: More well funded (typically by VC) web3 gaming companies, such as Faraway and Horizon, are making their games free-to-play. However, these games suffer from the same challenges as traditional F2P gaming companies. The traditional F2P companies depend on 1% whale spenders to fund the game for the rest of 99% of non-payers. In a web3 F2P model, companies are also potentially acquiring long term non spenders that are not lucrative.
• Grant Players a “Free” NFT: Some web3 games such as Crabada gave limited Access NFTs for free to community members to jump-start the game. Rules around granting a free NFT would have to be carefully designed (i.e. non tradable, limited utility beyond early levels, potentially player friendliness issues on RNG etc.) but studios could get players started with a NFT to allow them to experience the game without paying upfront. This accomplishes something similar to free to play, but key differences being 1) includes onboarding to a crypto infrastructure (i.e. wallets) 2) the asset may be endearing within itself (similar to starter Pokemon) and 3) depending on the genre of game, a full pure free to play experience may be hard to design / delineate from the crypto component of the game.

3. Capital Flight

The transactability of tokens (and NFTs to a lesser extent) also invites capital flight risk, like that experienced by traditional capital markets and nation-states. As token prices increase, success can be a double-edged sword. The stronger the currency, the higher the purchasing power of foreign goods, and the higher the likelihood of capital outflow. Furthermore, since most games do not have robust game economies (web3 games are all in early development with little gameplay and economy), there is little in-game utility and ways to spend. As a result, once there is a risk of market crash, players cash out. Below are some levers that companies and exchanges employ to combat capital flight risk:

• Staking Incentive: Companies incentivize token owners to stake (commit to non-withdrawal) the companies’ soft and governance tokens for a period of time, ranging from 1 to 12 months. As a reward, web3 companies pay an ultrahigh APY (e.g., 50 to 200%). The longer the stake period and the earlier the backing, the higher the incentive. However, monetary incentives attract income-seeking players and can become a disincentive once removed. Yield farming, where players bring their capital from game to game to generate the best return, is prevalent in web3 games and decentralized finance projects. In reality, staking incentives only secure capital for as long as the companies can offer an attractive return. Secondly, staking also disincentivizes engagement, since locking the tokens up means not spending them in-game.
• Store of Value in Less Liquid Assets: Games could incentivize players to store their wealth in more illiquid assets to prevent capital flight. These assets would be unique (non fungible), rare and increase in value as the game gets better. There could be many types of such assets, such as rare loots or awards. The asset should provide either emotional or functional utility for players.
• Capital Flight Control Policies: While players can and should be free to move their capital, companies can introduce friction to reduce capital outflow. Such policies must not be egregious to upset players, but serve as a deterrence to pump and dump behavior. Companies can limit the number of tokens in the system to restrict value transfer. Game inventory such as health potions, material and herbs must be converted into a currency before being transferred out of the system. Companies can also institute a minimum threshold for conversion to guarantee that there will always be value locked in the system.

4. Speculator Hogging

FOMO (fear of missing out) and the promise of high returns have attracted a lot of investors who buy and hold assets to speculate or rent. In 2021, the web3 metaverse platform Sandbox sold $35 million USD worth of digital land. Today 19,000 users own land in the Sandbox, but there are fewer than 50 experiences on the platform for 350,000 users. Due to the high entry price (land floor price at 1.8Eth), many players are prevented from owning land. Some may argue that the barrier to entry is a filter for those who are serious about developing experiences on Sandbox. However, majority of the Sandbox land owners are speculators without development experience (including Snoop Dogg and HSBC), who for the fear of missing out, are investing in the digital real estate boom. There are several levers to combat this challenge

• More Supply: Some players have urged companies to create more supply to deflate the cost so newer players can buy into the asset. However, this will dilute the value of existing supply and likely anger existing land holders.
• Land Value Tax: Web3 gaming analysts have suggested imposing a Land Value Tax on digital land, inspired by the Georgism principle that’s applied to real scarce land. A high land value tax forces the owner to either sell or be productive with the land. Forcing speculators to bring land to market and driving out bids from speculators who have no interest in actually using the land themselves both drive down the price of land. As the value goes down, so will the amount taken in land value tax. But if speculators try to bid up the price of land again, the tax rises proportionately, automatically deflating the bubble. The LVT ultimately discourages non-usage and investor-players from participating in the game.

5. Liquidity Management

Game tokens need sufficient liquidity to trade. Bootstrapping liquidity is the classic chicken and egg problem. Market makers need demand from users to offer liquidity. Users need market makers to provide liquidity. To bootstrap liquidity, game companies often incentivize participation with high return. Below are two ways they bootstrap liquidity

• Rent Liquidity: Some web3 games rent the initial liquidity from players by offering a high return. Typically, the fee is paid in the game’s governance token, which has limited supply. The return is highest in the beginning to incentivize early adopters. Liquidity providers can earn fees from 1) incentives from the game developers and 2) the decentralized exchange for providing market making service. When both fees dry up, either because 1) there is enough liquidity or 2) there is low trading volume, the liquidity providers will move their capital to a new opportunity to maximize yield. This behavior is called yield farming. Games must offer good returns to maintain liquidity. Renting liquidity is extremely expensive and does not provide for a permanent solution. Companies allocate 0–30% of the total governance token supply to pay liquidity providers.
• Buy Liquidity: To combat yield farming, some web3 companies such as Crypto Raiders have employed protocol-owned liquidity. This mechanism is pioneered by defi protocol, OlympusDAO, in which a company buys liquidity from providers. The company could bootstrap liquidity in a similar manner (offering high APY), but purchase liquidity pairs at a premium to reduce capital flight risk. This is a relatively new phenomenon and has not been tested by time or many web3 gaming companies.

Web 3 economic decisions are impactful and often hard to reverse. Some of the aforementioned solutions, such as high staking incentives, are clearly bandaids, not antidotes. As a result, new games economies are improving at microscopic speed. Fortunately, there are a lot of smart people working on and writing about web3 game economies.

Beyond the Minutia: What’s Next?

The web3 gaming industry is in its infancy and new companies emerge daily to try their luck in becoming the next Axie Infinity. Our research suggests there are many challenges to be overcome. We are cautiously optimistic about the future of the web3 games and believe that a sustainable web3 game must be fun-first and earn-second. This will require a deep integration of traditional game development and crypto/defi expertise. Below are five theories for the future of web3 games:

Theory 1: Blockchain gaming is a more liquid form of eSports for everyone

For the token economies that seem and have been sustainable in the space so far, player’s aren’t making a lot from playing the game itself. For example, Gods Unchained, launched in July 2018, has one of the best gameplay experiences but offers very little earning for players. Alexandra earned $2 USD from a $240 USD total investment.

The Future: Play and Earn will become a standard economics feature of free to play games but NOT the primary focus of an economy (similar to Battle Pass). It’s a way to put earning potential into the hands of the masses who are not professional level skilled but moderately skilled

Theory 2: Governance tokens may not always exist (or be necessary) in future web3 games

Many of the perverse incentives stem from the governance token (i.e. Mercenary behavior, speculator hogging, speculator sell off). Governance tokens also come with an onslaught of regulator risk and costs to maintain (i.e. treasury) for the studio.

The Future: Governance tokens may not be issued in Play and Earn games and community voting rights and benefits will be granted through holding specific NFTs or quantities of NFTs. However, there are risks associated with not releasing a governance token such as crowding out a lucrative retail investor that doesn’t truly want to play the game (and you might need some of them), inability to easily raise funding prior to game launch, and dealing with illiquidity on NFTs. More on token design from Nat Eliason.

Theory 3: The more “idle” the gaming genre, the more on chain the game will be

Every on-chain transaction requires a wallet approval, (A) withdrawing the player out of the gaming experience and (B) drastically slowing down the speed of gameplay.

The Future: Idle games (auto-battlers, time resource farmers) with elaborate economies will have many transactions taking place on chain (the game is the economy) vs. genres requiring mechanics and skill (TCG, MMO) will remain more off chain

Theory 4: There will be a target investor to player ratio of X / Y

Crypto games have too many investors eager to turn profit and not enough players, throwing the economy out of balance.

The Future: As the space evolves, web3 games will find the Goldilock ratio of investors and players, similar to F2P finding the ideal ratio between whales and non spenders

Theory 5: There is room in crypto gaming for the “hardcore economy games”

There have been vocal lamentations from the traditional community that creating games mimicking real world economies are not fun and defy the escapism games were meant to create. This has been tested in games like Ultima Online, experiences that simulated real world dangers, supply limitations, uneven economic conditions (i.e. economic disparity between the rich and poor) and did not meet large-scale success.

The Future: We agree that this “type of crypto game” may not be the one adopted by the masses, and may not be the game that propels adoption forward. However, just as studios like From Software serve a “hardcore segment” of the hack and slash gaming market, we think games with elaborate and hyper nation state like economies will serve the “hardcore segment” of the crypto gaming market for whom the economy game is the fun itself.