The thesis below was written by Arthur Cheong, Bailey Tan, and David Koh of Defiance Capital.
The Current Landscape of Web3 Games
Video Games have evolved tremendously ever since the first labels were shipped to the open market in the 1970s. From the release of pay-to-play single-class titles for the console and PC to freemium mobile games in the last decade, the gaming experience and business models have transformed in line with technological advances. Today, the gaming market is worth over $300B (according to both Accenture and BitKraft) with an expectation of a 12% annual growth rate from 2022 to 2028.
Our thesis is that the integration of Web3 elements into gaming will likely usher in a new era of gaming dubbed “Play-to-Own”. We posit that unlocking the economic activity within games will drastically expand the Total Addressable Market (“TAM”) for the gaming industry as well as supercharge value creation.
In 2021, we caught a glimpse of the potential of Web3 Gaming via Axie Infinity’s rise to fame. Popularizing the Play-to-Earn (P2E) model most of us are familiar with, Axie has grown from 10k DAUs in early 2021 to a peak of 3 million DAUs and brought in $1.3B revenue in 2021 according to Nansen. What’s more surprising is that Axie was still in its infancy; the simple battle game was just a Beta version.
Axie’s parabolic growth signaled to the gaming industry the untapped potential of Web3 Gaming, inspiring a great influx of gaming talent into crypto. Stock prices of publicly-listed gaming studios have even re-rated upwards due to Web3 pivots and token launches.
Games that integrated NFTs have experienced much greater success in terms of player retention, growth, and revenues compared to their Web2 counterparts. We are already beginning to see a myriad of projects launching with innovative Play-and-Earn mechanics embedded within their gameplay. Apart from gaming studios, an entire ecosystem has also quickly spawned around Play-to-Earn like gaming guilds, DAOs, tooling for these guilds, game discovery platforms, custody, trading infrastructure, and analytics.
The pitfalls of the current P2E model are well recognized, namely the challenges with managing an inflationary economy and attracting value extractors rather than real players. Most leading entrepreneurs in the Web3 gaming space are moving beyond this model to make it more sustainable. We expect rapid experimentation in the coming months and it is our firm belief that the next generation of successful Web 3 games will not require the P2E model to be successful.
To predict the future of Web3 games, we can look back into the history of business models in gaming for insights and the cumulative changes that brought us to this inflection point.
Paradigm Shifts in Business Model — Pay-to-Play, Free-to-Play, Play-to-Earn, Play-to-Own
Looking back at the last 50 years of gaming, one can see multiple distinctive periods where business model innovation occurred alongside technological advancements.
The very first commercially successful video game business model was the Pay-to-Play model that was popularized by the arcade game Pong — gamers inserted coins into arcade machines and played for a set amount of time or until they failed in-game levels. Arcade games tended to be simple but fun games that had competitive elements in the form of high scores that kept players coming back to play again and again.
Later on, Pay-to-Play boxed retail games such as Diablo also took off alongside the rise in the adoption of personal home computers and console gaming and allowed gamers to play from the comforts of their home. The drawback of Pay-to-play boxed retail games was that the revenue opportunity is once-off in nature — the only way for game developers to capitalize on this was to launch multiple series in cycles that typically took a few years.
The advancement of digital distribution technology that allowed live-service games alongside the desire of game developers to earn recurring revenue gave rise to the subscription-based Pay-to-Play model. In this model, gamers pay a fixed monthly fee to gain access to game content that is updated and enhanced regularly. Many successful games have utilized this model, including the venerable World of Warcraft which at its peak had more than 11.5 million monthly paying subscribers.
With the rise of mobile apps and the subsequent increase in preference for casual games, the Free-to-Play/Freemium model became popularized. In this model, the game’s basic gameplay is completely free, however, game publishers monetize via microtransactions. Examples of such microtransaction include Season passes and Loot boxes/Gacha which enables the players to get cosmetic items or other benefits that allow them to be more competitive vs other players either via faster leveling/stronger weapons.
The benefits of the freemium model were clear in that it allowed users to easily start playing the game and provided a recurring revenue stream for the game developers. However as time went on, developers pushed harder and harder on the monetization aspects and it disappointed gamers as they felt the increasingly strong “cash grab” behavior from developers and felt that gameplay loops were increasingly affected by “Pay-to-Win” players who could pay to achieve in-game success.
A common thread across these business model evolutions was that game developers increasingly leaned towards extracting more lifetime value from players while committing the minimum effort and cost.
The objective function has shifted towards profit at the cost of fairness: from products designed to deliver fun experiences to hyper-optimized businesses designed to make the player spend as much money as possible. This has been enabled via the increased granularity of data harvested to understand player behaviors and how to monetize users through predatory schemes.
In many cases, items that players grinded for are inflated away or nerfed unfairly in favor of new items sold through primary sales with revenues going to the developer. The concept of true ownership of in-game assets does not exist as players find their efforts are worth nothing of value once they decide to stop playing the game.
At the same time, a fundamental issue of incentive misalignment was present. Decision-making of an entire game ecosystem was made by developers who may not take into consideration the views of the community. There is rarely any intention or ways to compensate players and creators who contributed to the success of the games through their efforts.
Play-to-Earn — Incentivizing gameplay with financial value
Utilizing blockchain technology, token incentives for activity and true ownership of gaming assets via NFTs were introduced into games to give rise to the Play-to-Earn business model. P2E players are able to convert their time spent in a game into tokens and NFTs which can then be converted to cash to be used in the real world. Typically in such games, the “Earn” component of the game is heavily emphasized to attract players to play for rewards, hoping that a portion will be converted into paying players.
In Axie Infinity, players at one point were able to earn more than USD $200 per day if they were in a high MMR bracket. In developing countries such as the Philippines, this amount can be much higher than the minimum daily wage of ~USD$10. However, it is unwise to rely on games as jobs as token prices experience large fluctuations and are unable to sustain prices if supply exceeds demand. A nascent game economy with limited depth of content will not be able to support a player base that is predominantly value-extracting.
In the open economies of Play-to-Earn games, the health of the economy becomes paramount and there is an ever-pressing need to ensure that token faucets and sinks are balanced such that the value of the core currency and items are stable. Limiting the amount of speculation in a nascent economy is also important to limit the degradation of user experience due to volatility.
Following Axie’s footsteps, we have seen some P2E games try to emulate their success. Most have struggled with overly high inflation of their in-game currency due to poor economic design and management — a high percentage of players cashing out causes a death spiral where as token prices drop, earnings of players drop, and they stop playing the game because their main reason for playing is to earn financial yield.
Play-to-Own — The Future of Web 3 Gaming
From Axie Infinity, we learned that in the initial bootstrapping phase of the game economy, early believers and participants who are mainly driven by financial return take on the risk to acquire assets and work to mine resources to sell them to later entrants.
However, as incentives cannot subsidize growth forever, game developers will have to find ways to convert yield seekers into consumers in a sustainable game economy.
While this can be done in the short term through adjusting faucets and introducing new token sinks, organic spending can only be sustained via a constant stream of novel fun content and experiences that players would want to pay for without any expectation of financial return. Building immersive worlds and characters that are loved by the community is the most sustainable way to grow a game.
We believe that Play-to-Own will be the next evolution in gaming business models. Games are not jobs and should not emphasize the ability to earn money from playing. This terminology reflects the need to align both players and owners of a game as well as an understanding of NFT technology, which are all about improved ownership.
We define Play-to-Own as:
“A blockchain-enabled game developed with the ethos of Web3 — which is incentive alignment and true stakeholder ownership. Players are rewarded for their play and contributions with ownership of the game in the form of tokens or in-game assets.”
Unlike pure P2E, Play-to-Own will focus on fun gameplay, and a sustainable economy and foster a strong sense of ownership of in-game assets and IP — rather than a transient earning mentality among gamers. We believe this model will allow games to reap the real benefits of blockchains such as unlocking value from in-game assets, better price discovery, and building a strong sense of community ownership.
The term implies an active effort to actually play games in the way they are intended to be experienced in order to be rewarded with ownership of valuable assets rather than mindless click-farming that is ingrained in typical poorly designed play-to-earn games.
Furthermore, we believe that Play-to-Own games will have very low barriers for new players to start playing and will give out sustainable amounts of rewards as a user acquisition strategy.
For example, the game could be Free-to-Play at the start, allowing players to earn small rewards which are reinvested back into the game to acquire valuable game assets. Alternatively, users may be able to easily rent NFT assets from marketplaces via profit-sharing agreements and compete at a high level without spending a fortune upfront.
Nansen has a great visual explainer for stakeholder mapping in Web3 games:
Ultimately, we see Play-to-Own as a positive sum game — a simplified mental model:
We predict that player spending will be an order of magnitude greater than revenues seen in Web2 games and Web3 games transition to Gross Merchandise Value (GMV) as a metric to measure all transactions within the virtual economy.
Crucially, there will be net value creation (+$10 in this example from $10 to $20) to the ecosystem that is shared between developers and the community. With sound economy management and deep gameplay content, Play-to-Own will be much more sustainable compared to Play-to-Earn, generating revenues for developers and community over a much longer period of time.
Push & Pull Factors accelerating the Play-to-Own movement
Approaching this paradigm shift from first principles, we believe that the acceleration into Play-to-Own is supported by a combination of incentive misalignment in the current business models and the value propositions that Web3 provides:
Misalignment of Incentives in Web2 Games (Push Factor)
Push #1: Gamers will always seek to monetize their time spent on games and the ability to flex online wherever possible
Empirically, we know that it is natural for gamers to seek out ways to monetize time spent in games and to showcase the best game cosmetics.
In-game trading houses like the Grand Exchange in Runescape have taught a generation of players the economic aspects of games. Gold farming & account-boosting operations are also common in popular MMOs or MOBAs. Players have internal mental models for what is valuable within games (this can range from rare loot and hidden content to entire accounts), and trading these valuable items for money is always thought when quitting a game.
The restrictive economies of current games will push more players who understand the value of virtual items into Web3 games where the tokenization of in-game resources and assets reduces friction in exchanging value, therefore unlocking more economic activity.
These digital natives also increasingly favor digital flexes as time spent online increases; however, it is difficult to justify large amounts of spending in the game as the flow of value into the game is one-directional.
With NFTs that can be resold, the flow of value can be bi-directional. The shift in mindsets of gamers from pure consumption to asset ownership should increase the TAM of games significantly as players can psychologically justify spending when asset values can both grow and be sold to recover some residual value.
A huge barrier to the usage of decentralized applications has always been the apprehension when it comes to the self-custody of funds and sending on-chain transactions via wallets like Metamask. However, we believe this is less of an issue for gamers who are accustomed to managing game accounts with high-valued items and in-game currency.
Push #2: Disappointment with game developers due to incentive misalignment between developers and players.
Most games now are products of ROI-driven investments instead of fun and playability-focused. The objective of game companies is to extract the maximum amount of money while spending the least resources on players. Investor pressure, costly overheads & strict timelines to deliver can also result in the sale of unfinished products to players.
There have been numerous cases in recent years where the player’s trust was betrayed due to the failure to deliver a satisfactory gameplay experience after successive hyped trailers and teasers.
The list goes on: expensive paywalled content, unfair game patches that nerf items that players have painstakingly earned in favor of new drops, prohibitive microtransactions, intrusive advertisements, low-quality battle passes, lack of support for past season’s cosmetics when they break in-game…
As cash grabs become more blatant and promises broken, the player community feels increasingly disrespected and jaded with game studios.
Push #3: Game developers & publishers can and have abused UGC creators for their own bottom line without consulting the community.
Currently, user-generated content (UGC) creators pay high take rates for their work and in certain instances, may not be compensated at all. Game publishers can easily change the rules and royalty payouts as seen in Steam’s case.
An interesting example to study is Defense of the Ancients (popularly known as DOTA) which was a UGC game mode of Blizzard’s Warcraft 3 and had driven a huge influx of people to the game. It is still unclear how much the creators of the mod were able to monetize from this success. Eventually, the active developers of the mod moved on to work at Valve for DOTA2.
In a Web3 game, royalties enforced via smart contracts give professional UGC creators confidence to build their business on top of the game. This results in higher-quality work delivered to the community and a top-quality UGC market.
In addition, a significantly larger percentage of creators can make a living and benefit from their creative talents when token incentives are used to supercharge UGC efforts. At the same time, this unlocks the limits on the speed of content generation within the game. Any changes to the royalty splits can be put up for votes by stakeholders and a more healthy discourse can ensue.
Value Proposition of Web3 Games (Pull Factor)
Pull #1: Deeper liquidity of the secondary market leading to greater trading volumes and revenues
The open and trustless economy built on the blockchain enables a vibrant secondary market for game assets. Prices of items are set by market forces and natural demand & supply, barring interventions by game developers.
Game developers can have an alternative monetization strategy that is based on transaction fees and secondary market trading royalties enabled by smart contracts. Assets can be liquidated freely and players can recover some financial value derived from the time, effort, and money they have invested into the game.
We believe that this will lead to a significant increase in the TAM of the gaming industry in the long run.
Pull #2: Web3 games align incentives between players, investors, and developers. As a result, there is strong player empowerment and community stewardship as everyone is invested in the success of the game.
Currently, a game’s community does not have a direct way to grow alongside the success of the games and share any form of financial upside.
Players typically have no say in the game development direction as most games are playtested behind closed doors. Game revenues are also never shared with players and early believers even though they are a huge reason for the success of games.
NFTs and token-powered games offer a solution where the players can have financial exposure to the game tokens early on as well as after the games have launched.
In the early development phase, game devs can identify and involve some of these passionate holders in the game-building process. These early believers who have sufficient reputation or skin in the game can also be polled for their views on how the game should evolve.
As the game launches, governance tokens allow community participation in governance and stewardship of the game. Open channels of communication build trust and understanding, driving deeper engagement as players have a way to make their voices heard by developers.
Pull #3: New forms of user acquisition due to interoperability of assets, play history, and usage of tokens
Permissionless and open environments allow game developers to integrate 3rd party NFT assets (or even assets from other games) by creating special custom cosmetics to be used in their own game. Developers can look for the communities that look the most fervent or best fit their targeted personas to market their games.
As tools to determine legitimate wallet activity matures, a player’s on-chain history or metaverse profile can be accessed and targeted by other games for user acquisition and airdrops. This creates win-win situations where game developers have a new form of user acquisition while strengthening the IP, utility, and network effect across integrated NFT assets.
Ownership of tokens and NFTs help in organic marketing as the community becomes effective evangelists of the game with minimum spending of marketing budget.
Pull #4: The fundraising capability of game studios improves with the usage of Web 3
The earlier liquidity provided through token investments rather than equity has helped blockchain gaming projects raise funds from institutional investors due to less perceived risk of exit. According to a report from Dappradar and BGA, a total of $4B was raised in 2021 for the blockchain gaming sector specifically. In comparison, the total funding for traditional gaming startups was $4.7B in 2020.
The sale of future in-game assets as NFTs can help to raise substantial amounts of money that financially de-risks gaming projects so development efforts will be less constricted by tight budgets. The ability to resell on secondary markets freely makes it an easier purchase to make.
Other than pure speculation of assets, we see that players are willing to contribute funds to make their wishes a reality. As the market matures, players will choose to fund mostly the projects that show accountability on development progress and traction on community building.
What should a Successful Web3 Game look like?
To fully embrace the benefits of building in Web3, we think that developers should be executing on the following core elements:
#1 Intricate world-building and growing the Intellectual Property (IP)
Simply put, when there are a ton of activities to do within the world, players spend more time inside which has a direct correlation with money spent on the game.
Designing the game universe to be composable with a wide range of ideas enables a hotbed of UGC as the community steps in to create stories and characters. A strong emotional attachment to the game and IP is formed when the community is involved in world-building. Having a transmedia content strategy to reach the audience via a variety of mediums will be crucial for this objective.
Separately, developers should socially coordinate around common technical standards and actively champion their adoption to improve asset portability in various virtual game worlds. As more 3rd party titles and content creators integrate the original NFT assets, the value of IP increases with the growth in attention and awareness.
#2 Immersive social and MMO experience
A high degree of customization, identity-building, and social interactivity should be emphasized. As more attention is paid to in-game avatars and property, the impetus to spend and showcase gets stronger. This encourages consumption in the virtual economy.
A rewarding multiplayer experience in both PvE and PvP increases the interactivity and social elements of the game. Prestige in climbing the leaderboards and guild-vs-guild wars also cater to the competitive nature of players, encouraging spending to stay at the top.
Meeting the player’s psychological needs and bringing them into the “magic circle” is where games will find success in making the player forget about the open economy where assets are financialised.
#3 Deep economic metagames
Skill and effort should be rewarded more than passive gameplay or pure spending as these players are likely higher-value customers who will reinvest back into the economy. A steady cadence of content patches and live ops campaigns is needed to encourage a vibrant secondary trading market for materials and valuable items, boosting the game’s royalty revenues.
Token inflation is a tool for user acquisition and retention in the bootstrapping phase of the economy. Developers will need to monitor key economic metrics to adjust sinks and faucets, and actively manage the health of the economy over time. The goal is to strive for stability in the underlying token-based currencies by keeping inflation in line with the growth of the player base. In-game businesses and operations can only be set up when there is confidence in the long-term stability of the economy.
The open economy can be a double edge sword if speculation is not limited in the early stages. Economy designers should devise ways to protect the nascent economy from extreme volatility and misuse of assets. This can come in the form of direct and indirect taxes on trade and asset possession.
Overall, the goals for the game and the player need to be aligned — the game’s success and earnings should be predicated on the players deriving value from both entertainment and financial returns.
#4 Gradual democratization of the game
To prolong game lifecycles, decisions should be collectively made by developers with input from invested and reputable stakeholders from the community. A well-governed community-owned game should increase engagement and retention as the community’s views are represented.
It is also important to plan ahead for scenarios where a game’s economy is so huge that nation-state actors may engage in censorship. A decentralized technology stack will be essential in ensuring the longevity of the game while maintaining an uncensorable nature. This may apply to more mature games.
Open-sourcing game codes may be crucial as well to ensure the community has the ability to fork the game, preserving the continuity of the virtual economy if developers are deemed to be poor stewards of the game. We envision that there may be different teams of developers hired to create content and maintain live operations for the game, and players may vote at the end of each season whether they are competent in growing the game & retaining players.
Our Evaluation Framework
The success of a Game is a function of Product, Distribution, and Economic Balance, driven by a competent Team. A snippet of our evaluation process:
#1 Team pedigree. We love to see a good mix of game development and crypto-native talent with a strong vision for the game.
Shipping a game successfully requires the ability to attract and retain talent, allocate resources efficiently, and orchestrate efforts across functional teams such as art, music, and tech (often times 100+ people). With such complexity, it is unsurprising to see games being delayed for long periods of time and failing to launch.
In addition, knowing the distribution channels (publishers and marketing partners) and methods to build hype are key to a successful launch. Even after launch, it is crucial to maintain cadence for live services — to generate new content, and gameplay patches for the players to lengthen the game lifecycle.
For Web3 games, crypto-native experience comes into play as business models are different. Teams should possess deep knowledge on how to launch and drive value accrual to tokens & NFTs; manage treasuries and incentive programs; mechanisms offered by smart contracts (e.g staking) that a web3 game can take advantage of to kickstart flywheels and supercharge growth. Community building should be second nature — maintaining clear communication and accountability to build trust and a passionate community of players, contributors, and owners of the game.
Essentially, the Team creates the base layer for the ecosystem to thrive and are stewards of the grand vision. Having experienced people that have actually shipped games while possessing a genuine passion for Web3 will be critical to success.
#2 Product and Distribution. A fun game that can reach a wide audience that is willing to spend.
One question we love to ask ourselves is whether we can envision ourselves spending time and money on the concept if there was no potential return?
The game should be tested and iterated upon until there is sufficient confidence in the game loops before the official launch. An open iterative approach to game-building with the community helps in this regard. Differentiated game loops should be designed to accommodate diverse groups of stakeholders who each optimize for their own definitions of winning.
- Free-to-Play players who are casually spending time and effort for enjoyment
- Hardcore players that raid the most difficult dungeons and compete for Player-versus-Player and Guild-versus-Guild leaderboard positions
- Creatives that help design and build in-game areas and experiences
- Merchants and traders that speculate on economic resources and the metagame
A good understanding of the target player base and how to acquire them via the most effective distribution channels is essential. Marketing partners, launch campaigns & community-building efforts need to be planned out in advance to ensure a successful launch.
To improve the onboarding process and retention of play or mobile applications to enable higher conversion rates.rs, developers also need to abstract away the blockchain experience where necessary. Tokens and game assets will need to be easily accessible to players within game clients
#3 Economic sustainability: managing inflation and dampening volatility in the economy
We think that the health of the economy is crucial to the longevity of the game. As the blockchain unlocks the virtual in-game economy, it is imperative to model out faucets and sinks in the game and build in the macro levers that can be adjusted to balance token inflation against player growth.
Controlling and converting speculators and value extractors of the economy into consumers will be an important endeavor. In the long term, having good content that intrinsically motivates people to spend is the only way to build effective sinks that reduce the impact of inflationary rewards.
Major changes in game loops and the economy should be delicately balanced and communicated with input from community stakeholders. Developers should strive for a sound token design that ensures all fungible and non-fungible tokens within the ecosystem have clear utility and value accrual.
Thesis: The Best Games will form the Metaverse
We believe that the underlying blockchain technology is technically ready for what games require to target mainstream audiences. What needs to be innovated upon now is the user experience problem (asset custody, gas payments, bridging requirements, etc). Developers should try to educate the difference between on-chain and off-chain assets, and abstract away the complexities while slowly introducing the on-chain elements for more advanced users.
The most obvious genres that are best suited to leverage Web3 elements are MMORPGs (Massively Multiplayer Online Roleplaying Games) like World of Warcraft and 4X (Explore, Expand, Exploit, and Exterminate) strategy games like Clash of Clans due to the deep economic & social gameplay loops. Usage of blockchain technology will also result in 0 to 1 innovation in game design and create new genres due to the possibility of storing of assets and game logic on-chain.
Researching the current design space in gaming, we are excited about both “Top-Down” and “Bottom-Up” approaches to building a Web3 game — cognizant of the different sets of challenges encountered by each. Below is a table of the stereotypical profile of the two approaches:
Following our thesis, we invest across games and ancillary infrastructures like guilds and game discovery platforms. We avoid teams building casual games that have short life cycles and “GameFi”, which we define as zero-sum games with the only objective being to achieve the greatest financial return — they are essentially a gamified frontend over the same tired ponzi yield farming mechanisms.
Our approach is to actively support long-term-oriented projects which are delivering fun content and experiences with a focus on a sustainable game economy — executing across all value propositions of being a Web3 game. The most successful ones eventually form a core part of the Metaverse where the game holds immense influence on the digital realities of a huge player base.
The Bull Case
From the level of talent, we see coming into the space, we are reasonably confident that the next generation-defining franchises will be built on Web3 — flipping around the prevailing negative sentiment on Play-to-Own games that utilize NFTs.
We believe that having games built on open peer-to-peer networks will unlock greater economic value and drastically expand the Total Addressable Market (“TAM”) for the Gaming industry — with expectations of a trillion dollars in economic output to surface within the next 10 years.
We eagerly invest to bring forth such a future where real value flows to and from virtual worlds where experiences are as real as the physical world and DeFi emerges as the financial tools to serve these on-chain economies.
If you are building something that resonates with what we have written, we’d be keen to learn more!
This thesis belongs to and was written by Arthur @Arthur0x, Bailey @bottomd0g, and David David Koh and originally was published on the blog of DeFiance Capital, a Leading Web 3 & Crypto Investment Firm.
We discovered this article while doing our research and decided to share it with the Kayros community.
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