Increasingly, we’re hearing from clients excited about the possibilities of Web3, who are looking at how they can embrace decentralised finance (DeFi) or purchase a virtual presence in The Sandbox, a decentralised community-driven platform where creators can monetize assets and gaming experiences.
What’s interesting is that many of the same organisations are often also stating that they “are not doing crypto”. But can the two really be separated?
In this blog, we look to explain these terms in more detail and explore the interconnected relationship between web3, blockchain and crypto by discussing the story so far.
Where it all began (or close enough)
We need to go back to the 31st October 2008 which, coincidentally, is the day that the last ever batch of blank VHS cassettes rolled off the production line.
It was also the day that a whitepaper was published under the pseudonym of Satoshi Nakamoto. The paper was “Bitcoin: A peer-to-peer electronic cash system”. In this paper, Satoshi outlined the mechanism that would allow a fully distributed network to create and validate a ledger of transactions. Essentially it was a system whereby, through mathematics and computer science, a ledger of transactions could be recorded and everybody who had access to the ledger would be able to have total faith in the accuracy of it. This was the birth of blockchain.
Blockchains are a divergence from the traditional method of controlling trust in ledgers which required a central institution (or institutions) that we intrinsically trusted. The trust in the institution is transferred to trust in the ledger.
The vast majority of money exists only as entries in ledgers. We have trust in the ledger because we (to varying degrees) trust the banks and governments that control the ledgers. Blockchains do not need a trusted institution, control of the ledger is distributed amongst the participants on the blockchain network.
Bitcoin became reality on January 9th 2009 but remained largely unknown and worthless until July 2010, when the price “jumped” to $0.08. This was followed by a slow and choppy price journey from highs of $1,164 back down to $245 by October 2015. January 2016 was the start of the sustained price rise in Bitcoin and the price rise continued to accelerate. In 2017 Bitcoin became a mainstream investment and rose to $18,940 by December 2017 before crashing back to $3,190 in 2018. Covid saw a resurgence in the price up to a high of $68,649 in 2021.
However, the volatility in the value of Bitcoin has made it difficult to use as a currency (why would you spend something for $100 when 12 months later it might be worth $1000). It has been used for short term trading gain and as a mechanism for transacting anonymously, often for nefarious purposes.
Nowadays Bitcoin is gradually being accepted as a form of payment around the world and El Salvador has made it legal tender in a bid to reduce the transaction costs of citizens sending money home from abroad. It is also an increasingly popular long term investment option for investors who are not concerned about medium-term volatility.
Whilst Bitcoin will always be an important piece of crypto-history it was only the start, and actually not a very exciting start. Flaws in the design of the Bitcoin network as well as the reasons outlined above have meant that it has been of limited use. However, what Bitcoin demonstrates is that a distributed ledger, which can be trusted in a trustless world, can work using blockchain technology. We no longer needed a trusted central institution to validate transactions.
Several public blockchains followed the launch of Bitcoin and we started to see an interesting phenomenon where blockchains were being launched with the intention of solving particular issues in a decentralised way. For example, Namecoin was created in 2011 to provide an alternative to the ICANN controlled internet domain in an effort to evade censorship.
It is important to note that for a public blockchain to function, distributed nodes need to carry out work. That work can include recording transactions or verifying the transactions of others. This work requires computing power and hardware (which costs) and so a public blockchain must have an incentive scheme to encourage users to be involved.
It is for this reason that each public blockchain has its own cryptocurrency which it uses to pay rewards to those doing work on the chain. You cannot have public blockchains without cryptocurrencies.
In 2015 the Ethereum blockchain was launched which supports Turing-complete smart contracts.
A contract is an agreement between two parties that creates mutual obligations. A smart contract is executed automatically based on certain conditions being met. On a blockchain, all parties can be immediately certain of the outcome and there is no need for an intermediary to be involved. Turing-complete essentially means that the programming language used to create the smart contracts is complex enough to describe any set of circumstances and conditions.
Whilst Bitcoin did support smart contracts, Ethereum was specifically designed to become a smart contract platform and was the first of several similar blockchains now in existence such as Solana and Polygon.
Smart contracts can be combined and layered on top of each other to build applications to meet user needs. These applications follow the same principles as the distributed ledger. No one party has control over the application and the rules of how it works are recorded on the blockchain as computer code.
Many, but not all, of these applications are related to finance. This area of innovation is known as DeFi – Decentralised Finance (as opposed to TradFi – Traditional Finance).
The easiest way to understand the use case is by way of an example. Take Kickstarter: it is a platform for product teams to raise funding to build prototypes and products. A product team set a fundraising target. Investors pledge funds against the target that are held in trust by the platform. If the target is met then the funds are released to the product team, if the target is not met then the funds are returned to the investors.
All of the transactions that currently take place with Kickstarter as the trusted third party could be automated and written into smart contracts. A set of these smart contracts would then make up the application and there would be no need for a third party.
An investor would pledge an amount of ETH (the currency of the Ethereum blockchain) against a target. That money would be held by a smart contract for a defined period of time. If the target is met, all funds held against the target would be automatically sent to the product team. Otherwise, they would be automatically returned to the investors. The costs of verifying the transactions and executing the smart contracts (i.e. the payments to those who do that work on the blockchain) would come from the investor funds and also be paid automatically.
Why is this desirable? In many cases, it may not be. If we believe that Kickstarter is a good actor who runs an efficient business, with the advantage that they can return funds without charge because they subsidise their costs from successful funding rounds, and that everyone is happy with them taking a margin from investment funds to do so, then there is no pressure to move to a DeFi application.
In other cases though, there may be stronger motives. As an example, Funding Circle is a peer-to-peer lending platform. They act as the trusted third party and broker lending between investors and businesses (mainly SMEs). As an investor, you can recover funds either as borrowers make loan repayments or through a secondary market where you can sell your loan parts to other investors.
At the start of the pandemic, Funding Circle unilaterally changed the rules for investors by closing off the secondary market. This made a relatively liquid asset much more illiquid overnight. They have since announced that this change will be permanent as they are closing their service to retail investors. This would not be possible in a DeFi application. The rules would be written in code and change would only be possible through the participants’ consensus.
One of the most exciting things about DeFi is the speed of evolution. Traditional finance (TradFi) moves slowly. Sometimes excruciatingly so. DeFi and blockchain technology can evolve at speed to optimise and solve issues or develop new features to support more applications providing a wider range of services.
Outside of decentralised finance, apps include games, social media sites and marketplaces… the expansion of decentralised applications beyond finance has given prominence to the term web3.
The original world wide web was a platform for the dissemination of information. This is now known as Web 1. It was followed by the rise of social media and user-sourced content (e.g. Facebook, YouTube) which is known as Web 2.0.
Web 3.0 is a term popularised by Gavin Wood, the co-founder of Ethereum. It refers to the idea that blockchain technology will power a new era of decentralised applications which will remove control of content and data from the hands of a small group of Big Tech firms and place control in the hands of the users. It will use cryptocurrencies and tokens as the medium of exchange and will exist largely outside the control of governments, free from censorship.
Why it matters…
These technologies are here to stay and they are already disrupting industries. The changes are first being seen in finance, payments, lending and credit. We’re seeing the disruption to gaming, art and social media but this is just the beginning. We are in the year 2002 of the smartphone world… The iPhone is still five years away but it is coming and we’re only just starting to imagine the future use cases.