Blockchain developers have made rapid gains this year in improving the infrastructure of how these systems work. They are getting closer to viable solutions for a new type of internet, one that moves value (ie, money and securities) as easily as it moves information.
But as these infrastructure-related solutions become clearer, what’s the use case that will make Web3 an actual game-changer for financial services, consumers, and business in general?
Increasingly, investors in this space see a growing need for developers to expand from infrastructure into the realm of applications.
Gavin Wang, managing partner and chief investment officer at SNZ Capital, an early investor in Ethereum, speaking at a conference at Hong Kong’s Cyberport, said, “We’re looking for the killer app. Otherwise all this blockchain scalability is a bubble.”
His firm has avoided unsustainable projects in NFTs and gaming, such as the ‘play to earn’ fad, but has backed DeFi protocols such as MakerDAO, Uniswap and Chainlink Network. Wang believes it will take five to 10 years before Web3 is a mainstream phenomenon, but he’s looking now to place bets on ways to integrate blockchain with the existing, Web2-based world.
Jupiter Zheng Jialiang, partner at HashKey Capital, says the industry needs to have mass-adoption products ready for the next bullish cycle. “Over the next few years, we need a larger narrative than gamify or metaverse,” he said. “The infrastructure is close to ready.”
Infrastructure advances
Investors and builders in the space don’t agree on what ‘close to ready’ means.
But Sandeep Nailwal, co-founder of Polygon, says the advent of zero-knowledge proofs is enabling rapid progress on two important fronts. One is scalability, and the other is connectivity (or interoperability).
Other chains such as Ethereum and Solana have also addressed these challenges, with ZK proofs and other technologies. Success will have implications for traditional finance as well as crypto-native markets.
“Financial markets will benefit from near-instant, atomic settlement,” said Andrew O’Neill of S&P Global Market Intelligence in London. “This will reduce the need for intraday liquidity, improve the mobility of collateral, and cut down on counterparty risk.”
Barriers to adoption
Adoption of blockchain finance, or other uses, has been hindered by engineering problems with the leading ‘layer-1’ or settlement-layer blockchains, such as Ethereum. These have impeded scalability.
One problem is gas fees. The greater the demand for a particular service on a blockchain, the higher the price validators charge to confirm a transaction. Moreover, gas fees are impervious to the size of a given transaction: whether the value being exchanged is worth a dollar or a million dollars doesn’t matter, the gas fee is the same. What matters is the volume of transactions.
Second is speed. Until recently, Ethereum could process only about six to 10 blocks per second – very slow compared to a transaction-per-second speed of around 25,000 for Visa. If blockchains can reach such speed, it becomes more attractive for banks and others to build apps on top.
Currently the blockchain world is not there yet, although it’s made progress, with Ethereum, Polygon and Solana capable of TPS around 4,000. That’s a sign of progress, but there’s a long way to go.
Ethereum goes PoS
One important development on this path was Ethereum’s switch from a Bitcoin-like Proof of Work consensus mechanism (in which every node must validate every transaction) to one based on Proof of Stake. When Ethereum debuted in 2016, it prioritized decentralization and security over scalability (the so-called blockchain trilemma).
Proof of Stake represents a partial retreat from decentralization, but the process looks successful, says Gökhan Er, managing director at IOSG Ventures.
He notes that in 2023, Ethereum’s validators and app builders generated a combined $2 billion in revenue. Lido, a staking protocol for ETH tokens, generated $540 million in revenues. ConsenSys, the largest developer on Ethereum, generated revenues above $100 million in 2023, including from Metamask, its wallet, which now has 23 million monthly active users.
Another metric of adoption is staked Eth. Running a node on Ethereum requires a minimum of 32 ETH, which is beyond the means of most participants. Yet the network depends on such nodes to validate transactions – they are the first line of securing the network. Staking protocols like Lido are like a money-market fund, aggregating individual users’ tokens in order to run nodes at an omnibus level.
Lido currently operates 31 node operators chosen by the protocol’s governance mechanism (ie, by software), a design meant to mitigate against the risk of Lido becoming a giant, single point of failure or corruption. Ethereum, Polygon and Solana all have procedures to engage stakeholders and developers to protect against someone hijacking the network, although they all have vulnerabilities.
Nonetheless, the salient point is that staking on Ethereum is increasingly popular. In 2021, before Ethereum’s move to PoS, ETH token holders staked only $1.2 million. As of today, that figure is $27 million, representing 23 percent of all ETH tokens. This is a vote of confidence in the direction of the network.
Rollups
This year the industry has introduced out another important technology to improve scalability: the roll-up.
S&P’s O’Neill explains rollups enable Ethereum and Polygon to group transactions and execute them on a separate, ‘roll-up chain’, and return the batched output to the layer-1 for final settlement. (In Polygon’s case, it returns transactions to the Ethereum blockchain. Solana’s taken a different path, trying to keep everything on the Solana chain itself.)
Not all roll-ups are the same, however. Ethereum developers often use ‘optimistic rollups’, which assume the transactions are valid unless proven otherwise. It’s up to the validators to prove a fraud; they can freeze the transaction for a few days.
Being ‘optimistic’ puts the onus of discovering fraud and challenging it on validators, and if there’s a challenge, the pause on transactions can have spillover effects.
The solution is the zero-knowledge rollup. ZK proofs are a cryptographic technique to verify the truth of information without having to see the underlying data. Using ZK rollups means every transaction is confirmed automatically, without having to rely on activist validators or pausing transactions.
If successful, ZK rollups have obvious benefits to KYC and other compliance issues. Their adoption also clears out a lot of the processing that goes into validating – and the high gas fees. Remove this heavy lifting, and gas fees should become miniscule.
Zero knowledge
Polygon’s Nailwal says ZK rollups will enable blockchain infrastructure to scale infinitely, and to connect seamlessly with other blockchains.
That means blockchain can create a true ‘internet of value’, or Web3, with the same ability for anyone with an internet connection to create an app, surf easily from site to site, and consume or move data and value anywhere – just as a company posting a video on its website today can populate other social media with its content.
Introducing ZK rollups has not been easy. Polygon invested almost $1 billion over the past two years in ZK programmers and related projects, Nailwal says. This has generated results. “A lot of people thought it would take up to five years to deploy a full-blown, audited ZK validity rollup,” he said at the Cyberport event. “But we launched ours in March.”
He predicts the advent of ZK rollups will have an outsized impact on the entire Web3 industry, because it enables people to prove the validity of an environment or a data set without having to reproduce it themselves.
For example, an auditor of a company’s operations will ask for its data and business logic, so the auditor can test the veracity of what the company is telling them. With ZK tech, the company can simply give the auditor a simple compute proof. Similarly, with rollups, the layer-2 blockchains do an awful lot of computation across many apps, but then prove back the output to Ethereum.
Banks and Web3
The trustless nature of SK proofs means that layer-1 chains don’t have to be fully decentralized for their security. This means banks and other enterprises won’t have to worry about launching applications in permissionless environments, where they can’t tell if they’re trading with a sanctioned counterparty or a fraudster.
Banks today operate only on permissioned, closed-loop blockchains. This makes it impossible for them to benefit from the global nature of digital networks – it means that money or securities represented by their tokens isn’t fungible. ZK proofs, Nailwal argues, will give them the comfort of leaving their walled gardens.
IOSG’s Er says the improving infrastructure of blockchain will also enable the ultimate triumph of Web3 companies over the giant, monopolistic platforms that dominate today’s internet.
He notes that today, the top 1 percent of websites receive 95 percent of all traffic. The trend is similar for mobile apps. This has given companies like Meta, Spotify, WeChat and Google enormous financial power.
For example, Meta generated $117 billion in revenue in 2022, in part because it fully monetizes all the content that ordinary people build on it. YouTubers give up 45 percent of their revenues to the platform. Spotify and the Apple App Store take 30 percent of revenues from artists or apps on their sites.
This doesn’t happen in Web3 environments. Er says that Opensea, the NFT marketplace, generated $25.3 billion of trading volumes in 2022, but received only a 2.5 percent take rate. Uniswap, the DeFi protocol, supported $840 billion in volumes, but its take rate was only 0.3 percent.
“These projects are open source, permissionless, and forkable,” Er said. “If you charge too much for any app on crypto, someone can fork your project, build another version and charge less.”
On the plus side for developers, if they build an app, they’re not dependent on a giant platform. Twitter under Elon Musk’s ownership recently closed its APIs to developers it doesn’t like, so anyone who built apps on Twitter have lost time and money. If Google changes its search algorithm, many businesses relying on Google ads or rankings will find themselves in the cold.
This has implications for the finance sector, because crypto is, after all, a speculative environment. Everything depends on incentives to keep people building and validating. “Whenever crypto enters a new sector, the industry gets financialized faster,” Er said.
Therefore as the infrastructure scales and connects, finance will become an even bigger industry – albeit in Web3 form.
Killer app – or just easy to use
The infrastructure build still has plenty left to achieve. Infrastructure in traditional finance remains an ever-changing landscape, so it’s never ‘done’. But the technology is now being deployed to make Web3 scalable and interoperable.
If Web3 is to go mainstream, though, it will also need a lot more apps – and a lot better ones. Today the space is only populated by techies and insiders, because the apps are clumsy.
“Crypto wallets like Metamask are painful to use,” Er said. “When you download it you have to sign off on a lot of messages; if you write the wrong number, you might lose the money you’re trying to send. We need apps as good as those in Web2.”
Another problem is fragmentation – the lack of seamlessness. Using a wallet to lend or stake or buy insurance all require transacting on different blockchains.
SNZ’s Wang said, “Scalability is the flip side of mass adoption. It’s not just about low gas fees or higher TPS. It’s also about connectivity, integration with Web2, and bringing down the barriers to user adoption. We still have a long way to go.”
Alan Li, blockchain investment director at Da Wan Asset Management, says VCs are still investing in infrastructure projects. “For the application part, we still have to rely on Web2 companies…Even Facebook or Google will embed a crypto wallet in their browser or application.”
He thinks there will be investment opportunities in more DeFi-related projects, noting markets such as Aave and Uniswap are just for spot transactions. There’s still room to build derivatives and structured products, he says, although it might take another bull market to generate enough users for new projects to pay off.
But Er says the tide of investment is beginning to pivot. “In the past few years we invested in infrastructure,” he said. “Now it’s time to move into applications.”
