Let’s talk about Web3 and why investors are betting big on a decentralized future
Carol Tarr — Portfolio Manager
Decentralization drives much of the promise behind Web3, offering the promise of a “bankless” and “permissionless” future meaning to operate without the need for centralized banks or government oversight. Although one may think that Decentralized Financed (DeFi as opposed to TradFi or Traditional Finance) is all about crypto-derivatives, yield-farming and speculative “moonshots” making millions overnight on dog-meme coins, you might be surprised to learn that DeFi offers new and innovative opportunities for solving old inequalities.
In one of DeFi’s best use-cases for SDG (UN Sustainable Development Goals), DeFi provides vulnerable people with limited access to banking and insurance — the “underbanked” and “underinsured” — with an alternate means to save their money, make deposits, pool savings for a major event, make payments and ultimately just transfer it to someone else. Decentralization offers consumers a financial alternative if faced with government-induced hyperinflation or geo-political instability while getting around the fee squeeze of financial institutions. And speaking about those fees: it can cost easily 12% of someone’s paycheck in fees if they’re trying to remit money abroad, hitting migrant workers and people with the least resources the hardest (Remittance Prices Worldwide, World Bank: 2020). Hence, decentralized remittance and payment technologies have experienced tremendous growth for just these reasons.
DeFi’s potential as a great equalizer is undeniable and many of the visionaries behind what has become Web3, like Bitcoin’s pseudonymously named Satoshi Nakamoto and Etherium’s young Vitalik Buterin, had motivations other than profits and ROI in mind when they painstakingly created white papers that laid the mathematical foundations for what would become the two widest used and widest held cryptocurrencies which never needed the involvement of external investors. Only recently have VCs managed to get any kind of foothold into Web3 and it has been mostly through purchasing coins just like everyone else although ideally early, in bulk and at reduced prices. Liquidity events occur faster than in other investments, on an 18 month to 3-year timeline and can occur with just the listing on an exchange, although lock-up periods are usually required before those investment coins can be sold.
Traditional VC funds have encountered barriers in trying to enter the Web3 investment space. Limited Partner agreements typically have not allowed for the liquidity necessary to buy coins in their agreements and VCs have needed to either launch entirely new funds, specializing in crypto or push through an amendment to their original agreements, along the lines of needing as much as 2/3 agreement by existing LPs. Convincing your LPs is not always an easy task.
Further, some major investors are now investing in DAOs, Decentralized Autonomous Organizations, which are distinguished by the three factors:
- they are digitally native,
- are governed by smart contracts, and
- token holders vote or decision making.
DAOs are decentralized organizations by design and can operate as investment pools, learning organizations and civic organizations. Decentralization is maintained with a “code is law” ethos and the integrity of the governance mechanism. The typically desired 20% of equity that VCs like in an investment simply does not work for DAOs because that would destroy the decentralization. Are they securities? That is up for discussion but generally, if control is not concentrated in a small minority and people are not investing with the intention to make money off their holdings, then not. However, there have been governmental rulings that some DAOs are selling securities and need to be regulated. Again, do your own research!
As you can see, there has been a fundamental paradigm shift, a “mind blown” moment where an investor understands that they cannot control a decentralized investment because of the mechanisms behind its very design.
What kind of mechanisms might these be? The blockchain for one makes everything open, transparent and immutable, meaning it stays on the electronic ledger (which is what the blockchain is) forever and operates via peer-to-peer smart contracts.
The main problem with the promise of all of this openness and decentralization are the issues of regulations and security. Poorly written smart contracts have provided numerous opportunities to hackers and bad actors who see the opportunity to run off with millions… perversely all are seen in the open because the thefts and breaches are also transparently displayed, after the fact, on the blockchain. Adding insult to injury, a hacked owner can track down and see their former asset, now all but out of reach. Whether the thief can hide it for long or can sell it is another matter entirely but one thing is for sure, the asset is no longer in the hands of its rightful owner and may be lost forever. Law enforcement is limited in both ability and options. That said, as seen with identifying the wallet behind the recent USD $640 Million Axie Infinity hacks by a government-run team of North Korean hackers, law enforcement is getting better at tracing the funds and identifying bad actors. Even more bizarrely, some hacks aren’t even illegal but just exploitations of loopholes in bad code; all perhaps perfectly legal from a contract viewpoint, just highly unethical. With many of the best Web3 auditors fully booked until 2030, I would say this further illustrates the importance of due diligence and knowing the project and the people behind it very well before investing. Be wary, bad code has led to the downfalls of many big projects.
Remember, all of the acts of lawlessness and exploitation are also a result of decentralization, which is still at the root of much of what makes Web3 what it is. You may wish for more “adults in the room” but that kind of control would lead to greater centralization which contradicts the very principle of decentralization. Ultimately any goal is about striking the right balance and it remains to be seen if even the best-constructed regulations can manage to do this. However, in light of recent exploits and depegging of so-called “stable coins”, some form of regulation appears to be on the horizon. But for now, we must rely on the limited resources of law enforcement, insurance, “bug bounties” (rewards for hackers who identify weaknesses) and overbooked auditors.
As for money lost: the current practice has hacked DAOs, DEXs, play-to-win games and NFTs restituting stolen funds but this is simply financially unsustainable in the long term.
Still, with more developers and projects expanding the use-cases for decentralization with each passing day, Web3 remains a potential deep value growth area. Investors have always had an important role in innovation and though there is a constant push and pull between forces of centralization, more regulation and decentralization — the motto “follow the developers” may reveal where the next leap in innovation lies.
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