Ethereum: The Gateway to Web3

There is a wise old saying that goes, “the best time to plant a tree was 20 years ago, the second best time is now.” You may be kicking yourself for not investing in Bitcoin at a time when 10k bitcoins were exchanged for 2 large pizzas, but you haven't completely missed the opportunity.

This post will discuss general crypto market dynamics, the importance of Ethereum, a breakdown of web3 and why the intersection of second layer protocols with great consumer products is the most exciting place in crypto.

What drove the recent correction in the crypto markets (May 2021 version)?

Nothing technical has changed with the underlying blockchain technologies but most of the recent volatility in the market can be traced back to following:

1. Geopolitical events (China banning crypto)
2. Elon Musk and Tesla no longer accepting Bitcoin for environmental reasons

3. The massive amount of leverage which has caused wide swings in price. Firms in Asia, like BitMEX, allows 100-to-1 leverage for cryptocurrency trades. From a WSJ article,

“The implosion of leveraged bets has been a key factor in accelerating a month-long selloff in bitcoin and other cryptocurrencies. As prices tumbled, many bullish bets were automatically liquidated, adding more downward pressure on prices and leading to a vicious cycle of further liquidations.”

Why is Ethereum (ETH) so important...I thought Bitcoin was #1?

Currently Bitcoin ($683B) is still well ahead of Ethereum ($299B) in market cap. Over the years we have seen Bitcoin's size compared to rest of the market slowly recede with the addition of more projects. We are now near the all time low previous set during the crash at the end of 2017.

Bitcoin isn't just being beat out by the shear number of alt-coins though, users and developers are finally finding utility and consumer traction with the bitcoin alternatives.

In the best thing I have read lately, a post titled “Own the Internet”, the author Packy McCormick introduces the bull cases for Ethereum by saying,

"Owning ETH is like owning shares in the internet. Demand for ETH will go up with increased web3 adoption, while upcoming [technical] changes will decrease the supply of ETH and let more value accrue to holders."

I am not going to get into the upcoming technical changes to ETH but this does. I do want to focus on the connection between Ethereum and web3 adoption. Think of Ethereum as a blank slate for creators to build on. To better understand the tools available to builders check the bottom of this post for more information on smart contracts, oracles and DAOs (distributed anonymous organization). Let's talk about web3 to understand why Ethereum increasing its adoption is important.

What is web3?

Let’s start with web1. Web1 involves static desktop web pages designed for information consumption and served from expensive servers. Web1 turned into web2 when companies like Facebook and AirBnB infused interactive experiences and user-generated content into their applications. The calling card of a Web2 application is that it is mobile, has a strong social element and is powered by the cloud. Web2 already has clear winners who have harnessed strong network effects to build an insurmountable lead in a winner-take-all world. 

For those working hard to regulate Big Tech's political power, web3 might be the framework to breaking up their dominant market positions.

Web3 applications are built on open, trustless and permissionless networks.

• Open - Built in public by a developer community connected by the open source software they are collectively working to improve
• Trustless - The network is architected in a way that participants can interact publicly or privately without a trusted third party. Transactions and counter-parties are transparently listed on the Ethereum blockchain.  
• Permissionless - Any participant in the application can participate without authorization from a governing body

Web3 networks are built to facilitate the exchange of massive amounts of information in a controlled manner so other exciting technologies like edge computing, decentralized data storage and machine learning can be easily weaved in to new applications.[1]

What are some examples of Web1, 2 and 3?

Finance

1. Web1 - Most traditional community banks are stuck in web1. Many have launched a mobile application but a great deal of these financial institutions are stuck on old core financial platforms, with data locked in on-premise servers.
2. Web2 - PayPal CEO Dan Schulman considers Venmo's social feed of transactions the service's "secret sauce” along with the core app function of sending/receiving large volumes of $$ between friends.
3. Web3 - Maker lets borrowers use Ethereum as collateral for loans of digital currency pegged to the U.S. dollar. Changes to parts of the token are voted on by owners of the governance token (MKR) organized through a DAO.

Weather data for farmer’s insurance

1. Local Newspaper/ Farmer’s Almanac
2. Weather.com app
3. Chainlink’s decentralized oracle network provides reliable, tamper-proof weather data for smart contracts. Insurance startup Arbol provides crop insurance for small to medium-sized farmers or enterprises. Smart contracts pay claims to subscribers when a preset value – such as the average monthly temperature or rainfall – turns out different than the contract specifies.

The downsides

The market - I have no idea what the price of ETH will be in the short or long term. The crypto market is wildly speculative, driven by a great deal of leverage, and can be drastically moved from a single Elon Musk tweet. I do believe in the long term prospects... HODL!

Technical limitations - Ethereum has received criticism for its high usage fees and its transactions that are too slow for the applications built on top. In a previous post, I talked about NBA Top Shots which built their own blockchain (Flow) to get around these issues. 

The Opportunity

While the core developers of Ethereum are working to improve their platform, there are other companies in “layer two” (L2) that are delivering both significant increases in speed as well as lower fees. 

• Union Square Ventures recently posted about a L2 solution they are investing in called zkSync. This venture uses "zero-knowledge proofs to verify and consolidate transactions in an extremely performant and scalable way, without sacrificing integrity and security.”
• Other interesting L2 projects worth investigating include Arbitrum, Polygon and Matic

Below is the web3 tech stack with ETH at L1, zkSync (and oracles) at L2, APIs at L3 and the user interface at L4.

Where do we go from here?

If you have been on the crypto sidelines, and are just looking to get skin in the game, now is the time to consider investing some $$ into Ethereum. I personally am going to start looking critically at the consumer applications built on top of these L2 solutions described above. We might be at a critical juncture in this space where classic venture capital rigor (customer lifetime value/acquisition cost, churn, gross margin, etc.) can be applied to web3 companies and not investing on pure speculation!

Call To Action // What I Am Looking For

I researched and wrote this post for my own education as well as to see more deals in this specific niche. If you are a startup that is looking for funding, a technical guru that can vet these projects, a VC that is well-versed in right/wrong seed stage pattern-recognition, or just an interested party who wants to get skin in the game drop me a line.

Definitions

• Smart contracts - Contracts are underpinned by a large legal apparatus including lawyers, police, and notaries (among many associated jobs). Ethereum abstracts all those functions so the requisites of a contract can be put in the blockchain and executed through pre-determined code creating a trustless environment for negligible cost.
• Oracles - "Oracles are data feeds that connect Ethereum to off-chain, real-world information, so you can query data in your smart contracts." Below I discuss a how an oracle can be used to integrating weather data into a contract.
• Decentralized Autonomous Organization (DAO) - A DAO takes the smart contract functionality to enable trustless organizations, from two friends splitting NFT proceeds up to large multi-national corporations.

Follow on reading...

[1] Max Mersch and Richard Muirhead. "What Is Web 3.0 & Why It Matters." Dec 31, 2019.

Kyle Samani. "On Value Capture at Layers 1 and 2." March 14, 2019.

David Hoffman. "The Layer 2 Gold Rush." May 31, 2021.