We provide an overview of how businesses should think of working around Web3, its impact and the legitimate use cases from Web3. Getting industry use cases up and running successfully is a complex techno-legal endeavour. Clear regulations for blockchain business applications will benefit project builders by invoking confidence.
Although we are admittedly in a crypto winter now and confidence around crypto has bottomed due to recent bad actors, there are still many legitimate use cases for crypto, many revolving around infrastructure. However, it may be time before these projects take off properly in the mainstream as regulators catch up and provide more clarity on (and regulate) what can be done in the blockchain project realm to evoke confidence around the crypto builders.
What excites us in the Web3 space?
One use case that excites us at Latent is the tokenised real-world assets collectively managing it on a distributed ledger. Getting this working successfully is a complex techno-legal endeavour. Interesting to see service providers springing up to provide services to issue asset tokens and deal with the KYC and AML requirements and processes.
Web3 technology is still in the early stages, evolving quickly and potentially uprooting many industries like money and finance. However, we need better practices. We need substantial education about potential, threads and their socio-economic implications.
People still need to learn what to do with tokens or how to design tokens with the advent of the Ethereum network properly. This info piece will talk about the building blocks of Web3, applications and socio-economic impacts.
Web3 reinvents how data is stored and managed over the internet, providing a universal state layer recognised and managed by all nodes in the network. This unique concept of a shared state layer provides a value settlement method and enables genuine P2P transactions. Web3 is a backend revolution powered by distributed ledgers. Management ruling is embedded into the protocol and secured by a majority consensus of the network participants. For a hacker to manipulate data, the data must break into multiple houses (nodes) across the globe simultaneously. Breaking in is possible but prohibitively expensive.
Evolution of the Web
- Web 1 – Read – Web browsers fetching data from the internet
- Web 2 – Read & Write – Producers and consumers of information are brought together online via a trusted intermediary like social media platforms
- Web 3 – Read, Write & Execute – Anyone can participate in participating in the transaction and be rewarded with a network token; smart contracts govern P2P agreements
The internet we use now – TCP/IP, SMTP or HTTP, is stateless and does not have a native mechanism to transfer state. Instead, it relies on centralised data storage for long-term state preservation and session cookies for the short term.
Web2 undeniably has produced many beneficial services and created significant social and economic value over the years. The companies offering the services accumulated wealth, and public users contributed content and value to these services. Hence, the so-called saying – If you are not paying for it, you’re not the customer; you’re the product being sold.”. Most web2 platforms monetise via advertising, and users pay using their private data.
Blockchain networks, like the Bitcoin network, allowing tokens to be sent and received by nodes in the network and have the state recorded in a digitally native manner. The network can collectively remember preceding events, solving the double spending problem.
Various protocols are needed to create decentralised applications, including fire storage, messaging, external data & oracles. One key concern for protocol technology is to determine how to reward network participants with tokens and for the network to stay attack resistant.
Compared to centralised solutions, decentralised architectures are slower, although more resilient than their counterparts. Speed, performance and usability are issued to be resolved over time. Centralised solutions will always have their place and advantages for many use cases.
Blockchain and Ledgers
Blockchain networks build on P2P networks, with a universal data set allowing unknown actors to trust each other. In addition, immutable copies are stored in every node with native token incentives to make the network fault-tolerant, attack and collision resistant.
Double spending problem – the current status of the internet is that digital files can be spent many times because they can be copied and shared around. Blockchain protocol makes it expensive to copy digital values.
Chain of blocks – Tokens are recorded in batches and hashed, creating a digital fingerprint of the block. Each block carries a hash of the previous block. The chain hashing process ensures the integrity of the blocks to the first genesis block. This list of the chained block is the ledger.
Ledger – Cryptographically secured list of transaction records. The hash value of a block helps to check the transaction’s authenticity on the ledger.
Distributed ledger – The ledger is stored on multiple nodes simultaneously. Therefore, all network nodes need to reach a mutual agreement to update and change the record of the ledger via a consensus mechanism.
Blockchain Use Cases
Blockchain networks and distributed ledgers provide a ripe infrastructure for rights management. Each process, payment and interaction will have a digital record and signature that can be identified, validated, stored and shared. Some scope of traditional intermediaries like lawyers, brokers, banks and public administrators may be replaced by distributed ledger systems.
Use cases are:
- Transparency and control – Useful for the supply chain of goods and services, tokenised financial services that resolve issues around supply chain transparency, corruption and personal data control, buyers and sellers to have more information on the provenance of products they buy
- Reduction of bureaucracy – Smart contracts and rights management solutions can reduce the coordination costs of business transactions
- Resolve principal-agent organisation dilemma – Deceanlized autonomous organisations allow for global coordination
Smart contracts come into the picture by encoding and algorithmically enforcing business logic and governance rules of agreements. Smart contracts with user-centric identity systems can help formalise relationships between people and institutions and the assets they own P2P without needing a trusted intermediate. Currently, web2 giants like Amazon, Airbnb and Uber have come to fill this need.
A smart contract allows us to publicly and verifiably embed governance and business logic in a few lines of code. It can be invoked inside and outside the blockchain network via external data sources. Oracles help inject off-chain data into the blockchain and track the performance of the agreement in real-time.
Smart contracts reduce the transaction cost of agreements, an alternative to traditional contract law. However, we still need to resolve smart contract security on a technical level. In addition, we are still early in making smart contracts compliant with legal agreements with better dispute resolution solutions.
Industry Uses Cases for Web3 & Smart Contracts
The smart contract helps register ownership and property rights with many possible use cases in banking, insurance, energy, government, muisic and film industry, fine art and education. As a result, traditional intermediaries like lawyers and brokers will be less needed.
Smart contracts help to provide a native settlement layer for the sharing economy. It makes micropayments even more economically feasible.
Oracles are data feeds to bring data from the outside world into blockchain entworks and smart contracts to induce state changes to the ledger. People need to trust these external sources of information. Gas has to be spent to invoke a contract call to feed data from an outside source.
Smart contract security needs to be managed well. This includes oracle security, ensuring that off-chain data can be trusted, secure coding and procedural security and dispute settlements – there should be some on-chain and off-chain mechanisms to resolve complaints and unforeseen situations from using smart contracts. The intertwining of smart contracts and legal contracts require cross0dsiciplinar research and development. At the same time, it needs to offer privacy by design. Only involved actors know explicit information.
Tokens are the atomic unit of Web3. They are issued with just a few lines of code, collectively managed by a ledge. They are rights management tools representing some digital or physical assets and permissions in the material, digital or legal world. They facilitate interactions and incentives an autonomous group of people to contribute in a selected way.
How can we drive the properties of a token:
- Technical – Protocol (native) tokens, second layer (side chain) tokens, multi-asset ledger tokens – ledgers that allow the creation of multiple tokens
- Rights – Tokens can represent the right to the asset, limited access to assets and services others provide, voting rights
- Fungibility – Tokens and digital assets are identical to each other and can be replaced
- Transferability – Identity-bound tokens can be non-transferable, while tokens by default are transferable
- Durability – To be resilient against censorship or network attack
- Regulatory – Regulators are playing the catching-up game; they need a clear taxonomy of the different token types to understand what they are regulating
- Incentive – Tokens can be programmed to incentivise contribution patterns
- Supply – Tokens have different supply strategies
- Token Flow – Tokens can be created for a single purpose and destroyed after the goal has been fulfilled
Web3 Decentralised Finance
Money needs to serve as a medium of exchange, store of value and unit of account to denominate debt. The properties of money are liquidity, fungibility, durability, portability, cognizability and stability.
DeFi encompasses apps built on distributed ledges and publicises traditional financial services. In the current economic system, intermediary services are needed to mitigate counterparty risk, market making and secured funds. DeFi aims to provide disintermediation and self-executes with little institutional intervention other than code upgrades, bug fixes and dispute resolution.
Central Bank Digital Currency
CBDC is a tokenised representation of a country’s fiat currency. Tokens will be part of the base money supply with other forms of money: M0 & M1 cash and other cash equivalents, M2 short-term deposit, and M3 long-term deposits. In addition, CBDCs can be used to settle smart contracts, and the underlying ledger can manage the tokenised equivalent.
CBDCs may compete with commercial bank deposits and lower the cost of managing local and international payment systems. The cost of operating the cash supply of a country is high, similar to cross-border transactions. Some traditional bank accounts can be replaced by mobile crypto wallets, including more of the underbanked. In addition, CBDCs can challenge the practice of fractional reserve banking and eliminate the need for deposit guarantees.
Central banks can directly control the money supply and complement or indirectly substitute tools like interest rates of quantitative easing.
Tokenisation & Fractional Ownership
Tokenisation is to create a digital twin for any physical or financial asset managed by a distributed ledger. Virtual assets are easily tokenised, and material support is more complex because of the need for possession of the asset.
To tokenise a real asset, one generates a token with a smart contract and associates the real asset’s value with the token. The ownership can be divided and traded into parts. To facilitate tokenising tangible world assets, we need online exchanges specialised in asset tokens, trust custodians of wallets that can manage assets and well-defined regulatory environments for asset tokens.
Security tokens represent ownership of existing securities. We can pay out dividends and settle financially using a smart contract. These tokens will be subjected to regulation by financial conduct authorities. Smart contracts can facilitate frictionless settlement processes without sacrificing legal protection, and fully operational 24/7 markets can reduce settlement time from 2 working days to minutes. Any system for trading security tokens is a complex techno-legal process, and providers have created standards to issue asset and security tokens with KYC and AML processes.
Tokenising the art and entertainment market can resolve the inefficiencies of the current systems from fraction ownership, provenance, digital rights management, settlement and crowdfunding. Tokens can also enable new derivative artworks.
With better provenance, we can have a more transparent market, and potential investors can have access to verified artworks. Assigning origin to be managed by a public infrastructure resolves challenges of the current system like corruption, counterfeiting and hacking. Hashes and cryptography will publicity verify the provenance of artworks. In addition, there will be real-time settlements of ownership transfers.
How to design a token system
There are four critical aspects to token engineering with their considerations.
- Decide if it is infrastructure (layer 1) or application token (layer 2)
- For layer 1, consideration should be given to security, stability (trade-off between security, decentralisation and scalability) and privacy
- For layer, consideration should be given to the infrastructure used, interoperability between distributed ledger and standards of tokens created
- To make the tokenisation of existing assets, access rights and voting rights legally compliant with local legislation
- Smart contracts to replace many existing human-paper-client-server-based operations
- It answers the question of how we design smart contracts to be legally compliant
- Do we need to change the jurisdiction to cater to new tokenisation dynamics
- To deal with studies of economic institutions, policies and ethics
- Sociotechnical systems of interactions of various communities
- Transparency vs privacy, the trade-off between public and private interests
- Power structures, how much decentralisation is needed and the values of a community
An interdisciplinary team is needed for the token engineer process. For example, technical engineers will work with lawyers, economists and social scientists.
Many real-world opportunities lie within Web3. Smart contracts provide many disintermediation benefits, which we should take seriously.
Generally, many use cases can benefit from a design that uses a smart contract to provide 80% of on-chain broking services and have an off-chain layer to perform the last 20% of off-chain dispute resolution handling. This serves as a fail-safe for technical, programmatic and business risks to manage many of the risks we often see today that break systems. However, centralised systems are unlikely to disappear, and we should consider using centralisation to augment the Achilles heel of DeFi processes in many industry use cases.