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Web3: Revolutionizing Finance and Beyond – Exploring the Potential and Challenges of the Next Digital Frontier

September 6, 2023

Web3: Revolutionizing Finance and Beyond – Exploring the Potential and Challenges of the Next Digital Frontier

Introduction Web3 has recently emerged as a transformative force poised to reshape various industries. Despite recent market fluctuations and regulatory concerns, Web3’s […]

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Web3 has recently emerged as a transformative force poised to reshape various industries. Despite recent market fluctuations and regulatory concerns, Web3's fundamental principles—decentralization, blockchain technology, smart contracts, and digital assets—continue to drive innovation and hold the promise of substantial disruption.

Web3's Origins in Finance

To illustrate Web3's disruptive potential, it's worth examining its first successful application: financial services. Smart contracts have begun to streamline processes in remittances, asset exchanges, trade finance, and insurance. Among these applications, lending stands out as one of the most compelling use cases for Web3.

Traditional financial services heavily rely on banks as trusted intermediaries responsible for safeguarding funds and facilitating loans. Depositors provide their funds in exchange for nominal interest. Banks maintain private ledgers and assess potential borrowers' creditworthiness, determining loan terms and interest rates. Additional fees charged to borrowers contribute to the bank's revenues. However, in recent years, historically low interest rates have resulted in minimal returns for depositors.

Web3's Impact on Lending

Web3 introduces a paradigm shift in lending. Instead of entrusting their funds to banks or unregulated platforms, depositors maintain control through noncustodial wallets representing blockchain-based accounts. All ownership and transaction data are securely recorded on the blockchain rather than within the confines of a bank or nonregulated entity. This eliminates the need to rely on a third party to lend deposited funds. Instead, depositors can provide liquidity through smart contracts.

Smart contracts act as escrow agents, disbursing funds only when predefined conditions are met. Borrowers, seeking loans, must post sufficient collateral in order to access these funds originally provided by depositors. Borrowers can benefit from potential collateral appreciation without triggering taxable events that would result from selling their assets.

Crucially, all loan terms, including loan-to-value (LTV) ratios, interest rates, and liquidation thresholds, are predetermined by smart contract logic, ensuring transparency for all participants. While borrowers continue to pay interest on loans, these interest payments no longer accrue to management or shareholders. In fact, many smart contracts are governed by decentralized autonomous organizations (DAOs), which rarely claim any portion of the revenues generated. Interest payments return to the smart contract and are subsequently distributed to the original depositors who provided liquidity. To mitigate credit risk, strict overcollateralization requirements and automated liquidation processes are in place. Remarkably, despite significant market volatility, Web3 lending platforms disbursed over $200 billion in loans last year, with cumulative bad debt standing at approximately $1 million.

This shift underscores how Web3 eliminates the need for traditional banks to serve as custodians, central ledgers, and credit decision engines. Revenue streams traditionally enjoyed by banks' management and shareholders now benefit depositors. While smart contracts themselves often generate minimal revenue, occasional small spreads may be retained for insuring funds. Recent months have demonstrated that smart contracts can trigger automatic loan liquidations without causing delinquencies.

Web3: Beyond Finance

While deposit and lending services were among the first to find product-market fit, other decentralized finance (DeFi) applications have emerged, particularly in the realm of asset swaps. Similarly, Web3 implementation enables depositors (liquidity providers) to capture trading fee revenues from popular swap pairs, such as Ethereum and USD Coin. These liquidity providers averaged trading fee revenues ranging from 30% to 70% of their provided capital last year. Notably, DAOs governing smart contracts do not extract revenue, ensuring that all earnings accrue to liquidity providers rather than central exchange management.

These promising returns raise the prospect of reducing trading administration costs through smart contracts and outsourcing infrastructure costs through blockchain. This could lead to pricing compression due to the open-source nature of the protocols and enhanced automation.

A Diverse Web3 Landscape

While some Web3 applications have speculative underpinnings, the expanding range of financial services applications underscores the substantial innovation potential of Web3. Before the recent market downturn, more than $250 billion was actively utilized in smart contracts, generating autonomous returns for depositors.

In DeFi, automated and programmable smart contracts now compete with traditional intermediaries such as banks, brokers, and insurance agents. They offer solutions to longstanding issues in traditional finance, including counterparty risk, high transaction fees, protracted settlement times, excessive intermediary value capture, lack of transparency, and interoperability challenges. Businesses that offer services amenable to automation through smart contracts would be wise to take notice of this transformative shift.

Web3's Rapid Evolution

Despite recent market fluctuations, the pace of innovation in Web3 remains robust. Thousands of new developers are joining the Web3 movement every month, taking advantage of the open-source nature of the technology. They can rapidly develop new applications by building on established, battle-tested programs that have withstood severe market conditions. This scale of global developer engagement and innovation presents a formidable challenge for even the largest organizations to compete with.

Challenges and Opportunities

Web3 is extending its reach into various sectors, including the social sector, carbon markets, art, real estate, gaming, and more. It also plays a foundational role in constructing an interoperable metaverse—an entirely virtual parallel universe—currently attracting substantial investment from consumer companies and venture capitalists. As with any technology heralded as disruptive, it remains to be seen how revolutionary blockchain, smart contracts, and digital assets will ultimately prove to be.

Navigating Challenges in the Web3 Landscape

While doubts linger in some quarters, especially in the aftermath of significant declines in digital asset valuations and recent bankruptcies affecting specific funds and consumer deposit firms, user interest is on the upswing. Younger generations, in particular, are actively engaging in this domain. According to a recent McKinsey survey, approximately 20% of respondents aged 25 to 44 now possess digital assets. A significant portion of this demographic has leveraged digital assets for various purposes, including payments, and has even embraced NFTs for digital identity and play-to-earn activities.

Addressing Hurdles in the Web3 Ecosystem

Nevertheless, several obstacles and potential challenges must be confronted for Web3 to realize its full potential. The landscape is witnessing increased regulatory scrutiny, which necessitates a balanced approach that effectively manages risks while fostering an environment conducive to innovation. Issues surrounding privacy, security, scalability, and governance call for well-considered solutions. The debate surrounding the decentralization of control and governance within these networks remains an ongoing and contentious topic. However, despite these challenges, the spirit of innovation and the transformative potential of Web3 continue to be the driving forces behind its expansion and adoption.

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