By: Carlos Salinas (guest author)
This has been a difficult year for the sector…cryptocurrency prices are constantly falling, NFT trading volumes are at rock bottom and some of the pioneers in this technology are going bankrupt, mainly due to risk management issues.
Web3 financial applications are the ones that have mostly adapted the technology, where large volumes of assets have been traded ($10bn daily volume at peak).
It is true that it is still a very young sector where the user experience is very improvable and the lack of regulation and investor protection acts as a brake on its development, but it is essential for the financial sector and others not to lose sight of the potential and the change that this technology represents.
The potential for change of the Web3
Its main feature is the ability to decentralize business models. It is the evolution of the Internet and shifts the status quo towards users by making use of open protocols in “permisionless” block chains and through smart contracts. The governance of these protocols is also in the hands of the community and the benefits are in the hands of the content creators or users who receive incentives for participating in the community.
What does all this mean in practice?…mainly the disintermediation of everything.
An example: Automated loans
Currently, loans depend on a bank as a trusted counterparty to protect funds and originate loans. Depositors give funds to the bank in exchange for a small return. The bank records the exchange on its books, selects the lending counterparty and marks the price of the loan.
In the Web3 version, the depositors themselves hold their funds in a wallet that is represented on the blockchain. All transaction information resides on the blockchain. They themselves can place their funds in the form of liquidity in a Smart Contract. It is the Smart Contract that manages the funds and pays the agreed flows. Borrowers seeking funding now have to interact with the Smart Contract which will request collateral in order to access the loan.
All the terms and conditions are pre-established and reside in the Smart Contract…Loan To Value, interest, settlement limits. The economic flows are automatically distributed by the Smart Contract. In this model, the credit risk is minimized thanks to the borrowers’ guarantees and automatic settlements….
The largest lending platforms have continued to operate during the most turbulent periods without problems. This example demonstrates how the traditional financial sector can be displaced from one of its core businesses.
There are many other use cases that threaten traditional business models such as decentralized Exchanges, derivatives, insurance, etc.
Risks and challenges still to be managed in Web3
Web3 is rapidly expanding into other sectors such as art, real estate, carbon credits, etc. …. and will also be the key to building an interoperability metaverse.
In this environment, in which we have seen many frauds and bankruptcies due to basic lack of business and risk management, the main challenge will be to overcome regulatory scrutiny. Many countries are thinking about how to regulate this environment, but it is not easy as it is developing at a high speed and in countries going at different paces.
How to ensure correct and fair governance, how to improve usability, how to manage the security of the protocols to avoid fraud, avoid money laundering or ponzi schemes, etc….
Clearly the level of user protection is very deficient, and this is even more so when the user has not understood the risks of the decentralized environment and expects the same level of protection as when operating in the traditional world.
In its current state, the technology is not ready for mass adoption, since, for example, there is no control over data privacy….it is true that a wallet is anonymous by definition, but as soon as a wallet can be linked to its user, all information is public.
Finally, transaction costs make some protocols excessively expensive, in addition to the questionable robustness of some infrastructures where prices differ greatly due to errors in the “oracles” whose function is to feed the smart contracts with correct prices at all times.
Imagining the Web3 of the future.
Huge amounts of investment are going into the sector with around $32bn of venture capital entering the sector in 2021 and this is why we need to pay attention to it.
The next wave of innovation will come from the new products, infrastructure and services side.
In new products we will have developments in CBCD’s, governance tokens, NFT’s, etc due to new use cases that will emerge….
In infrastructure we will see improvements around the custody of digital assets where traditional banks will have a fundamental role, new methods of settlement, issuance, risks, regulatory compliance, etc…
In terms of services, we can expect the complete development of a new ecosystem to service this new sector…gaming, social platforms that provide a new value proposition to their customers and that are able to develop the necessary layers of usability and security to enable mass adoption of the technology.
In short, it is still a very incipient technology but it is necessary to keep abreast of these innovations so as not to be left out of the game by a new way of doing business.