Web3 Was Supposed To Save the Internet

Early this year when anything still seemed possible for technology companies, futurists and venture capitalists were enthralled with the idea of building a new internet. Web3, as it became known, was poised to recapture the 1990s promise of a decentralized internet, free from gatekeepers and trillion-dollar platforms.

Cryptocurrencies had the starring role in the Web3 dream. Crypto, in theory, could wrest control from giants like Meta Platforms (ticker: FB), Alphabet (GOOGL), Amazon.com (AMZN), and Apple (AAPL). It would shift our online activities to blockchains—handling everything from payments and trading to videogaming, social media, even real estate. It could also shift the economics to users, giving them financial incentives to govern and secure the networks.

A record $25 billion was plowed into crypto start-ups last year, with another $30 billion on track for this year, according to Bank of America. Even the recent downturn in crypto doesn’t seem to have chilled new investment. This past week, venture-capital firm a16z announced a new crypto fund totaling $4.5 billion.

“We think we are now entering the golden era of web3,” a16z partner Chris Dixon wrote in announcing the investment.

And yet Web3 remains a heavy lift—it’s full of contradictions, glitchy technology, regulatory uncertainty, and competing economic interests. There’s debate over who will “own” it—companies backed by Silicon Valley venture capital, or the users themselves. And the crypto markets’ downturn—wiping out more than $1 trillion in value for tokens this year—makes a blockchain-based web even harder to fathom.

In the near term, Web3 may be a casualty of a tech backlash that has sent the Nasdaq Composite index down more than 25% this year. Crypto-related stocks have tanked, including Coinbase Global (COIN) and Microstrategy (MSTR), and payment apps Block (SQ) and PayPal Holdings (PYPL). Among crypto start-ups, investment is harder to come by, and valuations are falling. Morgan Stanley forecasts that failure rates will rise.

Crypto fans talking up Web3 as a revolution face pushback from critics who see it as a marketing gimmick. In the end, Web3 is likely to fall somewhere in between.

“We may have to go through one or two hype cycles before the most important elements of the technology break through,” says Gavin Wood, a co-founder of the Ethereum blockchain and head of another blockchain enterprise called Polkadot. As he sees it, Web3 today is where the internet was in 1998—early in its adoption but with vast potential and boom-bust cycles ahead.

“Web3 is the next generation of the internet with capabilities that go well beyond what we have today,” says Mark Palmer, a digital-asset analyst at brokerage BTIG. “But the citizenry is not rising up to overthrow Web2.”

Understanding Web3 requires a dip in the hot-tub time machine. Web1, the first generation from the 1990s, was based on static pages and directories that served as the first internet indexes. Web1’s dial-up services, browsers, and banner ads evolved into the more modern internet, which came to be known as Web2. Companies like Amazon, Meta, Alphabet, Apple, and Microsoft (MSFT) now oversee the core of our web experiences. Walled gardens like Instagram, YouTube, and Apple’s App Store prevail. Digital assets like videogame avatars and social-media followings sit on platforms owned by the giants.

In some ways, Web3 aims to turn back the clock, cutting out the intermediaries and dispersing apps, services, and digital assets on decentralized networks like Ethereum and other blockchains. Today, those networks are primarily used for trading and lending crypto assets, including new varieties like nonfungible tokens, or NFTs, and stablecoins, which are designed to maintain a fixed value.

But all sorts of other financial products and services could live on blockchains, potentially reducing the economic friction now associated with cross-border payments and transaction fees for goods and services. “Blockchains have the potential to clear and settle transactions in a much more efficient way than traditional technology,” says Sarah Hammer, an adjunct professor at the University of Pennsylvania Law School who specializes in crypto.

One example of Web3 already in practice is Filecoin, a crypto-powered storage network. Rather than storing files on cloud-based servers—where they are ultimately controlled by a handful of big-tech operators—they can be distributed and encrypted on personal hard drives with spare capacity. Testimonies of Holocaust and other genocide survivors are being preserved through Filecoin.

“It’s like Airbnb for file storage,” says Marta Belcher, president and chair of the Filecoin Foundation. “If you have extra space on your hard drive, you can rent it out. We think of it as the foundation for the next generation of the internet.”

Filecoin may just scratch the surface of decentralized technologies. Projects like Helium aim to challenge telecom networks by distributing long-range Wi-Fi hot spots to individuals, giving financial incentives and payments for data traffic in tokens. NFTs allow for property rights, licensing agreements, and royalties to be traced and tracked. That opens up avenues for NFTs to become conduits for things like mortgages, car ownership titles, diplomas, and concert tickets. “There’s an infinite number of things you can do with a computer, and that’s equivalent to what you can do with an NFT,” says Gui Karyo, chief information officer of Dapper Labs, a leading NFT company.

Ideally, Web3 advocates say, the technology will lay the foundations for a more egalitarian web where the “rents” now charged by intermediaries will be more widely distributed. “We should be moving to an internet where your digital property rights are genuine—you’re not a serf on Jack Dorsey’s or Mark Zuckerberg’s plantation; you own your homestead,” says Nic Carter, a venture-capital investor in Web3 start-ups at Castle Island Ventures.

Silicon Valley’s biggest and most successful venture-capital firms are investing heavily. “Programmable blockchains are sufficiently advanced, and a diverse range of apps have reached tens of millions of users,” a16z’s Dixon said in a post this past week. Tokens also give users “property rights: the ability to own a piece of the internet,” he said in an previous post on Web3.

Web3 overlaps with the metaverse, another of tech’s hottest topics before the recent selloff. The metaverse foresees a new internet based on virtual realities, online avatars, and new ways for people to socialize and work.

Facebook rebranded itself as Meta Platforms, betting that its Instagram, Facebook, and WhatsApp could become Web2 relics without help from blockchains, cryptos, and NFTs, which could grant consumers more control of their digital lives. Meta is now working on incorporating NFTs into Instagram. The currencies of digital worlds, whether for gaming, social, or e-commerce, are likely to be stablecoins—digital tokens aimed at holding a peg to a dollar.

Yet Facebook’s move is a reminder that the Web2 giants aren’t sitting still. In the end, Web3 is unlikely to displace them. Indeed, there’s good reason to think Web3 won’t be all that decentralized. For one, it’s being funded by many of the same entities that built Web2.

A16z, formally called Andreessen Horowitz, was an early investor in many Web2 stalwarts, including Facebook, Box, Lyft, and Pinterest.

Now, the firm owns stakes in dozens of crypto start-ups, including OpenSea and Dapper Labs, along with decentralized-finance, or DeFi, platforms including Ava Labs, Uniswap Labs, dYdX, and Compound. These DeFi platforms consist of “smart contracts” that set the conditions of a trade, cutting out intermediaries like a brokerage or centralized exchange.

VC firms aren’t making investments based on sheer goodwill. They expect returns on capital and are likely to maintain stakes through token ownership or warrants. The platforms themselves may be decentralized, in the sense that anyone with some technical skills can write a “permissionless” smart contract and execute a trade without a broker/dealer. But that doesn’t mean the platform isn’t owned or governed by a corporate entity.

That rubs some tech gurus the wrong way. Twitter co-founder Jack Dorsey stirred up an online frenzy last December when he tweeted, “You don’t own ‘web3.’ The VCs and their LPs do,” referring to venture-capital firms and their investors known as limited partners. “It’s ultimately a centralized entity with a different label.”

Representatives for Dorsey and a16z declined to comment.

Crypto is proving enticing to VC firms partly because of the attractive “tokenomics.” For a traditional VC deal, the path from initial funding to exit usually takes five to seven years. In crypto, that timeline can be compressed to just two years, with VCs exiting their investment when a token goes live on an exchange or takes off on a DeFi platform.

“You have a very short time to liquidity—often it’s like 24 months—so even if the business doesn’t pan out, you can still exit,” says Carter. “That’s why crypto is so popular with VCs; even your losers can get liquidity, and you can exit before a product comes out.”

The nebulous nature of Web3 is also alluring for early backers. “There’s no definition, and that’s deliberate,” says Carter, who backs crypto start-ups. “If something is poorly defined, as an entrepreneur you can claim you’re building it even if you’re not. The lack of codification works to the benefit of people in the industry.”

The spoils of the crypto boom may already be accruing to the founders and early backers, leaving later entrants holding the bag. That’s apparent in the many projects that shut down or fizzle after their tokens go live on an exchange. The most public failure happened this month when an “algorithmic” stablecoin, TerraUSD, and a related token called LUNA collapsed, wiping out $40 billion dollars in value. Terra’s problems heighten concerns that crypto markets remain packed with dodgy projects and speculative excesses.

The potential windfall for VC firms doesn’t change the main argument from Web3 proponents, which is that blockchains can democratize networks, both economically and through their governance. Two blockchain innovations are making that possible.

Major blockchain networks like Ethereum that would form the basis for Web3 run on a system of processing transactions called “proof of stake.” Anyone who owns a blockchain’s native tokens can pledge or delegate them to the network operators that process and secure the blockchain’s transactions. In return, those stakeholders receive a cut of the transaction fees. The idea is to disperse ownership and let anyone participate in a network’s economics and growth, similar to owning shares of a software company that runs a widely used operating system. Proof of stake consumes far less electricity than first-generation blockchains like Bitcoin. They’re known as “proof of work,” because the network requires a massive amount of computing power to secure and process transactions.

Blockchains can also be democratized through decentralized autonomous organizations, or DAOs, which grant token owners a vote on how to assess transaction fees or to invest the group’s assets (one DAO tried unsuccessfully last year to buy a rare copy of the U.S. Constitution).

Here again, though, the financial interests complicate matters. Founders and early investors tend to control most of the tokens and oversee the DAO, similar to how a start-up’s equity is concentrated in a small group of investors before it goes public.

Some software engineers view Web3 as a step back from the original idea of Bitcoin—a peer-to-peer payment network operated by individuals worldwide. “The things calling themselves DAOs are often neither decentralized nor autonomous—the founders call all the shots,” says Molly White, a software engineer and author of a critical blog, Web3 Is Going Just Great. “This idea that Web3 will be egalitarian, with no one controlling the wealth, is an enormous contradiction.”

The web’s incumbents are far more likely to incorporate Web3 than sit by while the technology renders them obsolete. “It doesn’t seem like Amazon faces any meaningful Web3 threats right now,” said Ryan Selkis, CEO of crypto data firm Messari, in a recent report. “Google search and Microsoft Office may have impregnable walls,” he added. Apple is still dominant in hardware, first and foremost.”

Legally, Web3 is unsettling. Governments aren’t eager to allow financial products and services to shift from regulated brokerages, exchanges, and banks onto DeFi networks. Some legal scholars argue that DeFi is “Shadow Banking 2.0,” a high-tech version of the loosely regulated securities and other products that led to the financial collapse of 2008-09. “DeFi doesn’t so much disintermediate finance as replace trust in regulated banks with trust in new intermediaries who are often unidentified and unregulated,” said Hilary Allen, a law professor at American University, in a recent paper.

Bitcoiners espouse libertarian economics, yet Web3 has Marxist ideas of collective ownership and distributed profits, according to some views.

That’s not to say that Web3 is all decentralisation theatre, manifestos, and speculation. The idea that an online bookstore would transform into a cloud giant wasn’t apparent when Amazon first issued stock in 1997; Facebook didn’t exist back then, and TikTok was associated with a clock. Coders are working hard to build Web3, and the capital flowing in will support lots more apps, services, and development.

But it does face a Catch-22; without corporate and legal wrappers, Web3 is unlikely to attract institutions and individuals en masse. Companies will get involved for the profits. That means the hope for a flat web topography could keep drifting away.

The most likely impact is that the promise of a potential Web3 brings us something more like Web2.5, in which the web’s current landlords face pressure to lower rents and open up their walled gardens. In the end, that may motivate everyone to stick with the comforts of the internet we have today.