Web3 Explained | Part 2 of 2
The inner workings of tomorrow's internet
Hi friends 👋,
Happy Monday!
I hope everyone had a great Halloweekend. This year I seriously considered going as an NFT (not any one in particular, just the abstract idea of an NFT) but I had no idea how to execute without exposing myself as a Web3 evangelist to all my friends. So I went as a ghostbuster.
For anyone attending NFT.NYC, I hope you find pause amongst the madness to bask in this curious moment in time we find ourselves in.
This week thousands of NFT-enthusiasts are flooding the streets of New York to enjoy an action-packed schedule of Web3-themed events. Communities that have only ever interacted on Discord or Twitter are gathering together IRL to celebrate their shared love of jpegs and all things crypto. Iconically, the conference starts just after the anniversary of the release of the Bitcoin white paper (October 31st).
After seeing pictures and videos leading up to the event, I’m left asking: What could be more unexpected for the world than the shockingly large physical presence displayed by the NFT community? No doubt this event has turned heads, causing many to take a second look at Web3. To boot, Tim Ferriss released a stellar podcast with Web3 legends Naval Ravikant and Chris Dixon, at the same time that many tokens are breaking their all-time-highs, and right after Facebook changed its name to Meta. On the other hand, a majority of the world hasn’t even heard of ‘Web3’, there’s a good chance we’re in an asset bubble, and we have no idea how Web3 regulation is going to shake out. A curious moment indeed.
Which is why we’re back this week to round off our 2-parter on explaining Web3! Whereas last week’s article set the context for the internet paradigm we live in now (Web2), this article charges forward, explaining how we’ve been able to overcome the challenges of building open networks and what this means for the future of the internet.
Let’s get to it 🚀
P.S. As this is my longest article yet, I would feel remiss without telling you about my favorite tool for reading and taking notes on articles: Instapaper. No affiliation other than that I am a happy paying customer!
Web3 Explained: Part 2 of 2
To start, we would do well to recap what we explored in Part 1 of this series.
<sharply inhales>
The early internet started as a network governed by standardized and open protocols. Protocols will be mentioned many times in this piece, so it’s worth clearly defining what they are. A protocol is a defined way of transferring data between computers to complete a particular task.
When a protocol is ‘standardized’ it means that it is the widely accepted, de facto way of accomplishing that task, like sending an email
When a protocol is ‘open’ it means anyone can use the protocol to accomplish the task, like how we don’t need special permission to connect to the internet
The opposite of an open protocol is a proprietary one, where the rights to use the protocol are owned by private interests and companies
The early web, which we call Web1, was dominated by open, standardized protocols, like HTTP for connecting websites or SMTP for sending emails. These protocols still form the backbone of the internet, but are no longer the whole internet.
Midway through the internet’s history (early 2000s), there was a pragmatic and philosophical battle between those who saw the future of the web as open, and companies who built proprietary solutions. In the end, proprietary development won, mostly due to two major challenges in building the open web:
The state problem: Web1 never developed open protocols capable of storing data about users and their online activity. Without capturing this data, known as the internet’s ‘state’, early web applications couldn’t rely on Web1 protocols for a wide array of tasks (i.e. payments, search, etc.)
The challenges of open development: The process for developing and ratifying new open protocols was incredibly arduous. Collaboration and alignment were required across huge stakeholder groups, slowing down the rate of progress on new internet standards
In contrast, companies easily overcame the state problem by storing data on centralized databases, and could iterate on products without needing to move the entire industry with them. This advantage defined the current generation of the internet as being decisively led by companies and their proprietary internet solutions. We call this paradigm Web2.
Over time, Web2 companies grew to effectively become THE internet. Nowadays, the majority of our online experience is routed through a handful of mega-platforms that own distribution. While consumers have certainly benefited from great products and better online experiences, there are also critical problems with Web2’s composition:
Distribution Dependence: We rely on major platforms to provide the internet experience, and thus are exposed to profit motives and other rent-seeking behavior
Locked Value Chains: Winner-take-all network effects have centralized resources, enabling deep moats that prevent fair competition on most of the internet’s value chain
Digital Islands: Web2 operates as though built on siloed, digital islands. Data and users can’t be transferred across platforms
<loud exhale!>
How’d I do? If this is your first read through and you’re feeling in need of more depth, you can get that context from the first piece here.
The Necessary Ingredients for Web3
Now that we’ve defined Web1 and Web2, what about the fabled Web3? How might we describe it?
Luckily, we don’t need to theorize on what Web3 might look like - the movement to create a new generation of internet has already started and is relatively well-defined.
The current model for Web3 is a return to Web1’s vision for an open internet. It’s a digital experience where users and data can move more freely, enabled by open protocols that operate over a shared state.
As you might have guessed, the bolded words are important.
But even this description is filled with many promises. Open protocols for everything? Applications and users all sharing the same data? Didn’t we just outline crucial flaws that prevented these properties from existing in the open web?
You’re right. But much has changed over the past decade. New tools and platforms have rejuvenated our ability to collaborate over the internet. Breakthrough technologies like blockchain offer a solution to the open web’s technical shortcomings. In short, we can explain the rise of an open Web3 by answering the following two questions:
Have we solved the open state problem?
Is the process for open development now competitive with proprietary development?
We’ll answer both these questions, and along the way gain highly useful context for how Web3’s building blocks fit into the picture: blockchain, tokens, and a radical new approach to software development.
Fragmented vs Shared State
The state problem we’ve defined here is specifically the challenge of managing network data using open protocols. When computers successfully work together to manage this data, they have a shared network state - a dataset that everyone on the network has access to.
In contrast, Web2 has what we might call a fragmented state. There is no one snapshot of the network as a whole. Instead, Web2’s view of the internet is partitioned across different company databases.
Let’s imagine that today we want to create a new standard protocol for managing state across Web2. Our greatest challenge would be that everyone who owns a slice of the internet needs to be convinced to adopt our protocol. But the companies that own the greatest pieces of the internet are the least incentivized to do so. They are better off holding onto their data advantage, and building solutions on top of their private databases (problem #3, digital islands).
A great example here is Gravatar. Gravatar is an open API that website owners can use to establish user identity. The value here being that a user only has to make one Gravatar profile to have a compatible account on many websites.
Despite Gravatar’s 15 year run, it hasn’t been able to realize the vision of a shared online identity. As users, we still end up with dozens of accounts and passwords that need to be managed individually. Consider that nearly every website needs an account, but nearly every app builds their own solution. In fact, our closest experience to a universal account is logging in through Google or Facebook (problem #1, distribution dependence).
Moving forward, we’ll want the internet to be capable of supporting massively concurrent multi-user experiences, like the shared virtual reality space from Ready Player One. Except with a fragmented network state we are simply unlikely to achieve greater complexity.
A Solution to Open State
So just for fun, let’s picture the opposite: a massive database of containing a network’s state, with every application on top having read/write access. To escape generalities, this particular database will be used to manage payments by keeping track of user funds.
To make this work, we’ll define an open protocol for debiting and crediting user accounts. No matter which application is used, whenever a user transfers funds, the transaction needs to be reflected in the shared state. Right off the bat, we can see that managing data in this way has a number of interesting implications.
Any application that uses this database will have to honor the payment protocol. Otherwise, they risk separating users from their funds by inappropriately managing state. In other words, open state motivates adherence to open protocols
Open protocols exist in the world as open source code. This means anyone can make a better protocol for managing money simply by copying or ‘forking’ the code and adding useful new features. If successful, a better payment network could easily rise up overnight, meaning networks themselves become more agile
Now that all apps obey the same rules for managing money, it’s much easier for users to move around between any app using the database. So we also see that open state reduces switching costs for users
This seems to be an exciting new digital landscape, except for one thing: real life networks have bad actors. There is no guarantee that everyone will play by the rules. Especially in a network of money, if everyone has read/write access, anyone can fudge the data for individual gain. And when the data in a shared state can’t be trusted, the network on top is worthless.
This problem turns out not to be a technical challenge, but rather one of game theory. Can we create a system where all participants are incentivized to play by the rules? To do this, we’d want our system to have a few properties:
Transparency: Anyone can audit the database at any time
Consensus: All members of the network must agree on its current state
Economic Incentive: There is more to be gained in playing by the rules than breaking them
The first network to successfully combine all three of these properties was Bitcoin. Blockchain met the needs of a transparent and consensus-driven database. And Proof of Work attached a cost to network participation - to have a vote in consensus you’d need to do something expensive like set up a Bitcoin node.
More important, however, are the incentives that keep participants from misbehaving. In Bitcoin, a bad actor can only manipulate state if they overcome consensus, and to do this they need to own a majority of the network’s computers. This is hugely expensive, especially when you can play nice and receive Bitcoin as a reward.
It turns out that we can only maintain an open state by infusing networks with economic incentives. At first glance, it’s common to see tokens like Bitcoin and Ether as only an added layer of speculation on top of a blockchain. But the reality is that tokens are a mechanism for transferring value within the network, and fulfill the economic requirement needed to maintain an open state.
A Tool for Digital Collectivism
Since discovering that tokens are the key to open state, we’ve been developing exciting new ways to encode networks with incentives. Each new mechanism, like Ethereum’s Proof of Stake, adds to our toolkit for building new open networks. That’s why today we have networks that can do far more than manage payments.
It’s also why there’s no understanding Web3 without understanding tokens. On a base level, tokens establish incentives for network participants to choose collective interest over individual interest. And it goes deeper than preventing bad behaviour. It’s actually about encouraging stakeholders to engage in the best possible behavior for the network.
At this point in time, the best example for this is OlympusDAO’s OHM token. OlympusDAO has popularized the idea that if all token-holders act in the collective interest, it will enable peak financial return across the community of token-holders.
The table below is OHM’s Payoff Matrix - which is a visual tool used to express the game theoretic results of player’s choices in a game. Notationally, the choices of player 1 and player 2 are represented by (#, #), where ‘#’ is the amount of benefit a player’s choices awards the system.
If an OHM-holder decide to stake their tokens, this provides a system-wide benefit by buying OHM from the market (+1), locking away supply (+1), and providing liquidity for the protocol (+1). When two players do this, (3,3), they net the system 3 + 3 = 6 ‘benefit points’.
OlympusDAO is one of the first communities to directly popularize the merits of collective behavior, and as a result, the (3,3) meme has caught like wildfire across Web3 Twitter. The ‘(3,3)’ nomenclature appears in many Twitter handles, broadcasting an individual’s solidarity with the collective.
Did I mention they refer to each other as "“Ohmies”?
None of this would be possible without tokens creating explicit incentives for collectivism, making the idea of working together memetic and contagious.
Community Captured Value
By design, when stakeholders work together, networks are able to accrue value much faster. But tokens do more than define incentive structures, they also introduce a radical new way to include users in the value captured by digital networks.
When networks are early in their lifecycle, their value prop and utility are relatively undefined. A network might have a powerful narrative, but is unable to fulfill its promise without buy-in from the community. That’s likely why many crypto-networks were dismissed when they had low adoption numbers.
Critically, this phenomenon is not unique to Web3, but is actually common to all businesses based on network-effects, like social media sites and online marketplaces. Both AirBnB and Uber were laughed at until their marketplaces matured and communities bought into the concept of entering strangers’ homes and cars.
A key difference is that Web3 networks use tokens to implicate users in the success of the network. This enables a virtuous cycle, as all token holders, in some sense, are paid influencers. We see this clearly when Twitter users ‘shill’ one another their favorite cryptocurrencies or engage in tribalist discourse in the replies. While this quality can give any product a Ponzi-like after-taste, it is unreasonably effective at increasing the odds of network success. I’m reminded of the following line from our recent article, Tokenize Everything:
“Ethereum seeded its own success by making its core developers rich, as they can now work full time on increasing the value of the Ethereum network"
Whereas Bitcoin’s virtuous cycle is merely a social flywheel, Ethereum’s virtuous cycle gives its top contributors financial freedom, motivating talented individuals to build out the network. Developers can only increase the value of their position by increasing the value of the network as a whole. A weak example of this in Web2 products are customer referral programs. It’s only by making participation akin to ownership that a network can manifest the full power of this flywheel. So far, we can only do this using tokens.
A fascinating framework to conceptualize the impact of tokens is by using the infamous CAC metric (Customer Acquisition Cost). CAC is effectively how much a business pays to bring in new users. The goal of all businesses is to make more money from a user than it costs to bring them onto the platform.
In traditional products, businesses pay for customers by advertising or offering discounts. In Web3 products, tokens create flywheels that self-perpetuate virality. In effect, token network effects give businesses ‘negative CAC’ - a funny concept meant to imply that existing users are bringing new users onto the platform, at no cost to the business. But it’s more than just businesses that can benefit. In CommUNITY Economics we explored how NFTs infuse communities with network effects by making them compatible with vibrant digital ecosystems.
At this point you might be asking yourself: “All this token stuff seems pretty cool, but how does it… you know… work?”
I hear you. It’s hard to visualize how tokens fit into the internet because Web2 doesn’t really provide a way to ‘own’ things like tokens. A consequence of a fragmented state is that it’s near-impossible to track identity, and so ownership becomes an infeasible ideal. This is another area where Web3 brings profound changes.
A New Digital Identity
As we experience each day, Web2 companies define our identities as being dependent on applications and platforms. This looks like getting a new ‘identity’ or account for every service you use. In contrast, Web3 has what we’ll call an identity-focused model for the web. Applications define their services around a universally recognized notion of an account.
Now that an identity can be recognize by any application, it’s much easier to keep track of what you own. In fact, ownership in Web3 is like traversing the internet with a backpack of belongings. Your photos, articles, and subscriptions can move with you from platform to platform. This is achieved via cryptographically secure wallets that hold your digital possessions. From a tech perspective, adding new functionality to your identity is as simple as creating new ways to ‘own’ digital things. In other words, adding new protocols.
This is in stark contrast to Web2’s value-locked paradigm: where you can’t use your Instagram log-in to load photos onto Pinterest, or migrate your purchased apps from the Google Play store onto an iPhone.
The Self-Sovereign Identity
Identity isn’t just the schematic center of Web3, but a philosophical one as well. Web3 operates on the principle that a user should control all aspects of their online persona without any intermediaries. This is embodied by the idea of the Self-Sovereign Identity. Achieving the Self-Sovereign Identity requires changing the web on two main fronts: trust and ownership.
We already understand how tokens and wallet-based identities fulfill principles of self-sovereign ownership, so it’s worth explaining how Web3 removes the need for intermediaries.
Web3 systems aim to be trustless. You should be able to partake in a Web3 transaction without needing to bring ‘trust’ to the table. The modern legal system is an example of a trustless system in the real world. When you and a business partner both sign on the dotted line, your shared trust in the law creates the abstraction of trust between you.
Web3 accomplishes this same effect with code and cryptography. It’s an online network where you can engage with any party because you trust the program defining your interaction. And unlike the law, code is not open to interpretation.
Between understanding open state, tokens, and this new model for identity, we arrive at quite a full understanding of Web3. To me, these ideas are best captured by one of my favorite definitions, from (you guessed it) Chris Dixon. Chris defines Web3 as:
“An internet owned by users and builders, orchestrated by tokens”.
I think that sums it up quite nicely, don’t you?
The Fundamental Forces of Web3
So far, we’ve discussed ideas that are foundational to a new internet, but remember that our interest in Web3 had certain aspirations. We want to know if Web3 can undo the problems we inherited from Web2 (Distribution Dependence, Locked Value Chains, and Digital Islands).
With a new internet comes new forces that govern the ebb and flow of value and control. Web3 operates on entirely new rules, Fundamental Forces that shape the experience of all users and builders: These forces are:
The Law of Implicit Distribution
The Principle of Fluidity
Plug, Play, and Improve Dynamics
The Law of Implicit Distribution
In Web3, there is no such thing as an application having an entrenched user base. Users interact with the internet through their cryptographic wallets, and the set of wallets is maintained by the network itself. In a sense, all applications and users are on an even playing field when it comes to distribution. Any Ethereum address is accessible to any Ethereum application, and vice versa. This is the the Law of Implicit Distribution.
This creates a huge economic incentive for businesses to solve user problems. Companies don’t have to work as hard to build out distribution - in fact the problem of distribution in Web3 is almost entirely reduced to the effort of marketing. Users need to know about projects before they can try them out. This explains why products with high ‘meme-value’ have a natural advantage. Successful projects harness virality by doing something culturally notable or functionally meaningful. Once enough users have validated a project, the flywheel starts spinning.
The Principle of Fluidity
Web3 users have lots to gain by being early to a great project. There are meaningful, even life-changing rewards, to be had by obtaining an informational edge. This creates a huge incentive for users to try new products and networks, which they can do by simply exchanging a few tokens (e.g. Bitcoin → Ethereum).
Implicit distribution allows users to transfer value into any project as soon as it’s live. Combine this with the incentive for experimentation, and the velocity of value transfer goes supersonic.
This is the Principle of Fluidity. It’s never been easier for users to try new things, and there’s never been greater incentive to for them do so. A result of this principle is that businesses can acquire a majority of their addressable market in what seems like record-breaking speeds. There are plentiful examples of this happening:
OlympusDAO’s treasury increased in value from $5M to $638M between August 2021 and November 1st, 2021
Axie Infinity’s peak daily users increased from 5500 in October of 2020, to a whopping 2 million daily users in October of 2021
Plug, Play, and Improve Dynamics
A version of the Principle of Fluidity also appears in product development. Because Web3 operates on code that is open and standardized, applications are vastly composed of open source code. This code is freely available to be copied and used by the community, which translates to absolutely ludicrous product velocity.
That’s why there seems to be a hot new product or trend sweeping through Crypto Twitter every week. Because there is.
My favorite analogy for the Web3 ecosystem is that it behaves like an evolutionary petri dish. Every product and use case generates offspring, each a genetic remix of its predecessor recombined with crazy new ideas from the community. Every now and then, a new combination resonates with the ecosystem and becomes a new primitive for further innovation.
You’ll often hear that Web3 software behaves like ‘lego blocks’. Code can interoperate and work together frictionlessly because code is accessible, open, and standardized. For this reason, Web3 is the ultimate, plug, play, and improve ecosystem.
Vast stretches of the value chain are exposed to the peering eyes of the community. Any proficient developer can identify a weak spot in the chain, fork the code, and offer a better solution to the entire network.
Whereas Web2 platforms look like monolothic, single-owner platforms, Web3 value chains look more like a river delta; branching layers of code created and owned by communities.
Final Thoughts
In truth, there is so much more to say. This series likely deserves a Part 3 to dive deeper into other topics, analyze case studies, and speculate even farther into the future.
There are so many questions worth exploring together, like:
How should we think about the speculative, bubble-like behavior that results from using tokens? Should we be concerned about the hyper-financialization of our world?
Will Web3 be followed by a generation of internet that once again becomes centralized? Or have we created an internet that is impervious to centralization?
Why does Web3 matter compared to other problems we’re facing, like climate change and rising social inequality? What is the intersection between Web3 and these problems?
Each of these inquiries deserve an article in their own right.
If you’re reading this right now, I applaud you for your curiosity and dedication to learning. Web3 can be daunting. It’s the fastest moving area of technology I’ve ever encountered. I hope this series has provided you with useful frameworks and inspired you to dive deeper. If you feel like you’ve only scratched the surface… join the club. But no matter what, at the end of every piece I’m always left with the same feeling.
What a beautiful and exciting world to live in.
How to get started in Web3
For further reading, you can check out my curated Web3 reading list.
Get paid to learn about Web3 by using the crypto-onboarding platform RabbitHole
Follow thought leaders on Twitter. My favorite follows are: Annika Lewis (@annikasays), Chris Dixon (@cdixon), David Phelps (@divine_economy), Gaby Goldberg (@gaby_goldberg), Mario Gabriele (@mariogabriele), Natasha Che (@realnatashache), Nick deWilde (@nick_dewilde), Packy McCormick (@packym), 6529 (@punk6529) - and probably others I’m forgetting!
If you have any questions or areas you need further clarity on, you can reply to my newsletter or DM me on Twitter. I see every message.
If you enjoyed this article consider subscribing for weekly content on the technology that will shape our future!
If you really enjoyed this article consider sharing it with an intellectually curious friend or family member!
Let me know what you thought about this piece on Twitter.
With gratitude, ✌️
Cooper