An introduction to what Web3 and DeFi can bring to the world

Usually, people hearing the word “crypto” either associate it with pure speculation or with pseudo-crypto-influencers selling their umpteenth training course to get super rich super fast or, even worse, to entire pseudo-crypto-bank like FTX playing with billions of dollars. Mainstream media stop there because these are the juiciest things to talk about — headlines sell, knowledge does not —. This is heartbreaking knowing that an entire industry led by strong values (open-source, transparency, decentralization, privacy protection, etc.) is trying to push things forward. As part of this space, my goal is to spread knowledge and educate people about it. This article should open your eyes to this industry.

As described by Chris Dixon (cofounder of many software startups), the web as we know it faces different eras. The first era (from 1990 to 2005), called web1, was all about building open-source software and protocols that we still use, such as TCP/IP — powering the Internet — or SMTP — powering the junk emails you receive every day —.

The second era, called web2 (from 2006 to 2020), marks the advancement of proprietary platforms, such as Facebook or Twitter, leveraging web1 tools to build their own proprietary and closed-source software. This era really started with the release of the iPhone in 2007, when developers and users turned from open-source projects to build applications.

Proprietary platforms won over open-source ones because they provided a much better user experience (UX) and convenience. Open-source tools were too cumbersome for average users. They needed to store their own files and run their own servers, etc. Only very nerdy people could do that at the time.

https://twitter.com/cdixon/status/1444422178192068611

Storing data privately in siloed infrastructures imposes a high switching cost to users to migrate from one platform to another, effectively trapping them in the system. These platforms can then extract and capture the value created by users while leaving them without credible alternatives. If users disagree with the platform's management over privacy or data capture, their only option is to boycott the platform. It hinders innovation and reduces the diversity of projects.

The advancement of public programmable blockchains marks the start of the web3 era.

As blockchains cannot be shut down, they offer much more guarantees for developers to build their solution on top compared to Facebook’s API, which can change or, even worse, completely cease to exist at any time. For instance, the platform that I’m currently using to publish those articles, Mirror, stores the data on a decentralized network called Arweave. If the company behind it shuts down, all the content, network, and more can still be retrieved onchain so another team can easily revive the project, and projects built on top can still operate.

Moreover, since the code is open-source, developers can tweak, adapt, or improve existing pieces of code, fostering innovation.

Combined with decentralized ownership (section below), It facilitates the creation of open services and public goods that can compete with centralized players in terms of UX and scalability.

As we’ve seen, internet monopolies and, to a larger extent, financial infrastructures have misaligned economic interests with their users. Users are locked in while the platform extracts much more value than it provides. In addition, only a few individuals control the platform, leaving users without any say over decisions. Some users even face deplatforming (preventing someone from accessing a platform) without notice.

DAOs aim to fix this by managing a project without central authority. Instead, the ownership and voting power are distributed among a larger pool of participants. In web3, users are not just "consumers"; they become owners of the digital services and platforms they use.

As the Variant team said:

Simply put: the products and services that will define web3—and the next generation of the internet—are those that transform users into owners. We call this the ownership economy.

The positive side effects are numerous:

• Decentralized ownership boosts user loyalty, innovation, and participation which contributes to improving the service.

• It makes people stick to the product they use.

• It incentivizes newcomers to join and participate in the journey.

• People benefit directly from the value they create, it’s not captured by a few.

While DAOs may not make quick decisions as efficiently as startups due to their nature (consider how challenging it is to coordinate with just one person, let alone hundreds or thousands), they are perfectly suited for critical decisions that can impact many stakeholders.

The Decentralized Finance sector (DeFi) will become much more secure and resilient than the legacy financial system. This is because traditional finance (TradFi) and DeFi have opposite operating modes as described below.

DeFi protocols, such as lending protocols or decentralized exchanges (DEX), are typically small, open-source, and immutable pieces of code deployed on public blockchains. The inability to update these pieces of code is not a bug; it's a feature. No human can interfere with the code and its logic.

TradFi institutions are very large and opaque, sometimes poisoned by corruption, with thousands of people in the company, but only a few people have access to the codebase.

From a security perspective, TradFi actors seem stronger, thanks to their opacity. Vulnerabilities in their code should be harder to find and exploit. In fact, you can see them as fragile entities with many thin layers of protection, like an onion. Threats are expected to be detected and patched as they come in.

This starkly contrasts with DeFi, where the best hackers in the world can read the code and attempt to drain users' deposited funds, sometimes making instant profit. Patching vulnerabilities after an incident is not viable; it is either impossible or too late, as the funds are already gone. Hence, security measures must be taken proactively to mitigate risks.

To increase smart contracts’ defensibility, protocol designers must carefully consider any vulnerability, from basic math roundings to market manipulations. This is especially important since programmable blockchains have an uncertain action space; anyone anywhere can write another smart contract with custom logic that can interact with existing contracts. You can see DeFi protocols like money Legos where anyone can add their brick on top of others.

You might think that this open-source aspect is DeFi's Achilles heel. In fact, it’s the key component to unparalleled resiliency.

Natural selection operates. Code with flaws is quickly hacked or wiped out, effectively installing a positive feedback loop from which other protocols can learn. The secured ones can run forever undisrupted, benefitting from Lindy’s effect. Like Nietzsche would say, “what doesn't kill me makes me stronger.”

This is especially true since the space is still in its infancy; volatility is relatively high, exposing DeFi protocols to much more stress than institutions in TradFi. As the space matures and volatility decreases over time, protocols built to handle such harsh conditions will be considerably more resilient than their TradFi counterparts. Take the preparation for a marathon as an example; the more you train yourself, the longer and faster you’ll be able to run until you’re able to do a complete marathon.

Over time, this process makes the whole DeFi ecosystem anti-fragile.

On the opposite, the feedback loop is broken in TradFi. When a “too big to fail” institution is near bankruptcy, governments are steering the wheel to the rescue. It’s as if you were skipping each training before your marathon. There’s a 99% chance you’d fail at your marathon. Unfortunately, this is what happened during the 2008 crisis and, more recently, with the bankruptcy of SVB. Large institutions were not prepared for their marathon.

To sum up, DeFi's open-source aspect and rapid improvements will enable this space to outperform TradFi to endure crises and unexpected events

As written above, the code powering DeFi protocols is open-source. Any developer with the right expertise can read and understand the code. The behavior is fully known in advance, ensuring predictability regarding what the code is capable of.

Again, this starkly contrasts with traditional finance infrastructures where only accredited individuals within the company, external consultants, or compliance teams have access to the code.

You may wonder how the average person without coding knowledge could possibly audit a protocol. Good point. They can’t (sorry again). Those persons would indeed need to trust the codebase much like they trust their bank. However, the pool of persons able to decipher that codebase can only grow larger as learning resources are freely available online and accessible to all. Any developer can turn into an auditor and raise a warning if necessary.

Moreover, for immutable DeFi protocols, the behavior can’t change. They don’t rely on trust (a fallible human). Protocols are cold, rigorous, and unopinionated code. They are trustless. And that’s something to strive for as it brings assurance of execution

Besides the code, since DeFi is built on top of public blockchains, users’ actions are public and stored forever. This enables a whole new level of transparency for financial pieces of infrastructure far from TradFi opacity.

Users can monitor this onchain activity, perform analytics, and raise alarms when they spot something worrying. A good example is Dune Analytics, a platform allowing anyone to build public dashboards, graphs, and studies by directly querying and fetching onchain data. Empowering individuals to become their own Sherlock promotes responsible actions by DAOs and projects. This fosters accountability and enhances the system's resilience.

Many projects, including Angle (a project issuing a euro stablecoin), offer analytics on the protocol reserves and deposited funds. Although everything is already verifiable onchain, making it easily accessible is a significant advancement compared to TradFi.

More transparency can help write more tailored policies and regulations. The better we understand a system, the more effectively we can make meaningful decisions. It can also assist in combating money laundering and fraud, as transactions can be tracked even after they occur, discouraging misconduct.

Bonus point for this section: it should reconcile most people who are concerned about climate change (like I am) but disregard crypto due to its supposed “not so green” aspect.

We’ve seen that the 2 sections above make DeFi a significantly better infrastructure on which to build the financial system.

By automating what can be automated DeFi has the power to:

• Remove any unnecessary intermediaries taking fees at each step, thus drastically cutting down costs for end users (see in a section below the 80% cost cut for remittance payment).

• Remove financial actors' need to duplicate and run their own server infrastructure with their own security team. The logic is delegated to the blockchain and its decentralized network of nodes. It means that fewer data centers are required to make the financial system work. As a reminder, data centers were estimated to consume around 200 TWh in 2018 (~1% of global final electricity demand). Since the shift from Proof of Work to Proof of Stake, the Ethereum blockchain consumes “only” 2,601 MWh, roughly the equivalent of the annual electricity consumption of 244 American households (obviously not the greenest ones on the planet). As a reference, the cost of a transaction on Ethereum is in the same order of magnitude as a transaction via Mastercard, which is planned to improve over time. This deserves to be known to clarify a common misconception: not all blockchains are as energy-consuming as Bitcoin.

• Reallocate some brilliant minds from these duplicated infrastructures to tackle new topics rather than reinvent the wheel.

According to the World Bank's Global Findex database, as of 2021, approximately 1.4 billion adults worldwide remain unbanked. This issue primarily affects women and impoverished individuals living in rural areas.

Access to basic banking infrastructure — primarily guided by access to mobile phones — leads to more stability as people gain access to a reliable system. This fosters local economic growth, gets people out of poverty, and makes government policies more efficient (by easing support to small nascent companies, for example).

Although the digitization of financial services is rapidly evolving, particularly in the wake of COVID-19, much work still needs to be done. DeFi could be a catalyst in this process; in practice, users just need a smartphone and an internet connection, whose penetration is increasing rapidly in emerging and developing countries. The Celo blockchain is particularly involved in this topic.

Additionally, many immigrants send money to their families to sustain them (281 million for a volume of $600B in 2022). A study by Uniswap Labs, a major crypto-decentralized exchange (DEX), indicated that blockchain solutions could reduce remittance payment costs by 80%. This could save unbanked and underbanked individuals $30 billion per year. A similar study on lending and borrowing at Morpho is being considered!

Beyond the unbanked, numerous populations grapple with unstable economies. For the record, I went to Istanbul by train last November. There, I was searching for a restaurant and went through Google Maps, spotted a very nice restaurant, and briefly checked the menu on photos. The food looked good and was very reasonably priced, so I decided not to overthink and went there. When I sat at a table, I realized that prices were like 10 times higher than in the photo! Below you can see the price of the Turkish Lyra against the Euro here over time.

This is a reminder that Western countries are not used to very high inflation, while it’s the everyday life of dozens of countries in South America and East Asia.

DeFi, especially stablecoins, presents an effective solution for these populations to maintain their savings and purchasing power. This is evidenced by the widespread adoption of stablecoins in countries such as Venezuela, Argentina, and Turkey as well, where credible alternatives are lacking.

Most financial products yield returns for their owners, including risk-free investment opportunities like short-term government bonds. Those are mostly accessible to persons or entities with enough capital, i.e., rich people. Depending on how much you have in your bank account, the services and opportunities you’ll get from your bank will be drastically different.

With disintermediation and open access, the same opportunities will be accessible to a broader pool of users making the system more equal.

I mentioned several times that the system was transparent. If that’s the case, you might be concerned about your privacy. After all, you wouldn't want your neighbor to know that you've purchased and worn quirky Christmas socks at home, would you?

I’ve got your back. With the advancement of cryptography, especially Zero Knowledge Proof (ZKP), you can prove the validity of a statement without revealing the statement itself. A concrete example would be to prove that you’re indeed a French citizen without revealing who you are.

It unlocks some interesting use cases for DeFi and web3 in general:

• Decentralized identity with protected data.

• Keep protocols fully permissionless while restricting access only to assets that must enforce KYC/AML rules (like government bonds) without revealing who you are.

• Let dApps be compliant with data regulations like GDPR.

• Anonymous voting.

• Keep protocols fully permissionless.

By enhancing data privacy and security, Zero-Knowledge Proof (ZKP) can help projects comply with regulations and users’ data without harming decentralization or permissionlessness at the protocol level.

If you’ve reached the end of the article, you know more about web3 and DeFi than 99% of the rest of the world. Very cool, isn’t it? It has several advantages:

• You can now brag about it with your friends (don’t forget to share with them the article btw).

• You’d be more skeptical about "know-it-all" persons saying crypto is just garbage (you can send them my article).

• You may have found this space fascinating (it is!) and would like to know more. I highly recommend you to read Read Write Own by Chris Dixon. It’s a short book describing in a much more exhaustive and clear way what I’ve introduced in this article.

Web3 and DeFi have much more to offer than what media are willing to talk about. Please help spread the word and share this article with at least one person you know!

Thank you,

Merlin

PS: Special thanks to Sixtine Mailleux, Bastien Velitchkine, and Achraf Lamoum for your feedback and review.