Web3 for TradBiz — Web3 and Crypto Foundations (5 of 14)
Advanced Web3 topics
Explore value exchange models, tokenomics, cross-chain bridges, and security considerations in more detail
Now that we’ve covered the basics, it’s worth spending a bit more time exploring a few more advanced Web3 topics, including value exchange models, tokenomics, bridges, and security.
All Web3 ecosystems involve multiple participants who interact and create value for each other and the broader network. Think about Web3 ecosystems as focused economies where participants are coordinated and incentivized to create value around specific use cases. Value exchange models show how value is transferred between stakeholders to achieve an ecosystem’s objectives. These stakeholders frequently include a diverse set of participants, including users, developers, foundations, DAOs, validators, oracles, and investors. Users are the individuals, organizations or even software bots that are the primary beneficiaries of an ecosystem’s use case, such as people acquiring, storing, or spending a cryptoasset. Developers create, update, and manage the software on which the network runs, which often includes not only blockchain-specific functionality, but front-end websites and mobile apps used to access the ecosystem’s services. Some ecosystems have established non-profit foundations in jurisdictions like Switzerland that play a role in guiding and funding the ecosystem’s development. Others have organized around a decentralized autonomous organization, or DAO, which we discuss later. Layer one and two blockchains need some combination of miners, validators, and nodes, depending on the type of consensus mechanisms they use. Oracles may be used to provide validated external information that the ecosystem’s smart contract need to function, such as a cryptoasset’s current market price. Investors provide capital to the ecosystem in exchange for tokens that have the potential to appreciate over time, comparable to the roles venture capital and private equity firms play in the TradBiz world.
Tokenomics are mechanisms for driving ecosystem value. Just like traditional economies are based upon economics principles, so are Web3 ecosystems. Tokenomics are the mechanisms for creating, allocating, distributing, using, and exchanging tokens within these economies. In this sense, designing and governing a Web3 ecosystem is a bit like playing the role of central banker, as one needs to take into consideration concepts like token supply, issuance, distribution, burning, and fee structures. Maximum supply is the highest number of tokens that will ever be in circulation, usually determined upfront in the design of the ecosystem. For example, Bitcoin’s maximum supply of 21 million is encoded in the protocol, making it exceedingly difficult to change. Circulating supply refers to the number of tokens that have been issued to date, which in Bitcoin’s case is a bit more than 19 million. Issuance mechanisms determine how tokens are created and issued, differing greatly based upon the consensus mechanisms and use cases of each ecosystem. Once tokens are created, distribution mechanisms guide how they are allocated and distributed to stakeholders, such as rewards or incentives for ecosystem participation. Some ecosystems also have burning mechanisms meant to decrease token supply, which can be used to mitigate inflation or increase the future value of tokens. Finally, there is a wide range of fee structures used to fund ecosystem operations and development.
When evaluating the long-term sustainability of Web3 ecosystems, it is important to think about how each ecosystem’s tokenomics will impact the token supply curve over time. For example, Bitcoin had high token emissions in its earlier years, gradually decreasing over time with so-called halving rates that occur approximately every four years. Other projects, such as alternative layer one EOS and decentralized exchange Uniswap, are inflationary with token emission based on pre-determined inflation rates. Many decentralized apps have fixed supplies, with the maximum number of tokens minted at the time of launch. Examples of fixed supply ecosystems include Basic Attention Token and Chainlink. Binance coin and lending platform Aave utilize deflationary models, minting a maximum supply of tokens upon launch, which are then bought back and burned based upon the project’s utilization level, until the minimum supply has been reached. Mint-and-burn models, such as distributed telecom provider Helium and more recently, Ethereum, implement burning mechanisms to control inflation, based upon the project’s utilization level, and may or may not have a maximum token supply. Other token supply variations exist to manage stablecoins, NFTs, and other digital assets.
Cross-chain bridges enable interoperability between Layer One and Two ecosystems. Until relatively recently, there were limited options to move digital assets across different layer one and two ecosystems. To move value to a new ecosystem, users first had to exchange fiat currency or an existing cryptoasset, such as Ether, for a cryptoasset native to the desired target chain, like Sol on the Solana network. This is changing, as cross-chain bridges have emerged to connect two or more blockchain ecosystems, facilitating the transfer of cryptoassets, enabling dApps to utilize multiple blockchains, and allowing users to participate across ecosystems more easily.
Bridges work by allowing users to lock a cryptoasset into a smart contract on one network, which then issues the equivalent asset on another network. For example, to utilize decentralized finance (DeFi) apps running on the Ethereum-compatible Polygon network, one deposits Ether into the Polygon bridge, which then issues an equivalent amount of wrapped Ether on Polygon. While bridges provide more seamless experiences across blockchains, they are more centralized than the blockchains themselves, and are thus subject to greater security risks. In fact, there have been several notable hacks of bridges that have resulted in the loss of cryptoassets valued in the hundreds of millions of U.S. dollars.
Security is an important consideration when evaluating Web3 solutions. Keep in mind that Web3 transfers many responsibilities from companies and other legal entities to smart contracts and ecosystem users. This means that for many use cases there are no equivalents to banks, government depository insurance, or written legal contracts. Because of this, Web3 users should be aware of the various attack vectors that could potentially threaten crypto ecosystems, including those targeting network states, nodes, consensus rules, and token owners.
Layer one and two networks need to be designed to fend off a broad range of network state and operations attack vectors. These include double spending attempts to spend the same tokens twice, denial-of-service shutdowns caused by excessive spamming, 51% attacks where a single entity gains control of a blockchain’s consensus, forks that cause permanent divergence of blockchains, and many other attacks.
Every Web3 ecosystem, regardless of its layer in the Web3 stack, is also subject to smart contract risks, in which vulnerabilities in the smart contract code could lead to internal failures or external attacks. Potential smart contract risks include a malicious actor taking control of the code to burn existing tokens, mint new tokens, or transfer tokens to unauthorized addresses. Risks could also include programming logic mistakes that cause the smart contracts to not work the way they are supposed to. Fortunately, teams are learning from mistakes as Web3 matures, implementing tools and best practices to mitigate smart code risks. These include completing comprehensive contract testing on testnets before deploying live on mainnets, conducting smart contract security audits, hiring developers with up-to-date knowledge of vulnerabilities, and launching bounty campaigns to identify bugs early. Smart contract insurance providers, such as Nexus Mutual, have also emerged to cover users in the event of losses.
While the above discussion focused on blockchain and smart contract risks, token ownership and custody represent an equally important risk. Many crypto owners place their tokens into the custody of a third-party service, such as a centralized exchange, thereby removing control of the assets from the actual owner. By centralizing tokens into a single entity, this opens the possibility of high-value honeypots that hackers could attack. A common saying in Web3 is “not your keys, not your crypto,” which refers to the trust a user places in a custody provider who holds crypto for them, rather than securing keys individually.
Even when individuals hold keys themselves, there are numerous ways in which they could lose access to their cryptoassets. Phishing attacks, for example, use fake emails, websites, links, impersonations, tech support or other methods to gain access to a user’s private keys. Private keys and backup seed phrases should never be kept on an unencrypted computer, since this could make them accessible by hackers via malware infections. There is also the real risk of simply losing access to private keys, such as when losing a mobile device where the user has not properly backed up and secured their seed words. Best practices include being constantly on guard for attacks, as well as properly backing up and securing the seed phrases used to access crypto accounts.
These advanced topics provide a more complete picture of how Web3 works. In this chapter, we’ve covered how value exchange maps help us map how multiple participants in Web3 ecosystems interact, creating value for each other as well as the broader network. You now understand that tokenomics help coordinate ecosystem value, and include mechanisms governing token supply, issuance, distribution, and fees. Cross-chain bridges are enabling interoperability between layer one and two blockchains, paving the way for a more seamless multi-chain future. Finally, we discussed why security is such an important consideration when evaluating or using Web3 solutions. The next chapter will focus on understanding and Using crypto wallets, including setting up your own if you haven’t done so previously.
Monchester Macapagal and Kris Caigas of AcceleratingBiz contributed significantly to the research, writing and production of this series.
Explore other Web3 for TradBiz insights and resources at acceleratingbiz.com.
Click on the links below to progress through the Web3 for TradBiz series:
[1] Web3 for TradBiz introduction
Web3 and crypto foundations
[2] Why embrace Web3 now
[3] Inevitable Web3 future
[4] Crypto and Web3 basics
[5] Advanced Web3 topics
[6] Using crypto wallets
Use cases and value propositions
[7] Web3 use case categories
[8] Decentralized finance (DeFi)
[9] Non-fungible tokens (NFTs) and the Metaverse
[10] Decentralized autonomous organizations (DAOs)
Web3 implications and opportunities
[11] Web3 impact on TradBiz market and business models
[12] Emerging Web3 investment opportunities
[13] Evidence of mainstream Web3 adoption
