Exploring The Future of Web3 Wallets: Innovations, Challenges, and Key Questions to Ask

Introduction

This will not be another history of the evolution of Web3 wallets. Numerous articles on that topic have been published in recent months, and, likely, you have already read some of them. Instead of merely recounting the development, this article aims to delve into the current innovations, challenges, and key questions we need to be asking. Let us begin.

This article will first investigate the current state of Web3 wallets, referred to as Wallet 1.0, as well as advancements in Account Abstraction (AA), specifically ERC 4337, that are propelling the evolution of the next generation of wallets, referred to as Wallet 2.0. Additionally, the potential risks and limitations related to Wallet 2.0 will also be discussed.

Given the rapidly evolving nature of the Web3 wallet space, this article aims to establish a framework that can assist builders and investors in identifying long-term value. The framework will facilitate their approach to building and investing in this area. At its core, this framework should address five key questions:

1. Is this a great business in its own right?
2. Will building a Wallet 2.0 unlock a new way to solve a problem that is 10x better than before?
3. How does the business build a sustainable competitive advantage, particularly where there is heavy reliance on first-mover advantage?
4. Can the business find a distribution angle over incumbents that can add smart contract functionalities to their existing products?
5. What assumptions must we believe for this to succeed over existing wallet solutions?

Each of these questions will be explored in greater detail. However, let us first examine the current state of the Web3 wallet space to provide better context.

“Not your keys, not your coins”

The emergence of cryptocurrencies has revolutionized our perception of money and assets. However, the prevailing distrust in traditional financial institutions has necessitated the development of reliable and secure storage solutions. Recent failures of financial intermediaries such as FTX, BlockFi, and SVB have highlighted the fact that the safety of customers’ assets is dependent on the solvency of the provider. As a result, users are increasingly turning to cryptography instead of intermediaries for greater security. Web3 wallets have emerged as a solution to this problem by offering users the ability to securely store and manage their crypto assets while maintaining full control of their private keys. As the saying goes, “Not your keys, not your coins.”

If you don’t control the private keys to your crypto assets, then you don’t truly own them. Web3 wallets have emerged as a solution to this problem, allowing users to securely store and manage their crypto assets while maintaining full control of their private keys.

Key Attributes of a Web3 Wallet

Web3 wallets are a type of digital wallet designed to work seamlessly with decentralized applications (dApps) that use blockchain technology. Unlike traditional wallets, Web3 wallets allow users to retain full control of their assets, eliminating the need for third-party intermediaries like banks and financial institutions. Some of the key attributes of a Web3 wallet include:

Decentralization: Web3 wallets are decentralized, operating on a peer-to-peer network without reliance on centralized servers. This makes them more secure and resistant to hacking and other security threats.

Interoperability: Web3 wallets are designed to work with various blockchain protocols and cryptocurrencies, allowing users to manage and store multiple assets in one place.

Security: Web3 wallets use advanced encryption techniques to secure private keys and other sensitive information, protecting users from theft and fraud.

User-friendly: Web3 wallets are designed to be user-friendly, with simple and intuitive interfaces that make them accessible to anyone.

The Current Landscape of Wallet 1.0

Currently, the landscape of digital wallets can be broadly categorized into two types: custodial and non-custodial wallets.

Custodial wallets are services where a third-party company (e.g., centralized exchanges) holds and manages users’ private keys, essentially taking custody of their cryptocurrency assets.

On the other hand, non-custodial wallets are wallet solutions where users have full control over their private keys, ensuring they are the sole custodians of their crypto assets. Non-custodial wallets can be further separated into three categories: externally owned account (EOA) wallets, smart contract wallets, and multi-party computation (MPC) wallets.

1. EOA wallets are the most common digital wallets used to store and manage cryptocurrencies. These wallets require users to hold their private keys and are often provided by centralized exchanges or wallet providers. Examples of EOA wallets include Metamask, Backpack, Phantom, Rabby, and Rainbow.
2. Smart Contract Wallets are decentralized wallets that use smart contracts to manage assets. These wallets are more secure and flexible than EOA wallets, allowing for advanced functionalities such as social recovery and multi-sig support. Examples of smart contract wallets include Argent, Safe, and Sequence.
3. MPC wallets use a technique called threshold cryptography to enhance security. The private keys needed to authorize transactions are split into multiple pieces and distributed among different parties, ensuring that no single party can access the keys independently. This approach significantly reduces the risk of a single point of failure or attack, making it more difficult for hackers to steal funds. Examples of MPC wallets include Fireblocks, ZenGo, Coinbase MPC and Particle Network.

Lastly, it is essential to mention the emerging infrastructure category, where teams are developing solutions and primitives that enable other developers to create and customize wallets for end-users, streamlining the wallet creation process.

Current Challenges in Wallet 1.0

While crypto wallets have made significant progress in recent years, there are still several challenges that need to be addressed to make them more accessible and user-friendly. Some of the key challenges facing crypto wallets today include:

Inaccessibility to average users: Crypto wallets can be difficult for the average user to understand, making it hard for them to take advantage of the benefits of blockchain technology.

Complex onboarding: Setting up a crypto wallet can be a complicated process with many steps involved. This can be a barrier for new users, especially those who are not tech-savvy.

Lost or stolen seed phrases: Crypto wallets rely on a seed phrase, which is a series of words used to recover the wallet if the device is lost or stolen. However, if the seed phrase is lost or stolen, it can lead to the loss of all funds stored in the wallet.

Fragmented chains: Different wallets for different chains add another layer of complexity, making it harder for users to manage their assets seamlessly across various blockchain networks.

Even crypto OGs are losing their funds to exploits, as we most recently saw with this wallet-draining operation that @tayvano_ uncovered.

To address these challenges, wallet builders are exploring new approaches and technologies to create more user-friendly and secure digital wallets that can be easily adopted by the mainstream audience.

Innovations in Account Abstraction (“Why now?”)

The emergence of Account Abstraction (AA) in the Ethereum network has brought significant advancements to the development of Web3 wallets. AA introduces programmability on-chain through smart contracts, adding flexibility to Web3 wallets.

A key difference between EOA and smart contract accounts

Traditionally, only EOAs could control funds on the Ethereum network. This meant that smart contracts had to rely on EOAs to execute transactions, which limited the scope of what smart contracts could do.

With AA, smart contracts can now control funds directly, making them more powerful and versatile.

Why ERC 4337 matters today

One particular development that holds significance today is ERC 4337. This Ethereum standard enables AA on the protocol without any changes to the consensus layer. ERC 4337 introduces several key features that enhance the user-friendliness and accessibility of Wallet 2.0.

Social recovery: Wallet 2.0 can now have multiple owners, allowing for social recovery of lost private keys.

Atomic multi-operations: Smart contracts can execute multiple transactions as a single atomic operation, simplifying complex transactions and ensuring their integrity.

Pay transaction fees with ERC20 tokens: Smart contracts can now pay for transaction fees using ERC20 tokens, allowing for greater flexibility in payment options.

Paymaster: Wallet 2.0 can involve third-party paymasters who can sponsor transaction fees on behalf of users, optimizing gas usage and enhancing efficiency.

These features make Wallet 2.0 more accessible and user-friendly, which is crucial for the adoption of Web3 wallets.

The Road Ahead for Wallet 2.0

The development of Web3 wallets is still in its early stages, and there is much work to be done before they become mainstream. Wallet 2.0 is the next stage of development for Web3 wallets, and it will require a concerted effort from developers, entrepreneurs, and investors to make it a reality.

The development of ERC-4337 has led to the emergence of a new type of wallet, one that has the potential to revolutionize the way we store and manage our digital assets.

While Wallet 1.0 provided a great start, it was still limited in many ways, particularly in its user accessibility and the complexity of onboarding. The future of Wallet 2.0 lies in addressing these limitations while introducing new features that improve their functionality and security.

“What some of the builders are building right now”

Several builders are already working on building the Wallet 2.0 landscape. These wallets are built with a focus on user accessibility, security, and interoperability. They leverage the power of smart contracts to offer features like social recovery, atomic multi-operations, and sponsorship of gas fees.

Some up-and-coming Wallet 2.0s that will be focused on ERC-4337 include Castle, Soul Wallet, Candide, Unipass, Biconomy, Banana Wallet SDK, Stackup, and Etherspot.

5 Key Questions To Ask When Evaluating Wallet 2.0

As with any emerging technology, it is important to evaluate the potential risks and rewards associated with Wallet 2.0. Here are five key questions to consider when evaluating a Wallet 2.0 solution:

1. Is this a great business in its own right?

A successful Wallet 2.0 solution needs to be more than just a useful tool for users. It must also be a sustainable business model in and of itself. Builders must consider factors such as revenue streams, customer acquisition costs, and profitability. Additionally, they must assess the potential market size and competition to determine whether the business can scale and thrive in the long run.

The Wallet 2.0 space is highly competitive, and new solutions must offer a compelling value proposition to succeed. The business model must be sustainable and have a clear path to profitability.

2. Will building a Wallet 2.0 unlock a new way to solve a problem that is 10x better than before?

The second question to ask is whether Wallet 2.0 will unlock a new way to solve a problem that is 10x better than before. Wallet 2.0s have the potential to solve many of the problems associated with conventional wallets. For example, the social recovery and atomic multi-operations functionality could offer significant improvements over existing solutions.

Social recovery provides a more secure and user-friendly method of recovering lost private keys, while atomic multi-operations allow for multiple transactions to be executed as a single transaction, which can save users time and money. These features could provide an advantage over conventional wallets, which do not offer this functionality. However,

However, it is crucial to consider Peter Thiel’s principle that successful products must be at least 10x better than their competitors. When evaluating the potential of leveraging ERC-4337, businesses should assess whether the technology brings a substantial improvement in productivity, creativity, or quality. Furthermore, the economic viability of implementing smart contract functionalities should be evaluated to ensure that the benefits outweigh the associated costs.

3. How does the business build a sustainable competitive advantage, particularly where there is heavy reliance on first-mover advantage?

The third question to ask is how the business will build a sustainable competitive advantage, particularly where there is heavy reliance on first-mover advantage.

The social recovery and atomic multi-operations functionality may be key differentiators for Wallet 2.0, providing a first-mover advantage. However, the Wallet 2.0 space is highly competitive, and builders must build a sustainable competitive advantage to succeed in the long run. This advantage could be built around technology, network effects, or brand.

Wallet builders must identify a unique value proposition that distinguishes them from their competitors. In saying that, I do believe there are specific areas where defensibility will emerge. I will discuss two below, conscious this list is not exhaustive.

1. Unique and proprietary distribution channels: Having an exclusive and proprietary distribution channel sets a startup apart from its competitors. It provides a distinct advantage by offering a unique way to reach customers that is not easily replicable. This uniqueness can attract customers and differentiate the startup from similar offerings in the market. I’ll elaborate more on this point in the next question.
2. Thoughtfully engineering virality into the product: Building virality into a product is not a function of luck; virality is engineered. Many of the best companies have growth loops — flywheels that spin faster over time. Here’s Amazon’s famous growth loop. What’s yours?

4. Can the business find a distribution angle over incumbents that can add smart contract functionalities to their existing products?

Another important question to ask is whether the business can leverage existing partnerships and relationships with incumbents to distribute Wallet 2.0s to a wider audience. This is particularly relevant given the challenges of onboarding users to the current landscape of Wallet 2.0s.

One potential distribution angle for Wallet 2.0s is through partnerships with centralized exchanges, which currently hold the vast majority of user assets in the cryptocurrency ecosystem. By integrating Wallet 2.0 functionalities into their platforms, exchanges could provide users with enhanced security and self-custody options while still maintaining control over their funds. This could also help exchanges differentiate themselves in a crowded market and attract users who value self-custody and security. The key question here would be how can you convince an exchange to partner with yours, instead of building it themselves? Learning from past successes could be relevant here. Here’s a post by the CEO of Sardine on the cost-benefit of Buy vs. Build in the crypto fraud detection and AML space.

Another potential distribution angle is through partnerships with DeFi protocols, which could integrate Wallet 2.0s into their platforms to provide users with greater control and transparency over their funds. This could also help drive the adoption of Wallet 2.0s among users who are already comfortable with the DeFi ecosystem and are looking for more advanced self-custody options.

5. What assumptions must we believe for this to succeed over existing wallet solutions?

Finally, builders must critically evaluate the assumptions and beliefs that underpin their Wallet 2.0 solution. They must consider the technical feasibility, user adoption, and market trends that will determine the success of their solution over time. Additionally, they must be prepared to adapt their approach as the landscape evolves and new challenges emerge.

A. Users value the security and transparency provided by Wallet 2.0s enough to justify the complexity of using them.

Wallet 2.0s offer a higher degree of security and transparency than centralized wallets, thanks to their use of decentralized protocols and smart contract codes. However, this comes at the cost of increased complexity, which can make Wallet 2.0s less accessible to the average user. For Wallet 2.0s to succeed, users must be willing to put in the effort to learn how to use them and must value the added security and transparency enough to justify the additional complexity.

B. Wallet 2.0s can provide a user experience that is at least as good as existing wallet solutions, despite their more complex architecture.

Wallet 2.0s have a more complex architecture than existing wallet solutions, which can make them more difficult to use and less user-friendly. However, Wallet 2.0 developers are working to improve the user experience by building more intuitive interfaces and leveraging the latest user experience design principles. If Wallet 2.0s can provide a user experience that is at least as good as existing wallet solutions, despite their more complex architecture, they will be well-positioned to gain widespread adoption.

C. Wallet 2.0s can effectively address the challenges of seed phrase backup and recovery to reduce the risk of users losing their funds.

One of the biggest challenges facing users of existing wallets is the risk of losing their funds due to lost or stolen seed phrases. Wallet 2.0s offer potential solutions to this problem, such as social recovery mechanisms and other advanced key management techniques. If Wallet 2.0s can effectively address the challenges of seed phrase backup and recovery, they will be able to provide a more secure and user-friendly alternative to existing wallets.

D. Wallet 2.0s can gain widespread adoption through partnerships and integrations with existing players in the cryptocurrency ecosystem.

Finally, for Wallet 2.0s to gain widespread adoption, they will need to establish partnerships and integrations with existing players in the cryptocurrency ecosystem, such as exchanges, dApps, and other wallet providers. This will require Wallet 2.0 developers to build open and interoperable systems that can seamlessly integrate with existing infrastructure. If they are successful in doing so, they will be able to tap into existing user bases and expand the reach of their solutions.

Potential Risks and Limitations

While Wallet 2.0s hold great promise for the future of DeFi, there are also potential risks and limitations that builders and users must be aware of. Some of these include:

ERC-4337 does not solve high gas fees

Sending simple transfers using ERC-4337 can be more expensive than using an EOA, because of the need to make a contract call with ERC-4337. Nevertheless, on rollups, ERC4337 can be more cost-effective than EOAs because it can aggregate signatures to minimize the amount of data on the mainnet.

Security risks associated with ERC-4337

Wallet 2.0s introduce new security risks compared to traditional wallets. Malicious actors may attempt to exploit vulnerabilities in the smart contract code, potentially leading to loss of funds. When considering ERC-4337, potential security risks may arise due to the introduction of new opcodes, including the possibility of unintended bugs or attack vectors. Builders must prioritize security in their design and development process to minimize these risks. Such potential security risks are reasons why Safe will wait until it’s completely tested and audited before adding support to ERC-4337.

ERC-4337 is not chain-agnostic

Chain compatibility could also be a limitation when it comes to Wallet 2.0 implementation. These wallets are designed to interact with specific blockchain networks and their corresponding smart contract languages. However, they often lack compatibility with multiple chains, restricting their functionality and versatility. This means that if a user wants to switch between different blockchain networks or utilize smart contracts on various platforms, they would need to create separate wallets for each chain. This limitation hinders the seamless and efficient management of digital assets and transactions across multiple blockchain ecosystems. To address this challenge, developers are actively working on solutions such as cross-chain interoperability protocols, which aim to enable Wallet 2.0s to bridge different blockchain networks and enhance their compatibility.

Legal and regulatory challenges

The legal and regulatory landscape surrounding Wallet 2.0s is still evolving, and there is significant uncertainty in many jurisdictions. Builders must be aware of these risks and ensure they comply with relevant laws and regulations.

Conclusion

In conclusion, the Wallet 2.0 space is poised to revolutionize the way we store and manage our digital assets. As the web3 ecosystem continues to grow, the need for a secure and user-friendly wallet solution will only become more pressing. Wallet 2.0 represents the next generation of wallet technology, offering a range of new features and benefits that were previously impossible.

Throughout this report, we have explored the key attributes of a Web3 wallet, the current landscape of Wallet 1.0, the innovations in AA, and the road ahead for Wallet 2.0. We have also outlined five key questions builders in the wallet space should ask themselves when evaluating their business.

Future outlook of the Wallet 2.0 space

As the ecosystem continues to evolve, we can expect to see more advanced and user-friendly wallet designs, better key management solutions, and new use cases for Wallet 2.0s. The integration of new technologies, such as layer-2 scaling solutions and cross-chain interoperability, will further enhance the capabilities of Wallet 2.0s. As the blockchain industry matures, Wallet 2.0s are poised to become an essential tool for managing digital assets and interacting with dApps.

Suggestions for builders in the wallet space

Firstly, focus on building a sustainable competitive advantage that can withstand heavy reliance on first-mover advantage. Secondly, prioritize user experience and accessibility to make Wallet 2.0s more accessible to the average user. Thirdly, ensure that wallet design and key management solutions prioritize security and ease of use. Fourthly, identify potential distribution angles over incumbents that can add smart contract functionalities to their existing products. Finally, it’s essential to stay up-to-date with the latest trends and technologies in the blockchain ecosystem, to stay ahead of the curve and deliver innovative solutions that meet users’ needs.

The development of this space is incredibly exciting, undoubtedly at a frenetic pace. I hope that this article serves as a valuable reference when considering your future projects and investment choices. If you are building in this space, come talk to me about what you are doing! You can reach out to me on Twitter (@shaunhengcj) or LinkedIn.

In my next article, I’ll do a deep dive into what a Web2.0 wallet stack will look like. DM me if you have other topics that you would like me to take a crack on :)

Special thanks to Edison Lim (Suberra), Samuel Chua, Matthias Ang (SSV Network), Hayden Liu (Particle Network), and Pengyu Wang (Particle Network) for their thoughts and comments on the piece.