Waiting for the revolution: opportunities and obstacles presented by the blockchain, cryptocurrency and Web3

March 2022 | EXPERT BRIEFING | FINANCE & INVESTMENT

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The world is on the precipice of a revolution, a revolution in technology not seen since the advent of the internet. The revolution is based on digital ledger technology and the blockchain, most famously, cryptocurrencies, led by bitcoin.

In 2021, this digital revolution began to gain momentum. This article describes some of the more significant recent developments and looks forward to the key trends for 2022 that portend the direction and development of the digital world to come.

First, a brief explanation of what the revolution is about.

The digital revolution is founded on distributed ledger technology, a system for replicating and sharing an identical copy of information among computers (nodes) that are linked together in a network. The nodes validate the information for a transaction by a consensus of a majority of the nodes, determined by an algorithm, before storing the information in a permanent record. What makes this revolutionary is that the information is not maintained and controlled by a central authority. Changes to the ledger are constructed independently and only become part of the permanent ledger after reaching consensus.

The blockchain is one form of distributed ledger technology where the database is grouped together in append-only transaction records linked together cryptographically in blocks. This process provides security and efficiency. Security is obtained because once created and linked, the record of information cannot be altered or withdrawn, and the append and shared structure of the ledger requires that each change in the linked-digital record can only be accomplished by a consensus of the nodes. The greater the size of the chain, the more difficult it is to change, since any attempted change is transmitted to every participant in the blockchain. Only public blockchains, however, have this characteristic. Private blockchains have central administrators which can be more easily hacked, something that has occurred on a regular basis.

Bitcoin and most cryptocurrencies use a pubic blockchain. The origin of the use of the blockchain as an exchange for digital currencies can be traced to a white paper published under the pseudonym Satoshi Nakamoto in October 2008. The white paper proposed using a distributed ledger where the network of participants in the ledger would validate each transaction by consensus, including the value of each account. This resolved the previously intractable problem of double-spending because without consensus no transaction can become part of the permanent record.

So how and by who is bitcoin, or any cryptocurrency, created and confirmed? This function is performed by ‘miners’, who can be anyone with access to the internet and suitable hardware possessing the computing power to compile recent transactions in the cryptocurrency. Miners do this by dividing the transactions into blocks and solving a computationally progressively more difficult algorithm, and in return receive rewards in the form of newly released cryptocurrency and often transaction fees, payable in cryptocurrency.

There is a catch. The amount of the reward diminishes over time as additional cryptocurrency are released. Most significantly, the computational power to solve the algorithm requires progressively greater computer power, which in turn means greater energy is expended. This is a significant obstacle to the growth of a coin-based ecosystem, and until it is resolved will impede the arrival of the digital revolution.

Bitcoin is the most well-known and traded cryptocurrency, but bitcoin is restricted to the currency use case. There are other cryptocurrencies, of which ether is the best known. Ether can be used for purposes other than as a store of value. Ether permits developers to write their own programmes (smart contracts), which can be employed as autonomous means of executing agreements and functions. Ether or some variant can also be used as a means of buying services within the Ethereum blockchain. Web3, shorthand for an internet operating on so-called tokenomics, is generally based on and operates within the Ethereum blockchain.

In 2021, the digital revolution began to achieve momentum on the back of some of the same themes that have driven the turmoil experienced during the pandemic: (i) pervasive institutional distrust; (ii) the existence of an ocean of untapped liquid capital held by venture and private equity funds, including the venture arms of crypto companies; (iii) the development of innovative businesses, manifest in the digital realm by the uncoupling of crypto from the currency use case, as decentralised finance (DeFi) and non-fungible tokens (NFTs), as well as other use cases which have gained traction; (iv) the surge in public equities, opening the door to public options for the crypto industry, typified by Coinbase’s $86bn public offering and the BITO bitcoin exchange-traded fund, which was the fastest ever ETF to amass $1bn in investor capital; and (v) the national and international focus on governmental regulation of the private sector, including deciding the appropriate regulatory regime for the new digital world.

It is not news that across the spectrum of political and generational divides we are questioning institutions and those who lead them, and this extends beyond a distrust of government and includes private financial and technology companies ranging from Wall Street bankers to the leading Silicon Valley firms, and the doyens of social media. Regardless of the rationale or reason, the revolution is being driven by a common belief that decentralised technologies, which are coupled with financial incentives as preached by promoters of Web3, offer a potentially profitable alternative to these discredited institutions.

In April 2021, Coinbase, a cryptocurrency exchange, became a public company by use of a direct listing of its securities under the Securities Act of 1933. This was a landmark event for the digital revolution. It provided a means for ordinary investors to indirectly invest in cryptocurrency, as well as providing a currency for investment in digital infrastructure for Coinbase. It is no accident that the investment arm of Coinbase invested more than any other venture capital firm in various companies building the infrastructure of the digital revolution. Founded in 2012, Coinbase is a cryptocurrency exchange that permits people and companies to buy and sell various digital currencies for a transaction fee. Andreessen Horowitz, a prominent venture capital firm, notable for its early investment in internet infrastructure companies, was an early investor.

Coinbase and Andreesen have expended considerable time and funds to impact the regulatory regime which will determine the development of Web3 and the digital industry. Andreesen has engaged several prominent members of the public and private crypto and regulatory community such as William Hinman, former chief of the Security and Exchange Commission’s (SEC’s) Division of Corporation Finance, and Katie Haun, a former Justice Department cryptocurrency prosecutor, to ensure it has a prominent role in the development of the new regulatory regime.

Andreessen formed its first fund of $350m dedicated to crypto investment in 2018, followed by a second fund of $515m in 2020. In 2021, Andreessen formed a third crypto fund of $2.2bn for investment in Web3, the largest crypto fund ever until exceeded by a $2.5bn fund formed by Paradigm, later in 2021, part of the total of $30bn raised by venture capitalists for crypto projects in 2021, as reported by PitchBook.

Venture capitalist investment in 2021 has focused on Web3 startups typified by Sky Mavis, the developer of a blockchain based video game, BitClout, a decentralised social network and OpenSea, a marketplace for NFTs.

NFTs are nonfungible, meaning that each token is unique and cannot be replicated. NFTs can be records of ownership that cannot be changed. This limiting factor can give them value since ownership and their existence is time-stamped on the blockchain. In October 2021, a little-known painter, Cam Rackam, bundled 10,000 NFTs based on memes from Reddit’s Wall Street Bets message board, selling them for $2.5m. In 2021, more than $44.2bn worth of cryptocurrency was spent on major NFT platforms, according to Chainanalysis, surging from the $114m spent in 2020.

DeSo, a network for blockchain-based apps, has grown into an alternative social media network charging users for popularity, participation, posts and work, allowing users to bypass Twitter and TikTok.

The Federal Reserve, Congress and regulatory agencies have monitored the growth and use of DeFi and the blockchain, weighing its benefits against the costs and risks, for the most part simply recycling the archaic regulatory tools utilised for traditional finance and commerce to regulate the digital revolution.

In 2022, there are several trends and topics to watch.

First, the continued growth of the development and investment in Web3 applications, including NFTs (expanded to include applications for real estate, personal identification and consumer goods and services), and blockchain-based social media apps, highlighting a battle between Web 2.0 pioneers like Jack Dorsey of Twitter and Block fame, and Andreessen.

Second, the transition from energy intensive ‘proof of work’ to ‘proof of stake’ (a system based on a pledge of ownership of the mined token), used by miners to create and confirm new coins, facilitated by a recent upgrade to Ethereum, the blockchain on which ether is based, but requiring a new native currency as blockchain validators (ETH2).

Third, the growth of DeFi, including the increased use of stable coins tied to fiat currencies and other tangible assets, as well as the use of digital assets to secure loans, and the emergence of national digital currencies.

Finally, the development of a regulatory regime which slowly opens the door to increased use of cryptocurrencies and DeFi, in public and private transactions, led by the Federal Reserve and the SEC, which will include increased oversight of crypto-exchanges and private crypto funds, as well as mechanisms for taxation of digital transactions.

Robert C. Brighton, Jr is a shareholder at Becker & Poliakoff. He can be contacted on +1 (954) 985 4178 or by email: rbrighton@beckerlawyers.com.

Robert C. Brighton, Jr

Becker & Poliakoff