Web 3.0, Liquidity Pools, Base Layers, Sidechains and Rollups

Introduction

Within the next decade, decentralized networks under appropriate regulation are likely to provide almost frictionless transactions across borders in a Web 3.0 framework. A great example of Web 2.0 friction is when I moved to US for high school. As a student without a job, my parents sent money from their Swedish bank account to my US bank account for groceries, clothes and school supplies. I learned right away that moving money between countries in Web 2.0 is time consuming and expensive, as banks charge high fees, offer unfavorable FX rates and communicate poorly between jurisdictions. It is fair to state that moving money is much easier within jurisdictions. For example, after a meal with friends, it is common practice that one person pays with a credit or debit card and then charge others by individual Venmo (US) or Swish requests (Sweden). The problem is that Swish and Venmo are unable to communicate with each other on a global scale. When I go to Sweden, I cannot use Venmo and vice versa. Perhaps, Venmo and Swish can communicate in the future, but my bet is that decentralized wallets will revolutionize the finance game. The other day, I received 1 USDC – a stable coin pegged to the dollar – in a Web 3.0 transaction from a European Coinbase account in seconds without any fees. If enough people across the world download the Coinbase app, then maybe stores will accept Coinbase requests? The simple 1 dollar transaction is equivalent to a global Venmo/Swish transaction and doing so between two countries frictionless opens an ocean of possibilities. The battle with old institutions has begun.

Swedish Venmo

Betting in the Crypto Space

Investing in crypto is much like investing in early internet meaning that there is a few experts and therefore endless possibilities. Educating yourself within the space is super important to avoid scams if your goal is to gain exposure to Web 3.0 projects outside of Bitcoin and Ethereum. Viewing YouTube videos and reading blog posts about crypto is not enough, as you must also read up on economics, interest rates and fundamental financial concepts. Tying these traditional concepts into the more unique metrics of cryptos like tokenmoics, developer activity, vision and decentralization is key to generate a higher rate of return in Web 3.0. Tokens should be distributed widely, developer activity needs consistency, projects must have a clear vision and decentralization should be vast. Education also includes challenging yourself by creating a decentralized wallet like Metamask and start playing around with the UI and how it connects to Web 3.0 platforms like Aave. I recommend starting with low amounts of money and as you feel more comfortable maybe up the stakes. The winning cryptos will be those that provide real world economic value. These winners will not serve just as a means to barter goods and services like fiat currency, but they will also serve as a plumbing mechanism to the cryptographic infrastructure. To serve as a pipe in the plumbing system for crypto, the blockchain requires speed, security and decentralization. Leading blockchains like Ethereum, Solana, Cardano and Avalanche balance these three areas differently. They use their respective edge to attract capital and developers to build projects on their ecosystems. Capital and great developers are correlated because it is human nature to work on projects with the highest monetary incentives. More developers, means higher likelihood of creating successful projects, which leads to real world economic value. If I were to invest in the crypto space, I would therefore go with projects that attract the best developers because those are the areas where new ideas are executed. As of right now, Ethereum is the big daddy, but other blockchains may catch up.

Popular decentralized wallet

DeFi

One of the most interesting areas for Web 3.0 is decentralized finance. The goal of DeFi is to remove middlemen like bank, payment and insurance providers that extract value from the system. To outcompete centralized finance – whether it involves lending & borrowing, custody or simple peer to peer payments – a decentralized system must handle transactions faster, safer, and cheaper. Currently there are two cryptographic ecosystems – Bitcoin and Ethereum – showing promise and frankly outshining all other alternatives. Both BTC and ETH demonstrate proven security and decentralization, which is key with the advancement of rollups. BTC and ETH are blockchains, which means they are decentralized computer networks. A decentralized computer network is made up of many nodes that verifies transactions on the network, and they can either be computers solving puzzles like in a proof of work consensus mechanism or they can be stakers like in proof of stake. The problem with a centralized system is that all nodes are in one central location. If there is an attack on that central location then the entire network goes down. The nodes making up the decentralized network, however, exist in several geographic locations, which removes the main weakness of a centralized system. The entire decentralized network for both BTC and ETH is updated on all its nodes at the same time, which means there are multiple copies of the transaction history on each network. In other words, there are as many copies of the transaction history as there are nodes. For example, if there is an internet shutdown in US, the nodes verifying the decentralized network in Europe can pick up the slack, as they share the exact same database/information as the nodes in the US. The difference between BTC and ETH is that the former is arguably more of a pure store of value play like gold, while the latter is showing promise as a general purpose blockchain.

Top DeFi projects per market cap

Why DeFi Liquidity Pools?

It will take time before businesses tap into the DeFI market, but the fact is that running a business always requires capital. When companies raise capital to fund new projects or operations they historically either turn to equity or debt markets. The participants in equity and debt markets include venture capital firms, retail investors, governments and large institutions. Issuing debt through loans or bonds is generally cheaper than issuing equity because debt require full repayment to the lender. In return for having first claim on a business’ assets, debt lenders therefore generally earn lesser returns than equity holders. However, equity capital providers receive a claim on future cash flows of the business in form of stock appreciation or dividends. That means issuing equity for a business comes at the cost of upside from stock appreciation, but without the promise of repayment. For example, start-ups have no current income so they often issue equity in return for potential future profits for investors. Up until recently, most companies would fund operations with a combination of debt and equity, but a new avenue has opened up; blockchain funding. One of the biggest providers for blockchain funding is Aave. As an open source liquidity protocol, the objective of Aave per its website is to be a non-custodial liquidity protocol for earning interest on deposits and borrowing assets. Currently, Aave has over 27 billion dollars flowing through their platform. In the future, companies may use liquidity protocols to raise assets, as an alternative to debt markets. To access these liquidity protocols, companies must create decentralized wallets, which means there might be a growth in decentralized wallet providers. For individual investors, however, Aave is now a great platform to make money through yield farming.

Figure 1 - Aave

Yield Farming on Aave Liquidity Pool

Aave is a great liquidity pool, as the platform consists of many participants and supports a wide range of cryptos and stable coins on many different blockchains, as depicted in Figure 1. However, before using Aave, the first step for yield farming is to download or access a centralized or decentralized exchange to purchase cryptos. Coinbase Pro is an excellent choice for a first time user, but there are other alternatives in the digital currency space with exchanges like Kucoin and FTX. When fiat funds have been deposited and used to purchase cryptos, the next step is to move those cryptos to a decentralized wallet. This decentralized wallet should support blockchains like Ethereum or Polygon, which both work with Aave and are widely favored among people in the digital currency space. Ethereum is much more secure and has been around for a longer time, but is expensive, and Polygon – although less secure – is much cheaper. The two decentralized wallets that I use is Coinbase Wallet and Metamask. A decentralized wallet allows users to store, send and receive crypto anywhere on the planet through a public and private key. The public key is used to receive funds, while the private key is used to send funds. The private key should remain private otherwise anyone could access your cryptos in the decentralized wallet and defraud you. The public key is what I used for depositing funds into Aave through connecting Aave with my decentralized wallet in the top right corner as per Figure 1. After Metamask or another decentralized wallet has been connected to Aave, the tokens that are suitable for yield farming should be deposited. These suitable tokens should offer great upside through price appreciation or great yield given risk. Note, to use the Polygon blockchain, the Ethereum tokens must be transferred to the Polygon blockchain through a bridge. The bridge I use is called the Polygon Bridge. To complete the bridge transaction, Metamask swaps Ethereum tokens for the Polygon equivalent through the bridge. Metamask mainly supports Ethereum, but the Polygon network can be added in the account settings. After the cryptos are deposited on Aave on either Ethereum or Polygon, the tokens can be lent out for a fat yield.

Sidechain on Ethereum

Ethereum Sidechains and Rollups

Ethereum is a general purpose blockchain that has built up enormous network effects through a grassroots movement. As a result, Ethereum is now the second largest crypto currency per market capitalization and holds the most underlying real value projects. For example, Ethereum allows its network participants to use Ethereum based tokens to borrow and lend money without banking intermediaries on DeFi platforms like Aave, and Ethereum’s smart contract capability also powers big NFT markets. As of June 2021, Ethereum hosts more than 200,000 ERC tokens on its network and many of these tokens are among the top 100 cryptos per market capitalization like Polygon and Shiba Inu. Ethereum, however, has some scalability problems meaning that the network is unable to sufficiently process transactions in relation to transaction demand on the base layer. As of now, the Ethereum network can process up to 30tps, which is less than both VISA’s 45,000tps and competing blockchains such as Cardano’s 250tps and Solana’s 65000tps. The slow transaction throughput leads to sky-high gas prices because users have to bid against each other to be one of those 30 transactions verified on the blockchain. For a 1000 USD transaction on the Ethereum network, the gas price easily surpasses USD 100, which means a 1000 dollar send costs 100 dollars for a total cost of 1100 USD. Solving the scalability issue is therefore the top priority for the Ethereum community. Luckily, Ethereum is a general purpose blockchain so Ethereum developers are launching multiple projects on top of the Ethereum network to create faster transactions. These projects include layer 2 solutions such as Polygon and ImmutableX, which both improve transaction efficiency. Polygon is a layer 2 scaling platform using proof of stake. Basically, Polygon is the same as Ethereum, but with lower gas fees. As a result, over 3000 Dapps now exist on Polygon to for example connect lenders and borrowers. Polygon’s weakness is its own PoS consensus mechanism used to validate transactions, as Polygon money can be stolen in 51% attacks if the network is not sufficiently decentralized. That is why many layer 2s instead use rollups like ZK Snarks and Starks (zero knowledge proofs) to increase transaction speed, while benefitting from Ethereum’s great security and decentralization. Like Polygon, Immutable X is a layer 2 solution, but ImmutableX use ZK rollups instead of PoS. ImmutableX is an NFT project launched in 2021 with a goal to outcompete other NFT platforms like Open Sea. The objective of ImmutableX is to create the cheapest marketplace for carbon free NFT projects to be traded among users. The ImmutableX platform launched with its native 9000tps token IMX, which started trading on decentralized exchanges on November 5th. The coolest things about ImmutableX it is the use of Starkware technology.

NFT platform and project on top of the Ethereum base layer

Base Layer Competitors to Ethereum

There are many base layer blockchains competing for developer resources and investor capital. These competitors often argue they are general purpose like Ethereum, but more efficient. For example, some competitors use PoS directly on the mainchain instead of using Polygon sidechains or ZK rollups like Immutable X to improve transaction speed. The PoS consensus mechanism is extremely popular for base layers, which can be demonstrated by the over 100 billion dollar combined market cap of just Polkadot and Cardano. However, the PoS methodology deviates slightly between the different blockchain networks. One example is Solana, which uses Proof of History within its PoS network. PoH itself is not a consensus mechanism, but by integrating time into the PoS algorithm, all validators in the Solana network receive full information on the order of transactions without needing to communicating with other validators, which allows for faster sequencing validation. The nodes/validators in a blockchain network are actually computers and these computers are unaware of time in for example Ethereum. In PoW and normal PoS, the computers therefore waste precious time when communicating with each other to establish transaction times in the network. Say that you are communicating with your family by posting letters. If you want to save the letters from your aunt, uncle, and mom in an order based on time. It is better to beforehand agree upon a time when a letter should be received. However, each family member might use a different postal service like UPS or Fedex so there will always be a delay. If a letter that was supposed to be received on January 5th is received January 7th and another letter that was supposed to be received on January 6th is received on time, it might create some trouble to organize in Ethereum. However, if the letters are timestamped, it is then possible for you as the recipient to reorganize the letters so that they are placed in order of receipt. In terms of a blockchain network, it means that people with different internet speeds in Solana can all validate transactions without having to communicate time, as the PoH algorithm will make sure that all of the nodes have the same historical transaction ledger organized based on time. Founder of Solana, Anatoly Yakavenko, explains PoH more in depth in his extremely technical white paper for Solana. The block-time for Solana is 400 milliseconds, which you can compare to Bitcoins 10 minutes and Ethereum’s 10 seconds. Through using PoH, Solana says they can handle up to 710,000 of transactions per second, which is 30 times what VISA currently handles. The problem with Solana and other alternative base layers is that they tend to be highly centralized.

Base layer competitor to Ethereum

Conclusion

There are many paths for investing and make money in Web 3.0. The first way is to directly purchase cryptos like Ethereum and Bitcoin for the sake of price appreciation. The second way is to earn a yield by validating transactions through solving puzzles in PoW or staking in PoS. The third way is to lend and borrow through liquidity pools like Aave. The fourth way is to buy NFT art or yield farm in DeFi. The fifth way is to pool together capital and provide insurance. The sixth way is to pool capital in a DAO like Klima Dao and buy assets that provide a yield. The seventh way is to invest in companies that provide Web 3.0 services like Coinbase. Personally, I believe we are in the early stages of a digital revolution and that the total market cap of all things crypto will increase so the most important thing is to stay long. However, to invest in the best ideas within Web 3.0, it is up to each individual to do their own research.