Blockchain and DeFi as part of Web 3 in 2022

Thirty-three years on from the invention of the Internet and its impact on people’s lives is only becoming more apparent. With more work, schooling, and social events taking place online, a lack of access is not just seen as an inconvenience, but as detrimental to a person’s wellbeing and development.
Despite its obvious benefits, the internet has brought certain negative aspects, chiefly the lack of control over our personal information. As Tim Berner’s Lee, the creator of the Internet, put it in a recent interview when asked about data control:

I’ve got a vision for an alternative world, in which that data does exist, but it’s at the beck and call of the user themselves. Where the apps are actually separated from the data source. So when you use an app, it asks, where do you want me to store the data? And you have complete control over who gets access to it. It would be a new world. We’re talking about a future in which these programs work for you. They don’t work for Amazon, they don’t work for Apple.

This alternative world is Web 3.0, a space where blockchain technology, machine learning, and artificial intelligence helps to create an ecosystem that takes the most functional parts of Web 2.0, our current phase, but wrests control from programmers that assist the big tech companies in harvesting our data and using it for the pursuit of profit, no matter if it involves the spread of misinformation and clickbait or intrusive communications that follow you around the web.

In this article we will talk about:

Web 3 in comparison with Web 1 and Web 2;
How blockchain plays a large part in Web 3;
Decentralized finance on blockchain in Web 3;
Tools used to build the blockchain ecosystem;
Securing Web 3 — cybersecurity and best practices.

So simply read on to get a full understand of this phenomenon, which our company INC4 is fully committed to helping deliver!

Web 1 and Web 2 vs Web 3

What is Web 3 and how does it different from its forerunners? Before we get into further complexity this seems like a good place to start, so we’ll give you a quick summary of each iteration.

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Web 1

Web 1 is commonly referred to as the static web (due to the static pages written in HTML), coming onto the scene in the early 90’s and running until the mid-2000’s when Web 2 took over. There was a strict division between the creators and consumers of content; if you didn’t create a page, you were strictly a passive consumer.

Web 2

Web 2 is nicknamed the social web, due to the fact that user-generated content and social networks came to the fore. It is hard to imagine a time when Facebook, Twitter, and Reddit didn’t exist, but they are all a product of Web 2. Created in Javascript and HTML 5, this iteration of the web is dynamic, permits the free sorting of information, and sees the development of APIs.

Web 3

Web 3.0 is the new generation of the Internet, known as the ‘Semantic Web.’ The concept has been around for a while, part of Berners-Lee’s vision of an Internet that functions as a global brain that relies on AI and machine learning, while data is kept decentralized; that is, out of control of a third-party authority.

Web 3 — made possible by blockchain

Now that we’ve established the differences of Web 2 vs Web 3, we can examine how blockchain fits in. Crucial to the Web 3 movement is the use of open, trustless and permissionless networks. In short:

Open networks are developed and executed through open-source software, meaning transparency and network decentralization.

Trustless networks allow users to control whether they share their personal information publicly or privately, while retaining ownership over the data.

Permissionless networks give users the chance to participate in data exchange on a level playing field; the governing body does not need to provide permission to gain access.

With decentralization, equal access, transparency, and control, blockchain technology builds on previous peer-to-peer principles to bring us closer than ever to the bright future envisioned by Web enthusiasts.

Exploring the blockchain ecosystem

So can blockchain really be one of the pillars of Web 3? While blockchain originally had a more narrow focus, the ability to implement smart contracts, initiated by the Ethereum network, has allowed developers to launch applications that span the entire breadth of services that are currently available on Web 2. While some areas, such as decentralized finance (which we talk about below) have received more attention, we can see that the blockchain ecosystem 2022 has solutions in the following areas:

VPNs
Messengers
File storage
Content monetization
Fintechs
Marketplaces
Insurance
Rental
Trading
Gambling
Digital Identity
Gambling
Gaming
Environmental initiatives

Here it must be mentioned that this is far from an exhaustive list. Basically any company that has a digital component can benefit from blockchain. Even more traditional businesses that people wouldn’t associate with tech, such as Walmart, Ford, and, Coca-Cola are utilizing blockchain to improve their business capabilities.

INC4 can develop smart contracts on your preferred blockchain to future-proof your business.

Explore more

Decentralized finance on blockchain as part of Web 3

While decentralized finance (DeFi) has its underpinnings with Bitcoin, which came onto the scene in 2008, it was not until 2017 that DeFi became much more sophisticated. With projects like Aave and Maker, which launched on Ethereum, users now had the chance to borrow and lend through liquidity pools automated through smart contracts. With the popularity of DeFi yield farming, which exploded in 2020, the ecosystem has grown at a rapid rate, bringing in larger investors which has accelerated the number of projects being developed.

Today, we see DeFi not just mirroring traditional finance, but going beyond what is currently offered; however, it should be mentioned that with this flexibility and willingness to experiment have come security lapses exploited by malicious actors. This is where the burgeoning world of DeFi insurance has come to bring some more stability to the sector; after all, trust is what will bring those outside of the early adopter bubble to decentralized apps.

DeFi

You hold your money

You control where your money goes and how it’s spent

Transfers of funds happen in minutes

Transaction activity is pseudonymous

DeFi is open to anyone

The markets are always open

It’s built on transparency- anyone can look at a product’s data and inspect how the system works

Traditional finance

Your money is held by companies

You have to trust companies not to mismanage your money, like lend to risky borrowers

Payments can take days due to manual processes

Financial activity is tightly coupled with your identity

You must apply to use financial services

Markets close because employees need breaks

Financial institutions are closed books: you can’t ask to see their loan history a record of their managed assets and so on

Source: Ethereum blog

So how does DeFi conform to the principles of Web 3? Looking back at the next generation of the Web’s need to be open, trustless, and permissionless, we find that this is exactly what decentralized finance promises. DeFi is:

Non-custodial

Individuals have control over their own assets and data, with transfers able to be undertaken without intermediaries. Non-custodial means the decentralized applications you interact with don’t control your data – only you do.

Open

Unlike in the traditional financial system, anyone is able to gain access. There are no gatekeepers who work to find reasons to disenfrachise people or limits on how much and where you can send assets. DeFi presents a real way to reach those who are unbanked.

Transparent

Any transaction is traceable and can be inspected by anyone, with code for applications used to perform financial operations being open-source. This allows developers to build on top of each others’ applications, referred to as composability, or the ability to take source code and modify it to create a different app.

Decentralized

Built on public blockchains like Ethereum, Solana, and NEAR, transactions are verified by nodes, computers around the globe running the blockchain’s software. This ensures that one centralized party cannot gain control.

Popular DeFi applications

With billions of dollars locked into decentralized apps (Dapps), it can prove very lucrative to design a platform that is functional, secure, and easy to use. In the DeFi sphere, Dapps are becoming more sophisticated and reaching into new areas. Here are some of the popular types of applications, accessible in just a few clicks with your crypto wallet.

Lending platforms

DeFi lending platforms helped kick off the DeFi frenzy in 2020, offering a leaner and more efficient way to get loans. With a lower barrier to entry, cross-chain capabilities, and smart contracts taking the place of middlemen, billions of dollars are moving through top projects like Maker, Compound, and Aave each year.

The need to ensure enough liquidity for borrowers in the various pools means incentives need to be offered to people willing to lend their cryptocurrency. Compound’s high interest rates plus issuance of the COMP token, which could also be used for governance voting, made the practice of yield farming widespread.

DEXes

While centralized exchanges like Binance are still the most popular for small and large investors trading cryptocurrencies, the DEX has a role to play through peer-to-peer (P2P) buying and selling, aided by smart contracts. In this space, DEX tools give users full control over their assets and the ability to be anonymous.

On the downside, as this is a largely unregulated space, hacking and the recovery of funds can be more difficult on DEXes than with their established centralized counterparts.

Get the info you need on decentralized exchanges.

Metaverse platforms

Interest in the metaverse skyrocketed last year off the back of Facebook’s decision to rename itself Meta. While Zuckerberg’s centralized version of the metaverse seems like an attempt to exert even greater control over the online space, the metaverse on blockchain is comprised of decentralized entities, where users have more agency and control over their data. As we write about in our blog, while often used in conjunction with Web 3, the metaverse is a distinct online and virtual space where users can work, play games, and socialize.

Experts define the metaverse as a simulated digital environment that blends augmented reality (AR), virtual reality (VR), blockchain, and social media to create spaces for user interaction mirroring reality. What’s more, new economic opportunities are brought forward that are linked to the traditional economy. We can already see this with decentralized metaverse platforms like Decentraland and The Sandbox, who are attracting brands and artists who buy up plots of land to create monetizable spaces, or mint branded NFTs that can be traded and used within the decentralized world.

Metaverse pros and cons

The metaverse presents a whole new world of possibility, but in this rush to early adoption, we must also be mindful of some of the drawbacks.

Metaverse advantages

Immersive connections across greater distances - The metaverse provides captivating experiences as close to reality as possible, allowing people to make deeper connections with each other, no matter where they are in the world.

More niches to explore - As we mentioned above, metaverses can cater to all different subcultures, meaning people can easily explore differences avenues for relaxation, socialization, or even business opportunities.

Improved online learning - While more people have been making use of the flexibility and ease that online learning provides, sitting in front of a screen can quickly cause students to become disengaged. The metaverse provides a whole new bunch of scenarios for immersive education. Imagine language learning where textbook exercises are ditched for a lesson where students are put directly into a foreign environment and forced to explore and interact, making use of AI, games, and headsets.

Metaverse considerations

Centralization vs. decentralization - As mentioned in the context of Mark Zuckerberg’s metaverse push, centralized control is worrying to think about when we consider platforms that are this powerful. Decentralization seems the best choice, but this also brings its own worries. A decentralized platform may not be required to jump through the same regulatory hoops as a centralized one, leaving you more open to theft or extortion. Freedom in this context can be a double edged sword.

Lost connection with the physical world - Robert Nozick’s Experience Machine thought experiment asks us whether we would prefer a machine that could simulate pleasurable experiences for us to real life experiences. A metaverse where enhanced experiences can be simulated may cause us to neglect our realities, leading to a deterioration of our offline relationships and less of a connection and investment in the physical environments we inhabit.

The environment - As we will look at in more detail below, the use of NFTs in metaverses are central to helping fund the ecosystem and creating economic opportunities for participants. Drawing on figures calculated by computer scientist and artist Memo Atken, a piece in Wired at the beginning of 2022 entitled Can You Be an NFT Artist and an Environmentalist? talks about the still unacceptably high emissions involved in minting NFTs:

…by the end of 2020, mining an NFT took at least 35 kWh of electricity—that is, the process, from mouse click to claiming the right to produce the block, demanded that much energy, emitting 20 kg of CO2. For comparison, sending an email produces a few grams of CO2, and watching an hour of Netflix produces only 36 grams…

Despite the fact that future-focused layer one blockchains are no longer relying on the proof of work consensus mechanism, and that Ethereum transition to proof-of-stake is expected sometime later this year, it is naive to think that the environmental issues to do with blockchain are going to go away anytime soon.

NFTs

NFTs were the big trend of 2021, gaining extremely dedicated followers and detractors in equal measure. Mainly developed according to ERC-721 and ERC-1155 token standards, NFT smart contracts provide their holders with immutable proof that theirs is indeed the original artefact, whether it be a piece of digital art, music, or a collectible.

While the sector is still in its infancy, many are convinced that NFTs can play an important role in recording proofs of ownership for many of our real world assets. In a recent paper, Vitalik Buterin, E. Glen Weyl, and Puja Ohlhaver point to a possible future in the form of soulbound tokens (SBTs). Unlike the NFTs we have today, these would be non-transferable, helping to faithfully record a person’s assets and achievements for use as part of a more cohesive society.

See why NFTs have gotten so big so quickly in our comprehensive blog.

Metaverse considerations

With the meteoric rise of NFTs has come the inevitable scramble to become the dominant NFT marketplace. OpenSea holds the top spot with $3.5 billion in trading volume in April alone. Super Rare and Rarible are two of the other biggest standalone platforms, but then there are the marketplaces within metaverse applications.

The Decentraland marketplace, for example, showcases NFTs that can be used in its metaverse, with Samsung, Nike, and Coca-Cola minting tokens that are auctioned on the platform.

Read about the top NFT marketplaces here.

Fractional NFTs

The popularity of NFTs has caused their prices for skyrocket, meaning in-demand items are out of reach unless you have a spare 100 ETH lying around. Fractional NFTs take an existing asset and then lock it in a smart contract, where it is broken down into fungible ERC-20 tokens of equal value. This allows someone to purchase, for example, a part of one of the 50 CryptoPunks, fractionalized into 250,000 uPunk tokens on the Unicly platform.

GameFi (Play-to-earn) platforms

GameFi is another sector that is intertwined with the metaverse, NFTs, and DAOs gaining popularity mid-way through 2021 with games such as Alien Worlds, Axie Infinity, and CryptoBlades. Also called play-to-earn, GameFi gives users the opportunity to play in virtual worlds, collecting tokens and NFTs which can be exchanged with greater freedom than the in-game items of traditional centralized platforms.

Although decentralized applications using NFTs have been around since the likes of CryptoKitties, these games offer more interactivity and fun, while incorporating sophisticated aspects of DeFi, whether that be peer-to-peer lending, yield farming, or staking. Participants can even create games within metaverses and accumulate governance tokens to influence the future of a platform. In accordance with the principles of Web 3, GameFi promises greater agency and opportunities beyond what we have seen in centralized gaming so far.

Explore GameFi futher in our comprehensive blog!

(Leveraged) yield farming protocols

As we talked about in relation to lending platforms, yield farming exploded in 2020 with the ability to gain massive rewards for providing liquidity to protocols. Yield farming is often compared to gaining interest in a bank account, but there are some key differences, which include the fast changing rates, rapid movement of funds, and varied reward distribution mechanisms. Despite the risks of impernanent loss and market fluctuations, many people find the reward worth it.

A relatively new phenomenon, leveraged yield farming supercharges traditional farming by inviting users to access undercollateralized loans, leveraging up to three times their initial investment (depending on the platform and pool being farmed) to gain greater rewards. Benefits include bigger returns for users, more liquidity within protocols, and a greater utilization of funds, bringing growth to the DeFi ecosystem.

By opening and customizing different leveraged positions, users have the potential to profit even in bear markets. How is this possible? Well, one scenario involves borrowing a coin that drops relative to its pair, meaning that the loan on the borrowed coin can be paid off faster as the pool rebalances to keep its 50/50 ratio.

While leveraged yield farming can present great opportunities, with borrowed funds, risks are compounded, with the threat of liquidation joining our old friend imperanent loss.

See more about yield farming and top projects to watch here.

DeFi 2.0 - how is the sector evolving?

Despite the huge strides DeFi has taken over the past few years, there are still areas for improvement to do with scalability, smart contract vulnerabilities, the complexity of user interfaces, and of course the speed that liquidity within a protocol dries up when rewards to liquidity providers can’t keep up with those offered by another project.

Analysis by the blockchain analytics platform Nansen shows that 42% of yield farmers exit within 24 hours, and 16% within 48 hours. By the third day, 70% of these users leave the smart contract. The diagram below gives a further detailed breakdown.

What this means is that a project can be abandoned overnight, losing the sustainable funding that is needed to grow and keep providing benefits to its users. Here are three solutions that are helping improve the DeFi sector’s operations and flow of funds.

DeFi 2.0 and protocol owned liquidity

DeFi 2.0 covers projects that are actively incorporating different tokenomics to combat liquidity loss and bring more sustainability. This might include governance token vesting or bond mechanisms, the latter offered by Olympus DAO, a project that was one of the trends of 2021 with its 3,3 game theory staking principle. Olympus uses OHM as liquidity bonds and uses DAI and other LP (liquidity pool) tokens as reserve bonds. Since the price of OHM is above 1 DAI, bond sales are profitable for the protocol, and the Treasury uses the profit to produce more OHM, some of which are distributed to users and some of which are used to accumulate POL (Protocol Owned Liquidity). At the time of writing, Olympus controls 99.34% of OHM/DAI liquidity.

We wrote about Olympus in one of our blogs last year, but since then, OHM has dropped 98%, driven by liquidations caused by a whale dumping the token. While many have called Olympus a ponzi scheme, the project has not fallen, and continues to garner investment from those who believe in the mechanics and are sure the project will regain popularity without the fevered speculation that drove the token price to unsustainable highs.

DAOs

DAOs (Decentralized Autonomous Organizations) are another key contributor to the maturation of the DeFi sector. While they have been around for a long time, their scope is broadening, with different types pointing to a future of better organization and community engagement across projects.

While we have already touched a couple of times on the benefit of composability as part of Web 3 and DeFi as part of this sector, DAOs are now able to benefit from an increasing array of open-source tools that are being developed to serve this niche. Depending on a project’s needs, there are frontend, treasury management, discussion, and many other tools that are fully developed and ready to be integrated into the DAO to the benefit of participants.

While many DAOs are still governed through coin-based voting, Vitalik Buterin, in a rather lengthy blog that we summarize, talks about the drawbacks of this method and theorizes how different approaches could help to make DAOs more secure and democratic.

Read our detailed rundown of DAOs as part of DeFi 2.0 here.

L2 scaling solutions

As increased interest in DeFi combined with the NFT boom have caused Ethereum gas fees to increase over the last couple of years, bringing into focus the blockchain trilemma of scalability, security, and decentralization.

Convention says that it isn’t possible to service all three of these points equally; for example, if scalability and security are a focus, then decentralization will be compromised. In the case of Ethereum, decentralization and security are prioritized, making scalability an issue — hence the slow transaction time and rise in gas fees at peak times.

There are currently two ways to address this problem:

On-chain scalability

New layer 1 blockchains such as Cosmos, Solana, and NEAR, as well as the continually evolving Cardano and Ethereum 2.0 networks, offer scalability built into the underlying protocol.

Layer 2 solutions

These are built on top of the existing layer 1 network, expanding the functionality of the L1 technology by processing transactions outside the mainnet. In the context of Ethereum, which can currently handle between 15-45 transactions per second, level 2 scaling can significantly increase the number of transactions; up to several thousand transactions per second, depending on the solution.

Get a comprehensive summary of the different types of layer 2 solutions and which ones to follow here.

GameFi (Play-to-earn) platforms

Building an app that captures attention in an increasingly crowded marketplace requires knowledge, experience, and creativity. This is something that INC4 can provide with over 90 projects delivered successfully across multiple blockchains.

Tools used to build the blockchain ecosystem

Despite being a relatively new technology, building on blockchain, like other programming, involves mastery of different coding languages, the use of different frameworks, and often a strong foundation in mathematics. In this section, we will highlight some of the most popular tools for blockchain development.

Out of the box solutions

Hyperledger

Hyperledger is a global blockchain initiative that aims to provide builders with the standards, guidelines, frameworks, and tools to be able to contribute to open-source blockchain development for enterprises. Founded and with significant assistance from the Linux team, the Hyperledger Foundation is committed to supporting projects that are modular, highly secure, crypto-agnostic, interoperable, and offer API integration.

The most well-known Hyperledger project — Fabric — was created for building blockchain business applications. These applications help service the food, airline, coffee, and insurance industries.

Oracle cloud blockchain service

The Oracle Blockchain Platform Cloud Service is a ready-to-go platform for running smart contracts.

Built on Hyperledger Fabric, the service is also aimed at the enterprise market, where a developer can deploy a smart contract in a trusted environment that banks and large businesses can rely on for the recording of their companies’ data.

Blockchain development tools

While blockchain continues to make strides in the enterprise sphere, development is rapidly occurring on smaller scales, with teams around the world able to utilize open-source tools and integrations to create sophisticated and engaging projects.

Languages

Solidity is the predominant language for writing smart contracts. Used by Ethereum, it is based on existing programming languages, meaning developers who have worked in other spheres can learn it fairly easily. The rise of other layer 1 blockchains has meant that different languages have commensurately become more popular. NEAR and Polkadot use Rust, while Binance’s BNB Chain utilizes GO, Python, JavaScript and more.

Integrations

We mentioned before the concept of composability, where open-source code can be taken from one project and used in another. It’s often as simple as integrating an API into a smart contract. WalletConnect provides easy connection to a secure crypto wallet, while Chainlink is an oracle service that allows smart contracts to access off-chain data in real-time, such as weather, stock market updates, and more.

Development Environments

Development environments are applications used to compile code. The Remix Integrated Development Environment (IDE), for example, gives developers the ability to write a smart contract, incorporate plug-ins, debug it, and then deploy it on a blockchain. Truffle and Parity are other popular development environments.

Frameworks

Blockchain frameworks assist with the successful development and deployment of applications. Ethereum, Waves, and Consensys Quorum provide toolsets and components that can be used to securely and efficiently bring Web 3 applications to life.

Explore other top blockchain development frameworks and tools.

Securing Web 3

As we’ve seen so far, Web 3 brings a whole new world of possibilities, interweaving financial tools, the metaverse, social media, and culture into an ecosystem that is not owned or controlled by big multinational corporations. While this is a step in the right direction, we must acknowledge that there are still security concerns. This is precisely why decentralized insurance is growing more prominent; as is the need for a project to show that it has taken steps to safeguard its platform.

Web 3 cybersecurity risks

While blockchain proponents highlight the safety that decentralized data storage brings, there are still cybersecurity risks confronting Web 3; some of which are currently prominent in Web 2, while others are unique to blockchain.

Smart contract exploitation

New projects are popping up all the time, some of them neglecting thorough testing and auditing in order to quickly cash in on the latest cryptocurrency trend. This can lead to malicious actors looking for exploits in the smart contract. As we summarize in a recent blog, DeFi protocols can suffer from:

Reentrancy attacks – caused by a contract calling externally an untrusted contract before resolving.
Price oracle manipulation – caused by an oracle smart contract being manipulated by hackers, for example, while smart contracts are requesting token price details.
Logic errors – caused by internal errors that may open up a particular smart contract to an external exploit.

Resource hacking

Also known as cryptojacking, this involves hackers covertly installing crypto mining software onto a person’s computer, thus effectively using their resources to profit.

Ice phishing

While traditional financial institutions have extra safeguards in place, the onus in decentralized finance is on the individual to ensure the security of their funds. This removes a layer of difficulty for fraudsters, who can trick users of a protocol into delegating the use of their tokens to another party.

These are just three risks, exacerbated by the fact that Web 3 brings more anonymity, and so far, a lack of regulation.

Web 3 cybersecurity best practices

Despite the very public horror stories, the blockchain sector is now doing more than ever to counter any threats posed by crooks. Here are some best practices that any legitimate project should undertake.

Smart contract auditing

Smart contracts are incredibly complex pieces of code, incorporating everything from the user interface to the precise mechanics of a project. If we take the example of crypto lending platforms, just one number in the wrong place can be enough of a window for an exploit to occur.

While internal audits are a logical starting point, external smart contract security audit services bring professionals and a fresh set of eyes to a project’s code. Certik and Hacken are two of the most prominent companies who can undertake a smart contract audit for your business, and they will know doubt be joined by many others as the sector grows.

Penetration testing

Not just limited to blockchain projects, penetration testing involves simulated attacks on your platform’s architecture in order to ensure it is robust enough to repel any hackers once it hits the market. There are a whole bunch of penetration testing tools on the market, and a range of large and small companies who are able to undertake testing on a project’s behalf.

Bug bounty

In addition to internal and external smart contract audits, bug bounties are another great way to both test your project and drive community engagement. By providing rewards for those that find bugs in your smart contract, you can attract highly skilled individuals who find vulnerabilities that may have been overlooked. They are often also more cost effective than external audits and offer complete transparency. Your project is likely to be trusted more if it has been given the okay by community members.

Check out our blog for more info: Enhanced security: top reasons why your DeFi & NFT project needs a smart contract audit.

Web 3 cybersecurity best practices

As we’ve seen from this overview of Web 3, blockchain and DeFi have an important role to play in securing the ecosystem and expanding the number of decentralized platforms available to users. Blockchain development tools are helping to bring greater functionality to projects and encourage new ways of organization, which will help to bring in new participants, strengthening an Internet that more closely matches the vision of its founder, Tim Berners-Lee.

That being said, there are various hurdles involved in widespread adoption of a space that is open, trustless, and permissionless. Security is one aspect that looms large. The other, that we haven’t touched on here, but permeates every conversation about mass adoption, is regulation.

Web 3 won’t take a final form; much like Web 2, it will develop and morph to suit the needs and wishes of the current generation, taking advantage of evolved blockchain networks and platforms built on them. To what degree blockchain and DeFi networks as we know them will be integrated into this brave new world remains to be seen.

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