Ethereum: 2nd Generation Crypto, Web 3.0
July 20, 2021 by Marvin Bertin ‐ 11 min read
Series 1: Cardano The Only True 3rd Generation Crypto
- Introduction to Crypto, A Misunderstood Technology
- Bitcoin: 1st Generation Crypto, A Revolutionary Currency
- Ethereum: 2nd Generation Crypto, Web 3.0
- Cardano: 3rd Generation Crypto, A World Financial Computer
Ethereum was launched in 2015 by young and brilliant programmer, Vitalik Buterin. The platform’s key differentiator over Bitcoin is its smart contracts functionality, which can be viewed as a more flexible and generalized version of Bitcoin. Instead of only storing transactions in a blockchain, Ethereum stores executable programs. This seemingly small difference permits the emergence of fundamentally different and novel properties. Smart contracts are agreements written in code that execute automatically in a secure, transparent and decentralized environment. Using smart contracts, one can build a variety of products and services without relying on centralized organizations or intermediate parties. These include financial services, digital identity management systems, or supply chain tracking networks. Later we will introduce the idea of a DAO (Decentralized Autonomous Organization) and why supporters of Ethereum call it the “new internet” or the “internet of value”.
What are Ethereum’s Properties?
"[Smart contract] Instead of only storing transactions in a blockchain, Ethereum stores executable programs"
Ethereum builds upon many of Bitcoin’s features (i.e., openness, portability, and security) and introduces additional unique ones:
ERC-20 tokens - By leveraging smart contracts, Ethereum allows users to “mint” their own token other than Ether (Ethereum’s native token) and define their own tokenomics (i.e., economic properties and rules a token must follow). Just like other cryptocurrencies, ERC-20 tokens are blockchain-based assets that have value and can be sent and received. Rather than running on their own blockchain, ERC-20 tokens are issued on the Ethereum blockchain. This led to the explosion of custom tokens on the network, such as the governance tokens used in DAOs (more on that below) and interest-bearing tokens used in lending protocols.
DAO (Decentralized Autonomous organizations) - DAOs are member-owned organizations/corporations represented by rules encoded in a smart contract. They differ from traditional organizations as they do not have centralized leadership nor hierarchical power structures. Think of it as an internet-native cooperative, or co-op, that’s collectively owned and managed by its members. Every business decision is made through community voting, ensuring all members of the organization have a voice. Every change to the organization is encoded in smart contracts guaranteeing security and automated enforcement. On the blockchain code is law.
“A DAO is a business where community is not an afterthought, it is its raison d’être."
Such a fundamentally new organizational framework allows the operations of a business to be completely transparent and open to the public, while being securely backed by a blockchain. DAOs are probably the most powerful concept coming out of smart contract-based blockchains and are often misunderstood. They have the potential to completely redefine how companies are run and operated. A DAO is a business where community is not an afterthought, it is its raison d’être.
Composability - Composability is the ability to construct new systems from combining other simpler ones together. Like Lego pieces stacked together forming larger complex structures, smart contract-based applications are public, composable and permissionless by design. This modularity makes it easy for decentralized applications (Dapps) to compose themselves of other Dapps. For example, the creation of ERC-20 tokens led to the development of decentralized exchanges, which facilitated the exchange of tokens given market-based pricing (i.e., Uniswap, the largest decentralized exchange currently manages around $6 billion). These exchanges were then leveraged by other DAOs to construct lending platforms, providing crypto loans and credits (i.e., Compound has around $7 billion in value locked). Furthermore, new Dapps were built on top of lending protocols to maximize earned interest for liquidity providers, also called “yield farming” (Yearn Finance has about $3 billion in value locked). This led to the explosion of innovative DeFi (decentralized finance) apps in 2020, now referred to as the “DeFi Summer”. DeFi is the fastest growing type of smart contract-based apps and is already attracting top investors (i.e., Andreessen Horowitz launches $2.2 billion crypto fund) and software engineering talent.
Ethereum: Web 3.0
Do we need a new internet? What’s wrong with it? Many people may not be aware, but we are currently on the second version of the internet, Web 2.0. Web 1.0 refers to the birth of the World Wide Web and brought us static desktop web pages designed for simple information sharing. Web 2.0 is what we know and love. The upgrade allowed for interactive experiences and user-generated content via social networks and mobile apps like Instagram, Uber and Facebook. Web 2.0 started in the early 2000s and over the next 20 years has completely transformed how we consume and share information. It has even reshaped our economies, and transformed how humans communicate and interact. As a consequence, tech companies have now grown to be richer and more powerful than most world countries. Tech superpowers, such as Google, Facebook, and Amazon, have carved, in some sorts, their own online empires, and have monopolized almost every aspect of our online lives. At first glance, their services may appear free, but they are only free because we are the product. In fact, what these tech giants have monetized, without our consent, is our digital attention, our personal data, and for some, our sanity. This is the engagement economy that fuels Web 2.0. That being said, the web has also brought tremendous benefits and opportunities to create, share and consume. However, must it come at the cost of our privacy and our freedoms?
“They are only free because we are the product."
The idea is to reorganize the Internet in order to remove centralized data hosting services, using instead a peer-to-peer infrastructure to provide private, secure, censorship-resistant access to information and services. Web 2.0 was based on three core foundations: mobile, social and the cloud. In contracts, Web 3.0 will be based on a private, trustless, permissionless framework. In this new frontier, users no longer need to “login” to interact with internet applications and consequently give away personal information. Apps on Web 3.0 (i.e., Dapps) are open to anyone and won’t demand you to create an account on their platform, it is permissionless. Instead, you will have a Decentralized Identifier (DID) also referred to as “a wallet” (aka a digital passport), compatible across the decentralized web. This digital passport will give you full and secure custody of your personal information and digital assets (i.e., academic/professional credentials, medical records, financial data, or music rights). You now can roam the internet freely without surrendering to any tech empires. Now in full control of your privacy, only you decide when and how your data is released or shared as you surf the web. No longer can your information be resold to third parties without your consent. In other words, your digital life and digital creations are all cryptographically secured to an immutable blockchain without depending on any centralized organization like Google or Facebook. It is trustless.
“The technology is a fundamental transformation of the internet as we know it”
As covered in the Bitcoin section, these Dapps will be running on top of a global financial system, therefore the tracking and transferring of fungible assets (i.e., US dollars, gold, cryptocurrencies) and non-fungible ones (i.e., a house, a painting, a NFT) will be made cheap, efficient, and secure. This first wave of Dapps created on Ethereum, and other smart contract-based blockchains, have focused their attention mostly on financial applications such as decentralized banking services. However, these are just the low-hanging fruits in a new burgeoning industry. The technology is a fundamental transformation of the internet as we know it, and will enable the emergence of new and disruptive business models.
Just like the Industrial Revolution and Information Age, we are at the cusp of new economic forces with the potential to challenge modern capitalism itself. Imagine a digitally inclusive world, where privacy and individual freedom is built into every app and profits are redistributed fairly to the original creator. For instance, a blockchain-based supply chain tracking system would allow you to see which exact farmer produced the beans in your coffee cup and how much they got paid for it. Another application would be a blockchain-based national id system that would enable students to prove their academic credentials to an employer or a small business to prove its financial history to apply for a loan. These needs are especially relevant in developing nations where poor infrastructure, plagued with corruption, are holding back individuals from achieving social mobility.
“we are at the cusp of new economic forces with the potential to challenge modern capitalism itself”
Along the same line, a blockchain-based internet would allow every creator, musician, photographer to monetize their content directly to individuals within a secure, censorship-resistant, framework where copying someone else’s digital creation won’t be possible without providing cryptographic proof that you possess the rights to do so. If full decentralization of the web comes true, we could witness the biggest transfer of wealth in history, where individuals will be able to reclaim control of the internet from tech oligarchs. Web 3.0 will be more fair and distribute wealth generated by the tech industry to the very community it depends on.
What are Ethereum’s Shortcomings?
Ethereum’s new smart contract functionality has proven to be a game changer in the industry, however, the added flexibility and complexity also has come at a cost. In addition, many of Bitcoin’s drawbacks discussed earlier are still systemic issues in Ethereum, such as the high energy consumption (at least until the Ethereum 2.0 upgrade rolls out) and lack of a self-governance framework. These shortcomings were discussed in an earlier section, so instead, we will focus on the limitations specific to Ethereum’s smart contracts.
Network congestion and poor scalability - Ethereum is a victim of its own success. As the DeFi space exploded in popularity, so did the network congestion. In fact, smart contracts make scaling even more challenging, since they increase both the number and the complexity of transactions on the network. If Ethereum aims to achieve global scales, it will need to handle billions of interactions across billions of users. One approach being taken is the integration of “side chains” layered on top of the base protocol to offload heavy workloads. These are called “Layer 2 solutions”. However, they too have their own set of limitations. Without going into too much detail, the increased scalability from Layer 2 solutions often results with a tradeoff in token liquidity, inter-chain interoperability and protocol security. Scalability is an unsolved and ongoing challenge in the crypto space, forcing projects like Cardano to invest heavily in R&D to reimagine and experiment with novel protocol architectures that better handle scalability demand without compromising on decentralization or security.
High transaction fees - As network congestion increased, high transaction fees, too, skyrocketed, making any interaction with the ecosystem very costly. Higher fees make small transactions on the network no longer viable, while benefiting wealthier individuals disproportionally. What happened to the financial inclusivity we were promised? The DeFi space, as it stands today in Ethereum, appears to have mostly a circular utility. The crypto elites can earn fabulous compound interests on their crypto asset via “yield farming”, yet very few of these apps provide services useful in the “real world”. That being said, Ethereum has taken a number of steps to address its fee problem and has seen some improvements. However long-term longevity of Ethereum will hinge on it’s capacity to improve scalability by at least a couple of orders of magnitude.
DAO Vulnerabilities and attacks - Smart contracts are executable code on the blockchain and like most programs they can contain bugs and vulnerabilities. In 2016, Ethereum suffered a DAO hack that resulted in the loss of $60 million. The attack was so substantial that part of the community decided to execute a “hard fork”, a split in the network’s protocol to revert the transaction (What is a Hard Fork?). This controversial decision to revert a blockchain transaction broke one of the core immutability principles of the blockchain. This decision shook the Ethereum community so much, that the project was forced splitting into Ethereum and Ethereum Classic. The lack of on-chain governance prevented the community from coming to a consensus.
To mitigate such an event from occurring again, most Dapps on Ethereum will have their code audited by a third party to catch and fix vulnerabilities early. Although many projects are now more secure and reliable, attacks still happen on Ethereum and cost its users millions of dollars. The lack of inherit security guarantees on Ethereum’s smart contracts may also hinder institutional adoption in the long term. In order to protect their clients, large organizations like banks and insurance companies tend to be much more risk averse. They would rather maintain old legacy software they trust, then migrate to a new risky technology. What if there was a way to design smart contracts such that any bugs and vulnerabilities would be known in advance? This is the approach Cardano is taking by leveraging functional programming and formal code verification. Formal methods make it possible to mathematically prove that a program is “correct by construction”, making Cardano’s smart contracts substantially more predictable and secure.
Despite the potential of smart contract blockchains and their promise to reinvent the internet (i.e., an internet centered around community and fairness), the current state of the industry isn’t quite there yet. In recent years however, new cryptocurrencies have entered the space with the specific intention of addressing Ethereum’s limitations. Innovative designs around self-governance structures and novel distributed computational architectures are being deployed by top research organizations. These are the third-generation cryptocurrencies and Cardano is a leader amongst them. Join us in our next post Cardano: 3rd Generation Crypto, A World Financial Computer