Venture Deep Dives: Web3 Infrastructure

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  Jack:
  Hi, everyone. Thanks for joining us today. My name is Jack Statza, and my colleague Sophia Zhao is here with me as well. We’re both senior principals on Alumni Ventures Blockchain Fund, Fall Vintage team. Today’s deep dive topic will be on Web3 or blockchain infrastructure. The reality is that blockchain and crypto have become criticized in mainstream media as it focuses on headline-grabbing bankruptcies that had little to do with underlying blockchain technology.

  2022 has been a turning point for the crypto ecosystem. A severe slump in token prices, rising interest rates, and contagion from failures of many visible Web3 players, including Three Arrows Capital, Luna UST, BlockFi, Celsius, Voyager, Genesis, and FTX have all soured the perception of digital assets among some industry veterans and the broader public. But long drawdowns have a silver lining in that they encourage deeper reflection, giving us all a chance to reevaluate and refocus on what really matters.

  Much like how, as an internet user, you don’t need to understand how HTTP or SMTP protocols work to surf the web, the same case can be made for blockchain infrastructure. You just want the application to work seamlessly, with blockchain working behind the scenes. However, for the next disruptive Web3 app to exist to bring in mainstream adoption, it requires a secure, fast, and decentralized infrastructure. Similar to how Uber wouldn’t have existed without the iPhone as a platform, blockchain technology could unlock new applications that wouldn’t have been previously imaginable.

  In this video, we’ll define the space, share with you our investment thesis, some key numbers, trends, and opportunities, as well as other topical subjects relating to Web3 infrastructure. The evolution of the web came in three phases. Web1 was the period between the 1990s and early 2000s, where we saw open protocols like HTTP, SMTP, and FTP. And Web2 was characterized by the insurgence of social media behemoths, like Facebook, Twitter, and YouTube.

  In Web2, people began creating and posting their own content, actively participating in the internet rather than passively reading it. But most of that activity ended up being distributed and monetized by big corporations, which kept most, if not all, of the money and control for themselves. The infrastructure of Web2 is centralized cloud infrastructure that is defined by AWS, Google Cloud, and Microsoft Azure.

  Web3 is an idea for a new iteration of the internet, which incorporates concepts such as decentralization and token-based economics. Web3 will replace the centralized corporate platforms we see in Web2 with open protocols and decentralized community-run networks, combining the open infrastructure of Web1 with the public participation of Web2. If the Web1 era favored publishers and the Web2 era favored platforms, Web3 is all about tilting the scales of power and ownership back towards creators and users. The foundation of Web3 infrastructure is the blockchain.

  Blockchains act as a shared computer and storage network. Transactions are processed on-chain through smart contracts, and the results are then stored on-chain, packaged into the blocks that are validated and committed. Blockchains optimize among three major constraints, namely decentralization, scalability, and security. This is referred to as the blockchain trilemma.

  Now, the blockchain trilemma problem is a situation where, as blockchains gain adoption, they generate more data than all full nodes must store. This causes issues including: increased centralization as the burden of running a full node gets too high; limited scalability to ensure the network remains decentralized; and decreased security as more users run light clients over full nodes.

  And to overcome this problem, a blockchain would need to do the following. One, incentivize nodes to store history. This would allow the network to remain decentralized. Two, let nodes share the burden of storage. This would allow the network to scale with more users. And three, allow staked nodes to compute the state. This would give light clients the same security as a full node.

  To address the trilemma, new blockchain layers have come out to address storage, scalability, and security. But let’s take a step back to think about what blockchain layers actually mean. So please consider the below diagram with houses. Each house here represents an application that sits on top of a blockchain. You can think of applications such as NFTs, metaverses, or DeFi. Each of these houses or applications sit on a foundation, which represents a specific layer one or layer two blockchain—referred in the example as just layer one for simplicity.

  An example of a layer one blockchain is Bitcoin or Ethereum, and a layer two would be Polygon. These layer one blockchains represent the foundations for these houses, meaning that you can’t easily go between houses without a bridge. In the real world, this means you need to go to an exchange to convert your Bitcoin into Ethereum.

  Now, layer zero is the ground or earth by which all these foundations for these houses are laid upon. It shares a common historical database by housing all past transactions across blockchains, so those layer one blockchains and respective applications can continue to have cheap and fast transactions.

  By being the unifying layer zero for these houses (or applications) and foundations (or layer one blockchains), a layer zero could enable multiple chains to interact with each other through their shared data in the layer zero via cross-chain decentralized exchanges or bridges. This is all still an area under a lot of innovation.

  Jack:
  So now with all that said, this leads to our investment theses. Blockchains were not built for the level of demand we are seeing today. The Ethereum blockchain can process around 20 to 30 transactions per second, where Visa can process around 24,000 transactions per second. Further, when demand outweighs capacity, transaction costs, called gas prices, skyrocket. There are many new blockchains or layer ones that address this challenge. These new chains make trade-offs, often influenced by the different use cases these chains may cater to.

  As multiple blockchains develop in parallel, applications and assets tend to be siloed on disparate chains, creating walled gardens. For instance, if you have assets on Ethereum but want to transact on a chain that’s not compatible with Ethereum, you’d have to transfer the assets to an intermediary, whether it’s an exchange or a bridge, that shuffles assets between different chains. Bridges, however, remain a risky proposition. For instance, in March 2022, approximately $600 million in ETH and USDC was stolen from a Ronin Network bridge, the Ethereum-based side chain for the well-known cryptocurrency game, Axie Infinity.

  Now, on this slide, I want to take a look at some important numbers to put things into perspective. First, we are still in the early days of blockchain adoption. Crypto’s total market cap peaked at $3 trillion in November 2021, and its current market cap hovers around $1 trillion, which pales in comparison to the total size of global money, which is $90 trillion, or global stock market at $94 trillion.

  In terms of transaction numbers, Bitcoin’s blockchain processes over 260,000 transactions per day, while the NASDAQ alone processes in excess of 30 million transactions per day. That said, Bitcoin’s on-chain volume increased 435% from 2020 to 2021, while Ethereum’s on-chain volume increased 729% over the same period. Supporting this transaction growth are the over 20,000 monthly active developers in the greater Web3 ecosystem, and this number of developers doubled since 2021.

  Following the opportunities and promising new layer ones, developer activity continues to grow exponentially in these nascent ecosystems. For instance, developer counts grew 86% for chains outside of the top 200, dwarfing Bitcoin and Ethereum growth. Now, I would like to hand off the following slides to my colleague, Sophia. So Sophia, please take it away.

  Sophia:
  At the Blockchain Fund, we focus and prioritize on picks and shovel opportunities that are key to scaling Web3 development. We’re seeing new and innovative solutions that are addressing existing problems, built on the works of the predecessors and paving the way for a multi-chain future that is more dynamic and distributed than the current state.

  As we mentioned in the previous slide, developer interest in Web3 continues to grow, and we expect new dev tools and tech stacks, such as the Web3 versions of AWS and Google Cloud platforms, to emerge.

  Specifically, we want to highlight three trends that are taking shape. The first is the concept of layer zero. Currently, layer one blockchains, like Ethereum, Solana, Aptos, have a hard time talking to each other. The architecture, implementation, and even programming languages used vary greatly from chain to chain. And this becomes incredibly difficult to manage the execution of transactions across the differing consensus algorithms that these chains use.

  And this is where layer zero comes in. As my colleague Jack mentioned earlier, you can visualize this as a ground where the foundation, or layer one, for the houses, or apps, are laid upon. Layer zero networks augment a blockchain’s capability without interfering with its inner workings. More simply put, it lets blockchains talk to each other by creating this base layer that connects them together.

  Next, we have the modular blockchains. Imagine you are a car manufacturer and you’re breaking the car assembly into smaller components that are handled by specialized teams, such as the engineering design team, the car body team, etc. Similarly, a modular architecture in blockchain is one in which the main responsibilities of transaction execution, consensus, and data storage are broken up and delegated to a network of independent blockchains, or side chains, or layer two channels.

  This is very different from the traditional or monolithic blockchains, like Ethereum, where all these functions are performed by every node on the network. As such, modular blockchain innovations can help address the blockchain trilemma.

  Lastly, there also exists a huge movement to remove the technical overhead required to build on these blockchains in the form of defined APIs. These APIs abstract away low-level implementation concerns, such as the need to run your own node, and therefore reduce the length of development cycles.

  Within this space, we’re looking for a few specific markers of success. First, horizontal scaling for blockchains to be able to process more transactions simultaneously. Transactions are processed in parallel across multiple subsections of a blockchain called shards, but maintain consensus across them. This means that instead of requiring nodes to have better hardware to process transactions faster, we rely on having more nodes with lower hardware requirements instead, and this drastically reduces a barrier for new nodes to enter, promoting decentralization.

  And in order to attract and retain developers building in Web3, we need well-written documentation and tools that are compatible with existing dev tools and existing virtual machines. And of course, the cost of using blockchain technology shouldn’t be prohibitive. You may be aware of Ethereum’s high gas or transaction fee that can be a barrier for adoption.

  For instance, the transaction fee of your remittance might be worth half of what you’re remitting, or the transaction fee of your NFT purchase is almost the same as your NFT purchase. So overall, we’re looking for network designs that enable cheaper computing to help with increased adoption. And given the nature of the space, we’re looking for startups with strong engineering teams, ideally executing on pioneering academic research that can be validated by technical advisors. This is one sector where novel implementations are found both at the cutting edge of the market and academia.

  Looking forward, if we can find a way to make blockchain more scalable, secure, and fast—if that is possible—then many use cases will transition to the blockchain. Currently, major enterprises such as PayPal and MasterCard are already experimenting with blockchain adoption, and we look forward to seeing more traditional enterprises come into this space. And perhaps killer apps in gaming, digital identity, document verification, consumer education, etc., will trigger the next wave of adoption and attract more developers into the ecosystem, creating a positive loop.

  We might see a flourishing multi-chain world, where transactions, data, and assets will flow seamlessly through them. And on the flip side, if blockchain infrastructure development doesn’t evolve for the better, then blockchain may be fundamentally flawed as a method of shared compute and storage. Likely, the economics will not work out to the point of broader adoption.

  This means either that the cost would be prohibitive to the point of blocking users from participating at the retail level, or there’s not enough economic gains to warrant enterprises to invest in migration of their products and services, or that blockchain may not be performant enough to support the real-time use cases that we’re used to seeing today, such as high-velocity financial systems or responsive gaming. And of course, funding for the space will dry up as milestones of technical advancement or adoptions are far and few between.

  … to highlight two portfolio companies within the Web3 infrastructure space. The first one is Subspace Network. It is a next-generation, massively distributed, and decentralized infrastructure layer that aims to support Web3 at internet scale. Subspace introduces a novel architecture that can support millions of consensus nodes, which contribute their storage and computational resources to the network. Subspace lets blockchains talk to each other.

  Blockchains like Ethereum store a huge amount of historical data on-chain that impacts the network speed and fee, and Subspace can help alleviate this bloat by storing transactions for Ethereum. And Subspace can serve as an extra layer of transaction processing that any layer—from layer one to three—can leverage, something like a blockchain of blockchains. Subspace has raised $32.9 million in their early-stage funding round in March 2022, led by prominent investor Pantera Capital.

  Another portfolio company we want to highlight is Quai Network, which is an open-source, layer one, proof-of-work blockchain network utilizing the capabilities of merge mining to increase throughput and security. Quai Network takes a novel approach to solving the blockchain trilemma through its shared security by merge mining across its integrated rollups. The Quai Network provides Web3 applications with high speed without compromising decentralization and security.

  Currently, it has over 20,000 node validators, which is substantially larger than large layer one blockchains like Avalanche, Polkadot, and Solana. This ensures the network is highly protected against network outages that other layer one chains have suffered. Quai Network raised $10 million in the early-stage funding round in early 2022, led by Polychain Capital.

  If you’d like to learn more about Web3, here are some additional learning resources. A16z’s crypto site publishes food-for-thought pieces regularly, and their Crypto Canon has a collection of articles of building blocks, tech basics, foundations, and key concepts. Chainlink has a good article on explaining the blockchain trilemma and the general approaches to scaling a chain. Alchemy has a good article to go deeper on modular versus monolithic blockchains, expanding what we’ve touched upon in our deep dive. And for higher-level updates or news highlights, you can subscribe to Delphi Digital, Messari, and Blockworks.

  In summary, blockchain technology will enable shared computing and storage for retail and enterprise use cases. The blockchain trilemma is a challenge that many innovators in Web3 are addressing in the hopes that we don’t need to have trade-offs among scalability, security, and decentralization. We expect to see a multi-chain world in the future, and it is still early days, where the Web3 developer stack is still being discovered. We look forward to smoother developer experience with well-written documentation and compatibility with existing dev tools and virtual machines. And if all things go well, we are at the nascent stage of a paradigm shift. Thank you for watching our deep dive, and we appreciate your feedback. Hope to see you in the next deep dive.