Web3: Hype or Horror?

VCs love a hyped-up technology, and Web3 is the latest darling. What is it, and will it deliver on the high expectations?

Sunniva Kolostyak 21 September, 2022 | 10:36AM
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It’s human nature to always look for the next big thing. Whether it’s evolving as people, scrolling through endless social media feeds or identifying new investment opportunities, we don’t like standing still.

Technology is perhaps the fastest-moving aspect of our lives, and an area filled to the brim with exciting innovation across industries as companies realise the importance of everything from cloud to analytics and data. And, despite market turbulence, venture capital firms are still investing.

According to Morningstar’s PitchBook, emerging technologies account for about 11% of all seed and early-stage VC investment – and current favourites are areas like Web3, DevOps and AI. But what makes these opportunities so exciting for VCs and when – if ever – will they have any real-world relevance?

1, 2, Web3

The journey from conception to real adoption is long. For example, we’re currently being bombarded with information about the metaverse and how an alternative, digital universe is the future of everything from shopping to corporate conferences. But in reality, we’re still only really using the Oculus Quest for Beat Saber. Research firm Gartner even estimates that it’ll be at least a decade until the metaverse is a truly mainstream concept.

So back to VCs’ current darlings. According to PitchBook’s Emerging Technology Indicator (ETI) for the second quarter of 2022, Web3 and decentralised finance, or DeFi, is by far the most popular among VCs.

Web3 refers broadly to decentralised software protocols and blockchain-based products and services. DeFi is the term for the financially focused products within it. Companies attracting funding in this segment are creating everything from marketplaces and platforms, networks, custodial services, identity and privacy tools, and payment services.

The concept differs from the current web, or Web2, because of the “decentralised” blockchain aspect, but beyond this, Web3 is more an umbrella term than a fixed technology. By running on public, open-sourced blockchains, DeFi services, for example, remove the need for intermediaries by existing as peer-to-peer smart contracts.

The Web3 and DeFi segment took over as the biggest recipient of emerging tech capital in Q3 2021 – surpassing fintech and biotechnology – and it has been dominating ever since. Investments have been reduced by more than half since the Q4 peak, to $874 million from above $2 billion – but the amount is still sizeable, considering the crypto winter and increase in regulatory risk.

Is the Hype Right?

It’s visible from PitchBook’s deal analysis that interest in Web3 is at an all-time high, but according to Gartner, it could be heading towards a pretty significant trough. The firm has developed an analysis model called the “hype cycle” (despite not being a cycle at all) to track the development, popularity and adoption of technologies.

The growth of a significant innovation is of course not linear, nor is it guaranteed, but the model does offer some insights into the journey from inception to mainstay. Technologies go trough five phases: innovation trigger, peak of inflated expectations, through of disillusionment, slope of enlightenment and plateau of productivity.

In other words, when a new technology is discovered, the cycle starts with inflated attention, expectations and funding – before plummeting when investors realise there might not be enough uses, performance is weak, or receives bad press. Then, companies find ways to adopt the technology to fit their business, and over time, it becomes mainstream.

Garter places Web3 in the inflated expectation stage together with related technologies like NFTs, blockchain and decentralised identity. This is where the mass media hype begins and a plethora of new companies spring up, beyond the early adopters. And indeed, the sectors are receiving a lot of attention.

But signs that it could all come crashing down for Web3 are emerging. Tumbling cryptocurrency valuations have certainly provided a reality check, and bitcoin alone still uses more energy than Finland annually, at a huge cost to the environment. One software engineer, Molly White, has even started a blog titled “Web3 is Going Great” detailing some of the not-so-great developments in the space. For example, over $10 million has so far been lost to Web3 grifts and scams.

Through the Trough

Take autonomous vehicles, also known as self-driving cars. A couple of years ago, its arrival was meant to be revolutionary, but it’s turned into a very expensive and sometimes dangerous project, placing the technology in the “trough of disillusionment”. Driverless cars have received a lot of bad press about it “not living up to the hype”, for example, and the space has started to consolidate too. But, as of September 2021, three entities do have permits to operate autonomous vehicles in California: Cruise, Nuro and Waymo.

It’s this what’s ahead for Web3? Not yet, judging by the number and size of deals being made. The largest investment in Q2 included a $175 million Series A for Lightspark, a startup seeking to improve the Bitcoin network and speed up its transaction times. The next largest deal was a $148 million Series B raised by CertiK, which provides blockchain security, monitoring, and auditing technology. Other big deals focus on NFTs, crypto wallets, identity and tokens.

And while the roadblocks are certainly still ahead, some are getting ironed out. Ethereum, the blockchain used by a lot of Web3 developers, “finally” switched to a proof-of-stake system from the emission-heavy proof-of-work system (check our glossary for a refresher on everything crypto). But proof-of-stake has received criticism for not upholding the idea of decentralisation; it doesn’t rely on computers for security but on individuals or companies staking their own tokens – and they will be the new validators, not the decentralised servers.

Nothing New Under the Sun

But the idea of decentralisation and zero censorship were founding tenets of the internet in the first place, and Web3 has so far seen plenty projects that have been centralised in similar ways to BigTech, White writes on Web3 is Going Great. Moreover, there are also instances where “uncensorable” or “unmodifiable” platforms have removed or modified data.

“[Sceptics] also often mention that an awful lot of web3 projects sound quite a bit like Ponzi or pyramid schemes, and question the lack of regulation, oversight, and taxation that makes fraud, tax evasion, and other criminal behaviour particularly rampant in the space,” she writes.

Gartner believes it will take the technology segment between five to 10 years to mature. in an analyst note, PitchBook’s Robert Le says that while developments have been considerable over the past years, “many projects and digital assets are highly speculative and have yet to progress past the concept phase”. For DeFi, there’s technological, fraud, regulatory and centralisation risks, to name a few.

But for now Web3 is riding the funding wave, and who knows, in 15 years we might be sat in the back of our driverless cars, making blockchain transactions from the metaverse and laughing at crypto’s history as serial polluters. But I doubt it.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Sunniva Kolostyak

Sunniva Kolostyak  is data journalist for Morningstar.co.uk

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