Coinbase Ventures portfolio companies are denoted with an asterisk (*) when first referenced in the article below.   

In Oct 2024, Coinbase Ventures published its thesis on the convergence of Crypto x AI, in which we observed that blockchains and AI have complementary strengths - blockchains offer decentralization, censorship resistance, verifiability, and user ownership, while AI brings powerful data processing, reasoning, and automation capabilities. We believe this synergy can transform the way humans and machines interact in the digital economy, ultimately leading to the emergence of an “Agentic Web,” where AI agents operate on top of crypto infrastructure rails to drive significant economic activity and growth. 

A critical distinction from that thesis is between Decentralized AI and Onchain AI. Decentralized AI (“Crypto → AI”) refers to building generic AI infrastructure that inherits the open, peer-to-peer properties of blockchain networks​. This includes efforts to democratize access to compute, data, models, and training so that AI development isn’t monopolized by a few large firms. These DeAI resources are also an enabler of Onchain AI (“AI → Crypto”) – an ecosystem of apps and services that embed AI to power new and existing blockchain use cases (e.g., trading agents, onchain portfolio managers, DeFi abstraction, etc). While Decentralized AI projects have seen the lionshare of funding and growth over the last 18 months, we believe Onchain AI is gaining momentum and signaling the next phase of rapid innovation at the intersection.

An introduction to Onchain AI

Over the past year, we saw an AI agent (i.e., Truth Terminal), equipped with a self-custody wallet, create an internet-native religion and launch a memecoin that surpassed a $950M market cap, making it the first AI agent millionaire. Today, there are roughly ~1.6K+ agents accounting for a combined ~$11B+ market cap, per cookie.fun. Overall, we’re seeing the rapid emergence of AI agents (and associated “agent tokens”) take over social channels, some with utility, and rapidly transform Onchain AI from concept to burgeoning reality.  In particular, three interrelated concepts are gaining prominence: Onchain AI Agents, Onchain AI Applications, and Agentic Commerce.

Onchain AI Agents are autonomous programs (powered by AI models) that can perform onchain actions. Think of an AI agent as a smart software robot with a crypto wallet – it can hold tokens, interact with smart contracts, trade assets, or even vote in a DAO, all based on its programming and goals. Unlike the isolated AI chatbots we often see on our social channels today, these agents can learn, reason, and act within the onchain economy. 

Onchain AI Apps refer to blockchain-based apps that integrate AI into their core functionality. For instance, AI can be embedded into DeFi protocols to optimize yield, into games to control NPC behavior, or into decentralized social networks or consumer apps to hyper-personalize user content. We’ll explore these examples shortly, but the key is that these apps aim to seamlessly blur the line between blockchain and AI-powered logic.

Agentic Commerce is an emerging mode of commerce where AI agents transact with each other (and with humans) using blockchain rails. This is a paradigm shift from manual, search-based transactions to more autonomous, intent-driven and personalized transaction experiences. Agents will be the shoppers, negotiators, and service providers, handling transactions at software speed but aligned with human intent. Crucially, blockchains provide these agents with identities, wallets, stablecoins as a payment currency, and smart contract frameworks to programmatically transact. 

In short, the importance of Onchain AI lies in opening crypto to potentially billions of AI-powered participants. Every autonomous AI agent is like a new “user” of blockchains – one that can operate 24/7 and make sophisticated decisions, setting the stage for significant onchain activity and growth. With that said, let’s take a look at the burgeoning Onchain AI ecosystem and dive into the building blocks (New infrastructure services and types of onchain agents), the emerging onchain AI applications, and how commerce itself may be transformed.

Agents

Onchain AI agents are at the heart of the “Agentic Web.” These are AI-driven entities that can perceive, decide, and act within onchain economies. To understand their rise, let’s break down the enabling infrastructure needed to make onchain agents a reality and then look at the types of agents coming to life.

Agent Infrastructure & Services

Building a capable onchain AI agent is complex – it requires a new set of services and tools that leverage foundational DeAI infrastructure resources (e.g., compute, data, models, intelligence, etc) to enable an open, autonomous agent ecosystem. These services make it easier to create, deploy, discover, and operate autonomous onchain agents by abstracting away complexity and offering reusable components. Below we outline key emerging categories of agent infrastructure and their roles in the onchain AI stack.

• Trusted Execution Environments – To truly operate autonomously and securely, onchain AI agents need environments where their execution is tamperproof, verifiable, and independent of any centralized party. Trusted Execution Environments (TEEs), such as Intel SGX or decentralized alternatives like Eternis*, Fleek*, or Phala Network, offer a hardware-secured enclave where an agent’s code and data can be processed confidentially—even from the agent creators themselves. Agents running inside TEEs are shielded from external interference and can produce cryptographic attestations proving they acted as programmed. As the agentic economy scales, embedding sovereignty at the infrastructure level will be vital to earning user trust and enabling fully autonomous agent ecosystems.

• Agent Frameworks & Tools – Agent frameworks (e.g., ElizaOS, G.A.M.E. by Virtuals, RIG, Heurist, REI) are development environments and libraries for building AI agents without starting from scratch. They provide the core architectures for agent “brains” – handling memory, decision-making, prompt responses, and task execution. While frameworks provide the brains of agents, there are onchain agent toolkits (e.g., Coinbase AgentKit, SendAI) that pre-package these frameworks for specific use cases and connect agents with smart contracts, wallets, payment rails, and onchain data. By using these frameworks and tools, agent developers can spin up robust agents with built-in support for advanced, multi-platform interactions, long-term memory, and onchain connectivity.

• Agent Launchpads – Platforms in this category help create, launch, manage, and/or monetize AI agents by packaging them as onchain entities (often with their own tokens). In practice, agent launchpads (e.g., Virtuals, auto.fun, ARC) let creators deploy new agent instances and bootstrap communities or funding around them. By aligning incentives (through tokens or fees), these launch platforms empower agent developers to sustain and scale their onchain agents as standalone projects or businesses.

• Multi-agent Coordination – Not every problem is best solved by a single agent. Multi-agent coordination protocols (e.g., Virtuals ACP, Questflow, Theoriq) orchestrate multiple AI agents (an “agent swarm”) working together to accomplish complex tasks. One agent might handle data gathering while another evaluates results, all overseen by an onchain orchestrator agent. This swarm approach can outperform monolithic agents by leveraging specialization and parallelism. By enabling agents to cooperate, multi-agent coordination platforms can expand the scope of what onchain AI can automate, from multi-step workflows to entire autonomous organizations.

• Model Context Protocols (MCP)  – Sitting at the intersection between AI agents and external data, model context protocols (originally created by Anthropic) have emerged as a key service. These protocols help standardize how onchain agents fetch relevant context, knowledge, or tools from outside sources. Instead of custom integrations for every data source or smart contract, an agent integrated with an MCP standard can plug into any compliant context provider (whether that’s onchain data, offchain databases, or web services) and retrieve the information or tools it needs. Decentralized MCPs such as Heurist and DeMCP provide agents with self-developed and open-source MCP services, enabling one-stop access to mainstream large language models, thus making onchain agents more adaptable and powerful in practice.

• AI App Stores - AI app stores (e.g., Alchemist AI, ARC Ryzome) consist of platforms that function as marketplaces and discovery layers for onchain agents, tools, and experiences. These app stores make it easy for developers to launch, monetize, and distribute agents or AI modules, while allowing users to browse, summon, or customize agents with familiar interfaces. These app stores serve not just as distribution hubs, but as coordination surfaces for the broader onchain AI economy, fostering interoperability between agents, tools, and protocols. As the number of onchain agents and AI-native applications grows, these platforms may become vital ecosystems in their own right—curating experiences, routing users, and capturing a share of the value flowing through agentic interactions.

Types of Agents

With rapid advancements in the agent infrastructure and services layers, we believe we can broadly categorize onchain AI agents into a few segments today:

• Trading / DeFi Agents – These agents specialize in financial actions – for instance, executing trades (e.g., Bankr*, Cliza), providing liquidity (e.g., BasisOS), optimizing yield (e.g., ARMA*, Mamo*), or arbitraging price differences in DeFi. They may also participate in prediction markets (e.g., Billy Bets*) or manage entire investment funds or portfolios (e.g., ai16z, aiXCB). These trading agents can react faster than humans, operate 24/7, and potentially make more data-informed decisions, which could enhance market efficiency (or perhaps outcompete human traders).

• Service Agents – Service agents are those that provide useful services to users or protocols. For example, an agent could provide relevant market analysis research and insights (e.g., aiXBT, BitQuant*, Chaos AI*). Some agents may handle DAO governance tasks – reading proposals, summarizing them, even casting votes according to a preset logic. Other service agents might audit smart contracts for bugs or auto-generate code for new smart contracts based on natural-language inputs (e.g., AgenTao, Kolwaii). There are also commerce-related service agents (e.g., Byte AI), which we’ll cover later, like agents that negotiate deals or pay for items on behalf of human users. In essence, these are the “autonomous workers” of crypto, automating onchain tasks that normally require human labor or attention.

• Entertainment Agents  – These agents focus on engaging with users. In gaming, AI agents act as NPCs (non-player characters) that can interact naturally with players. Unlike scripted game bots, these AI NPCs can learn and evolve, making games more immersive. Beyond games, we have social agents: think AI influencers (e.g., Luna) on platforms like X or Farcaster* that can post content and interact, or AI agents that can create artwork and IP based on community inputs (e.g., Botto). In the future, you might follow an AI influencer onchain who manages its own treasury (perhaps it earns crypto from content it creates on Zora8 or from tasks it does for followers). There’s also AI companions that provide hyper-personalized interactions, some with very nuanced, multi-modal expressions and actions (e.g. Nectar AI).

It’s early days, but these categories show the breadth of possibilities. From AI fund managers to AI friend sims, onchain agents could occupy many niches. What unites them is that they use cryptographic primitives as their playground and toolkit – holding assets, executing smart contract code, and leveraging the transparency and composability of decentralized networks. 

Apps

Hand-in-hand with autonomous agents, we’re also witnessing a wave of AI-powered onchain applications. These are apps and platforms that embed AI into their user experiences or core functionality. Below are a few domains where Onchain AI apps are taking shape:

• DeFi (“DeFAI”) – AI is making inroads into DeFi in multiple ways. One clear trend is AI-assisted trading and portfolio management. Instead of manually navigating complex DeFi protocols, users can leverage AI interfaces that handle it for them. For example, HeyElsa* is an AI-powered crypto co-pilot where users can simply ask its agent to perform tasks (e.g., “Swap X for Y”), and the agent will execute those actions across protocols. Protocols like Giza* provide access to non-custodial agents that can monitor DeFi markets, identity yield optimization opportunities, and dynamically manage positions with real-time market awareness. We believe this kind of AI-powered UX represents a “Wealthfront for Crypto” moment, where the robo-advisor is an onchain AI agent that’s purpose built for DeFi, effectively becoming a personal crypto portfolio manager that’s available to anyone.

• Gaming & Agentic Metaverses – Gaming is a natural playground for AI agents, and when combined with true asset ownership onchain, we get the concept of agentic metaverses. These are game worlds or virtual environments populated by AI agents alongside other agents or human players to create richer, more dynamic gameplay content. The agents could be friendly NPCs, autonomous adversaries, or even AI avatars controlled by other players. For example, Youmio is building an autonomous world where AI agents continuously learn, play, and entertain in real-time, creating ever-running simulations onchain. Additionally, firms like Farcade* are creating an AI-powered onchain gaming studio where anyone can “vibe-code” and distribute onchain games via natural-language prompts.

• Consumer AI  – AI is transforming consumer applications by making them more personalized, interactive, and intelligent. ChatGPT alternatives such as Venice and FreedomGPT allow users to access powerful models with privacy-preserving and censorship resistant inputs and outputs. In onchain social networks, AI agents can act as influencers, curators, or creators—managing content in feeds, generating posts, engaging in conversations, and even executing onchain actions (e.g., Clanker). Within onchain consumer apps (e.g., Zo), AI can help streamline onboarding, recommend actions based on onchain behaviors, or negotiate on behalf of users in peer-to-peer marketplaces. Lastly, AI companions (e.g., Nectar) allow users to create and interact with agents that respond with nuanced, multimodal expressions and actions – all verifiable onchain. These kinds of agentic experiences can help unlock a significant step-function improvement in crypto UX, thus bringing it closer to mainstream consumer expectations.

Commerce

One of the most profound implications of onchain AI is how it enables a new form of digital commerce - what Coinbase Ventures refers to as Agentic Commerce. This is commerce driven by AI agents transacting with each other and with humans. In such an economy, crypto becomes the preferred payment rail for machines as well as people​. The reasoning is straightforward: autonomous AI agents operating around the globe can’t walk into a bank, but they can trustlessly send and receive cryptocurrency on public blockchains. Crypto’s borderless, programmable nature makes it ideal for machine-to-machine payments, microtransactions, and automated contracts​. For example, the Coinbase Developer Platform team recently launched x402, a new open-source payment protocol that enables AI agents and applications to autonomously pay for GPU compute, API access, digital content, and more using crypto rails. Additionally, startups like Payman* and Skyfire* are building infrastructure services that enable agent-to-human or agent-to-agent payment orchestration using stablecoins like USDC.

While agentic commerce is still nascent, we believe it holds the promise of automating and accelerating business transactions in ways not seen before. Commerce could become a machine-speed, always-on affair, with agents negotiating deals, executing contracts, and exchanging value in seconds. Importantly, humans set the goals and parameters, and the agents do the rest. Blockchain’s role is to provide a safe and interoperable playground for these agents to transact – with clear rules (smart contracts) and reliable money (stablecoins).

Future Outlook

Looking ahead, the future of onchain AI appears full of potential, though it will unfold in stages. In the near term, we expect continued experimentation with onchain AI agents and AI-powered apps. Long-term, we believe crypto is poised to become the de facto economic layer for AI, meaning any advanced AI agent will use crypto to store value and settle transactions. As AI increasingly aids in writing software and smart contract code, the pace of innovation within the onchain economy could rapidly accelerate, bringing an influx of new applications and users.

However, realizing this vision comes with several challenges to consider. Agentic technology is still early, and some expectations have run ahead of reality. AI agents today are limited in reliability and scope, and it may take time before they can fully handle open-ended tasks safely. Scalability of blockchains will also be tested if swarms of agents start transacting simultaneously. There’s also a pressing need for new trust and governance frameworks. AI agents can supercharge onchain systems, but also amplify security and trust issues if not properly governed. 

From a value capture perspective, we believe unlocking the potential for the onchain AI economy will require the following: robust infrastructure that improves agent intelligence (e.g., data networks and post-trained models purpose-built for onchain agent use cases), services and tools for orchestrating agent behavior (e.g., multi-agent coordination, decentralized MCP, agent identity/payment rails), and distribution of agents to mainstream consumers (e.g., agent launchpads, AI app stores, and consumer AI). 

​​In conclusion, the rise of onchain AI represents a frontier for machine-driven intelligence. From autonomous agents executing smart contracts to onchain apps that adapt to user needs in real-time, this movement could redefine how humans and machines interact. It is an exciting era – one that Coinbase Ventures and many in the crypto community believe could lead to the next big leap in the evolution of the internet, an Agentic Web that ushers in a more autonomous and intelligent digital economy. 

Thanks to Hoolie (Coinbase Ventures), Luca (Base), Lincoln (Coinbase), Vik (Coinbase), Daniel (Variant), Josh (Contango Digital), Anand (Canonical), Teng (Chain of Thought), and EtherMage (Virtuals) for their thoughtful feedback and discussion on this post.

Related work

• Demystifying the Crypto x AI Stack, Coinbase Ventures, October 2024

• Blockchain for AI, Rajarshi Gupta, March 2024

Disclosures

The contents in this post — and available on any associated distribution platforms and any public Coinbase Ventures online social media accounts, platforms, and sites (collectively, “content distribution outlets”) — should not be construed as or relied upon in any manner as investment, financial, legal, tax, or other advice. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment. Investments in startups and early-stage businesses are inherently risky and highly illiquid. These types of investments are suitable only for qualified, sophisticated investors who can afford to bear the risk of losing the entirety of their investment capital.

Under no circumstances should this post or any other information provided on the Coinbase Ventures website — or on associated content distribution outlets — be construed as an advertisement, solicitation, invitation, recommendation, offer or inducement of any kind. Nor should this post or such information be construed as an offer to provide investment advisory, investment management, financial advisory, or financial management services. The information on the content distribution outlets should not be relied upon as research, investment advice or a recommendation of any kind.

Past results of Coinbase Ventures’ investments or investment strategies are not indicative of future results.  Coinbase Ventures may in the future have a position or holding in any company referred to on the Coinbase Ventures website, any associated content distribution outlets, or otherwise.

Tl;dr: The future of AI can be built on blockchain technology, as crypto can help increase accessibility, transparency, and use cases within the emerging tech. The convergence of crypto’s efficiency, borderless nature, and programmability with AI has the potential to transform how humans and machines interact with the digital economy, including by enabling users to have sovereignty over their personal data. This includes the rise of the “Agentic Web,” where AI agents operating on crypto infrastructure can drive economic activity and growth.

Disclosures and footnotes: Coinbase Ventures' portfolio companies are denoted with an asterisk (*) when first referenced in the article below.

So what does this look like? AI agents making transactions on crypto infrastructure. Software code created by AI, including smart contracts, leading to a surge in onchain applications and experiences. Users owning, governing, and earning from the AI models they contribute to. Leveraging AI to improve user and developer experiences within the crypto ecosystem, enhancing smart contract capabilities and creating new use cases. And so much more.

As we imagine this crypto x AI future, today we are unveiling our core thesis on the future of this transformative technological convergence. At a glance:

• We do not believe crypto / blockchain technology is required to advance capabilities or solve emerging challenges in every layer of the AI tech stack. Rather, crypto can play a major role in bringing more distribution, verifiability, censorship-resistance, and native payment rails to AI, while benefiting from AI mechanisms to power new user experiences onchain. 

• Crypto x AI can give rise to the “Agentic Web”, a transformative paradigm in which AI agents operating on crypto infrastructure rails can become significant drivers of economic activity and growth. We predict a future where agents will have their own crypto wallets to autonomously transact and fulfill user intents, access lower-cost, decentralized compute and data resources, or leverage stablecoins to pay humans and other agents to complete tasks necessary for their overall objective function. 

• Preliminary beliefs underpinning this thesis include: (1) Crypto will be the preferred payment rail for agent-to-human and agent-to-agent commerce, (2) Generative AI and natural-language interfaces will become the primary modality for users seeking to transact onchain, and (3) AI will create the majority of all software code (incl. smart contracts), resulting in a cambrian explosion of onchain apps and experiences.

• The intersection of Crypto and AI is composed of two core sub-segments: (1) Decentralized AI (Crypto -> AI) defined as building generic AI infrastructure to inherit the properties of modern peer-to-peer blockchain networks and (2) Onchain AI (AI -> Crypto) defined as building infrastructure and apps that leverage AI to power both new and existing use cases.

• The Crypto x AI landscape can be segmented into the following layers: (1) Compute (i.e., networks focused on supplying latent graphics processing units (GPUs) to AI developers), (2) Data (i.e., networks that enable decentralized access, orchestration, and verifiability of the AI data pipeline), (3) Middleware (i.e., networks/platforms that enable the development, deployment, and hosting of AI models / agents), and (4) Applications (i.e., user-facing products (B2B or B2C) that leverage onchain AI mechanisms)

At Coinbase, we’re on a mission to help update the financial system to make it safer and more secure, while improving accessibility and usability for consumers and builders alike. We believe Crypto x AI is going to play a significant role in this. In this blog, we’ll dive deeper into the why, how, and what next of Crypto x AI.

The AI market has seen significant growth and investment, with venture capital firms pouring nearly $290 billion into the sector over the past five years. The World Economic Forum suggests that AI technologies could boost annual US GDP growth by 0.5-1.5% over the next decade. AI applications are demonstrating real traction, with apps like ChatGPT4 setting new records for user growth / adoption. However, as the AI market rapidly evolves, several challenges are emerging, including data privacy concerns, the need for AI talent, ethical considerations, centralization risks, and the rise of deepfake technology. These challenges are driving the current discourse around the intersection of crypto and AI, as stakeholders seek solutions that leverage the strengths of both technologies to address these emerging issues.

Crypto x AI combines blockchain's decentralized infrastructure with AI's ability to mimic human cognitive functions and learn from data, creating a synergy that could revolutionize various sectors. Blockchain redefines system architectures, data / transaction verification, and distribution. AI enhances data computation, analysis, and offers new content generation capabilities. This intersection has sparked both excitement and skepticism among developers in both technology communities, driving the exploration of novel use cases that could accelerate the adoption of both sectors in the long term. While crypto and AI are both general terms that encompass a wide range of different technologies and themes, we believe the intersection of both fields can be broken down into two core sub-segments:

• Decentralized AI (Crypto -> AI) enhances AI capabilities through crypto's permissionless, and composable infrastructure. This unlocks use cases such as democratized access to AI resources (e.g., compute, storage, bandwidth, training data, etc), collaborative, open-source model development, verifiable inference, or immutable ledgers and cryptographic signatures for content provenance and authenticity.

• Onchain AI (AI -> Crypto) brings AI's benefits to the crypto ecosystem, improving user and developer experiences via LLMs and natural-language interfaces or enhancing smart contract capabilities. Two pathways for onchain AI adoption include: (1) Developers integrating AI models or agents into their smart contracts and onchain apps and (2) AI agents leveraging crypto rails (e.g., self-custody wallets, stablecoins, etc) for payments and commissioning decentralized infrastructure resources.

While both segments are still nascent, the potential for “Crypto in AI” or “AI in Crypto” is significant and poised to unlock a new set of use cases that haven’t been conceived of, especially as compute infrastructure and intelligence speeds continue to improve.

Crypto x AI: A key unlock for the “Agentic Web”

One area that we find to be particularly exciting across Crypto and AI is the concept of AI agents operating on crypto infrastructure rails. This integration aims to create the “Agentic Web”, a transformative paradigm that could enhance security, efficiency, and collaboration in AI-driven economies, underpinned by robust incentive structures and cryptographic primitives. 

We believe that AI agents can become significant drivers of economic activity / growth and the predominant “users” of applications (both on/offchain), gradually shifting away from human users in the medium-to-long term. This paradigm shift would force many internet-native firms to rethink their core assumptions about the future and deliver the necessary products, services, and business models to best serve a largely agent-based economy. With that said, we do not believe crypto / blockchain technology is required to advance capabilities or solve emerging challenges in every layer of the AI tech stack. Rather, crypto can play a major role in bringing more distribution, verifiability, censorship-resistance, and native payment rails to AI, while benefiting from AI mechanisms to power new user experiences onchain. 

Our preliminary beliefs underpinning this thesis are as follows:

• Crypto will be the preferred payment rail for agent-to-human and agent-to-agent commerce: Crypto is internet-native, programmable money that has several advantages for powering the agent-based economy. As AI agents become more autonomous and engage in micro-transactions at scale (e.g., paying for inference, data, API access, decentralized compute or data resources, etc), crypto’s efficiency, borderless nature, and programmability will make it the preferred medium of exchange over traditional fiat rails. Additionally, agents will require unique, verifiable identities (i.e., “Know Your Agent”) to ensure adherence to regulatory rules and compliance requirements while transacting with enterprises and end-users. Low-fee blockchains, smart contracts, self-custody wallets (e.g., Coinbase AI Wallets), and stablecoins can help streamline and reduce costs for complex financial agreements between agents, while the verifiability and immutability of decentralized networks will ensure the trust and auditability of AI agent transactions.

• Generative AI and natural-language interfaces will become the primary modality for users seeking to transact onchain: As natural language processing speed and AI’s contextual understanding of crypto improves, interacting onchain through conversational interfaces will become the default user norm and expectation, in line with current web2 trends (e.g., ChatGPT). Users will simply describe their desired transaction intent in natural language (e.g., “Swap X for Y”), and AI agents will translate those intents into verifiable smart contract code, offering the most efficient and cost-effective transaction execution path.

• AI will create the majority of all software code (incl. smart contracts), resulting in a cambrian explosion of onchain apps and experiences: AI’s code generation capabilities are rapidly advancing in web2 (e.g., Devin, Replit), and fundamentally changing software development paradigms. We believe this shift will soon take center stage in crypto, with a near term focus on significantly lowering the barrier of entry for new and existing builders. However, the future state consists of AI “software agents” generating smart contracts and hyper-personalized apps from scratch in real-time, based on a user’s preferences, stored and verified onchain. 

These beliefs suggest a future where the lines between AI and crypto become increasingly blurred, creating a new paradigm of intelligent, autonomous, and decentralized systems. With this framing in mind, let’s take a closer look at the enabling Crypto x AI tech stack layer-by-layer.

The quest to integrate “Crypto into AI” or “AI into crypto” has given rise to a burgeoning, yet complex, landscape that is rapidly evolving, with many builders rushing to capitalize on market momentum. Today, we believe the Crypto x AI landscape can be segmented into the following layers: (1) Compute (i.e., networks focused on supplying latent graphics processing units (GPUs) to AI developers), (2) Data (i.e., networks that enable decentralized access, orchestration, and verifiability of the AI data pipeline), (3) Middleware (i.e., networks/platforms that enable the development, deployment, and hosting of AI models / agents), and (4) Applications (i.e., user-facing products (B2B or B2C) that leverage onchain AI mechanisms)

AI necessitates vast computational GPU resources for both the training of models and execution of inferences. Given that AI models are becoming increasingly complex and growing in their demand for compute, there is a scarcity of state-of-the-art GPUs, such as Nvidia’s offerings, resulting in long wait times and increasing costs. Decentralized compute networks are emerging as a potential solution to those challenges by: 

• Establishing permissionless marketplaces for buying, renting, and hosting physical GPUs

• Building GPU aggregators that enable anyone (e.g., Bitcoin miners) to contribute their excess GPU compute capacity for on-demand AI job execution, in return for token incentives

• Financializing physical GPUs by tokenizing them into digital assets onchain

• Developing distributed GPU networks for computationally intensive workloads (e.g., training, inference)

• Creating infrastructure that enables AI models to be run on personal devices (think decentralized Apple Intelligence)

Each of these proposed solutions aim to increase GPU compute supply and accessibility, while offering very competitive pricing. However, given that most players in this segment have varying degrees of support for advanced AI workloads, face challenges related to the lack of co-location of GPUs, and in some cases, lack developer tooling and uptime guarantees on par with centralized alternatives, we believe that mainstream adoption of these offerings is unlikely in the near-to-medium term. Emerging segments and sample projects building at this layer include the following:

• General-purpose Compute: Decentralized compute marketplaces that provide GPU computing resources that can be used for a variety of applications (e.g., Akash, Aethir)

• AI / ML Compute: Decentralized compute networks that provide GPU computing resources for a specific service, such as GPU aggregators, distributed training and inference, GPU tokenization, etc (e.g., io.net, Gensyn, Prime Intellect, Hyperbolic, Hyperspace)

• Edge Compute: Compute and storage networks that power on-device LLMs for personal, contextualized inference (e.g., PIN AI, Exo, Crynux.ai, Edge Matrix)

Scaling AI models requires growing training datasets, with LLMs being trained on trillions of words from human-generated text. However, there is only a finite amount of public, human-generated data today (Epoch AI estimates high quality language / data sources could be exhausted by 2024), which raises the question of whether the lack of training data could become a major bottleneck, potentially leading to a plateau in AI model performance. Therefore, we believe data-focused, crypto x AI firms have the following opportunities to address these challenges: 

• Incentivize users to share their private / proprietary data (e.g., “Data DAOs” - onchain entities where data contributors could see economic upside from contributing their private data from social platforms govern how that data is used and monetized)

• Create tooling for generating synthetic data assets from natural language prompts or provide user incentives to scrape data from public websites

• Incentivize users to help pre-process datasets for training models and maintain data quality (e.g., data labeling / reinforcement learning from human feedback)

• Establish multi-sided, permissionless data markets, where anyone can be compensated for contributing. 

These opportunities are giving rise to many of the emerging players we see in the data layer today. However, it’s worth noting that centralized incumbents across the AI model lifecycle have existing network effects and proven data compliance regimes that traditional enterprises value, which may leave little room for decentralized alternatives. With that said, we believe the data layer for decentralized AI presents a significant long-term opportunity to address the “Data Wall” challenge. Emerging segments and sample projects building at this layer include the following:

• Data Marketplaces: Decentralized data exchange protocols designed for data providers and consumers to share and trade data assets (e.g., Ocean Protocol, Masa, Sahara AI)

• User-owned / Private Data (incl. DataDAOs): Networks designed for incentivizing the collection of proprietary datasets, including private user-owned data (e.g., Vana*, NVG8)

• Public & Synthetic Data: Networks / platforms for scraping data from public websites or generating new datasets via natural language prompts (e.g., Dria, Mizu, Grass, Synesis One)

• Data Intelligence Tools: Platforms and applications designed to query, analyze, visualize, and provide actionable insights on onchain data (e.g., Nansen*, Dune*, Arkham, Messari*)

• Data Storage: File storage networks intended for long-term data storage / archiving and relational database networks designed for managing structured data that is accessed and updated frequently (e.g., Filecoin, Arweave*, Ceramic*, Tableland*)

• Data Orchestration / Provenance: Networks and platforms that optimize data ingestion pipelines and processing for AI and data-intensive applications and ensure proper provenance tracking and verifiable authenticity of AI-generated content (e.g., Space and Time, The Graph*, Story Protocol)

• Data Labeling: Networks and platforms that improve reinforcement learning and fine-tuning mechanisms for AI models by incentivizing a distributed network of human contributors to create high-quality training datasets (e.g., Sapien, Kiva AI, Fraction.AI)

• Oracles: Networks that use AI to provide verifiable offchain data for onchain smart contract (e.g., Ora, OpenLayer, Chainlink)

Realizing the full potential of an open, decentralized AI model or agent-based ecosystem requires new infrastructure to be constructed. Some high-potential areas that builders are exploring include the following:

• Employing the use of open-weight LLMs to power onchain AI use cases while simultaneously building foundational models that can quickly understand, process, and act on onchain data

• Distributed training solutions for large foundational models (e.g., 100B+ parameters); often seen as a pipe dream due to various technical complexities, but recent breakthroughs by Nous Research, Bittensor, and Prime Intellect are seeking to change that narrative 

• Leveraging zero-knowledge or optimistic machine learning (i.e., zkML, opML), trusted execution environments (TEEs), or fully-homomorphic encryption (FHE) to enable private, and verifiable inference

• Enabling open, collaborative AI model development via resource coordination networks or building agentic networks/platforms that leverage crypto infra rails to enhance AI agent potential for on/offchain use cases

While there has been some progress on building these fundamental infrastructure primitives, production-ready, onchain LLMs and AI agents are still nascent, and we don’t expect this dynamic to change in the near-to-medium term, subject to the underlying compute, data, and model infra maturing. With that said, we see this category as being very promising and a core focus for Coinbase Ventures’ investment strategy in the space, driven by the implied growth and demand for AI services long-term. Emerging segments and sample projects building at this layer include the following:

• Open-weight LLMs: AI models whose weights are publicly accessible, allowing anyone to use, modify, and distribute them freely (e.g., LLama3, Mistral, Stability AI)

• Onchain Model Creators: Networks and platforms enabling the creation of foundational LLMs for onchain use cases (e.g., Pond*, Nous, RPS)

• Training & Fine-tuning: Networks and platforms that enable incentivized and verifiable training or fine-tuning mechanisms onchain (e.g., Gensyn, Prime Intellect, Macrocosmos, Flock.io)

• Privacy: Networks and platforms that employ privacy-preserving mechanisms for the development, training, and inference of AI models (e.g., Bagel Network, Arcium*, ZAMA)

• Inference Networks: Networks that employ cryptographic techniques / proofs to verify the correctness of AI model outputs (e.g., OpenGradient*, Modulus Labs, Giza, Ritual)

• Resource Coordination Networks: Networks designed to facilitate the resource sharing, collaboration, and coordination of AI model development (e.g., Bittensor, Near*, Allora, Sentient)

• Agentic Networks & Platforms: Networks and platforms that facilitate the creation, deployment, and monetization of AI agents for both on/offchain environments (e.g., Morpheus, Olas, Wayfinder, Payman*, Skyfire*)

Within crypto, AI agents are beginning to make their presence felt, with early instances like Dawn Wallet (i.e., a crypto wallet that utilizes AI agents to send transactions and interact with protocols on behalf of users), Parallel Colony* (i.e., an onchain game where players partner with AI agents that have their own wallets and can create their own pathways within the game), or Venice.ai (i.e., a generative AI app / natural language prompt with verifiable inference and privacy-preservation mechanisms). However, app development is still largely experimental and opportunistic, with a disarray of app ideas blooming from hype in the space. With that said, we believe advancements in AI agent infrastructure and frameworks are poised to shift the crypto design space from primarily reactive smart contract applications to more complex, proactive applications in the medium-to-long term. Emerging segments and sample projects building at this layer include the following:

• AI Companions: Apps for creating, sharing, and monetizing user-owned AI models and  agents with personalized and contextual awareness (e.g., MagnetAI, MyShell, Deva, Virtuals Protocol)

• NLP-based Interfaces: Apps in which natural language prompts are the primary interface / entry point for interacting with and executing onchain transactions (e.g., Venice.AI, Veldt)

• Dev / Security Tools: Developer-facing apps/tools that leverage AI models / agents to enhance onchain developer experiences and security mechanisms (e.g., ChainGPT, Guardrail*)

• Risk Agents: Services that leverage ML models or AI agents to help protocols dynamically adjust and respond to onchain risk parameters in real-time (e.g., Chaos Labs*, Gauntlet*, Minerva*)

• Identity (Proof of Personhood): Apps that leverage cryptographic proofs and ML models to verify user’s proof of personhood. (e.g., Worldcoin*)

• Governance: Apps that leverage AI agents to execute transactions based on human-driven governance decisions / feedback (e.g., Botto, Hats)

• Trading / DeFi: AI-powered trading infrastructure and DeFi protocols that utilize AI agents to automate onchain transaction execution (e.g., Taoshi, Intent.Trade)

• Gaming: Onchain games that utilize intelligent NPCs or AI mechanisms to power core gameplay mechanics (e.g., Parallel*, PlayAI)

• Social: Apps that utilize AI mechanisms to power onchain social experiences (e.g., KaiKai, NFPrompt)

While the Crypto x AI stack is still in its nascent stages, we believe there will be significant advancements in decentralized AI infrastructure, onchain AI applications, and the emergence of an "Agentic Web" where AI agents become the primary drivers of economic activity. While challenges remain in areas such as compute infrastructure and data availability, the synergies between crypto and AI could accelerate innovation in both sectors, leading to more transparent, decentralized, and autonomous systems. As the landscape continues to rapidly evolve, driven by new teams securing funding and more established teams working towards finding product/market fit, it will be crucial for internet-native firms and developers to adapt to the changing paradigm and embrace the potential for Crypto x AI to create novel applications and experiences that were previously unimaginable.

Overall, Coinbase Ventures is excited about the future potential and opportunities within Crypto x AI, and we are actively investing within each layer of the stack. If you're building edge computing infrastructure, decentralized data collection / provenance networks, agentic networks or platforms employing onchain payment rails, or novel applications powered by onchain AI mechanisms, we would love to hear from you.

Related work

• Coinbase Developer Documentation: AI Wallets, September 2024

• Coinbase Research: Blockchain for AI, March 2024

Disclosures and footnotes: Coinbase Ventures portfolio company backed projects are mentioned in the article including – Optimism, Arbitrum, Celestia, Eigenlayer, Stack, ThirdWeb, Syndicate, Conduit, Alchemy, Socket, Everclear, Reservoir, Starkware, Matter Labs.

L3s (or “Layer 3s”) are an emerging phenomenon among onchain developer deployments especially in the EVM L2 landscape. This document explains the basics of L3s, the value propositions, and implications for the broader ecosystem.

TLDR:

• While L2s’ lower gas fees / increased throughput have enabled them to become the hub of onchain activity & account for a sizable portion of the ETH-based economy, they may be constrained by pressure to maintain decentralization & alignment with ETH L1.

• Builders that want to [1] experiment and customize their apps, and [2] align with an L2 for distribution, are now opting to build L3s – which are application-chains that settle to an underlying L2. 

• This document is focused on building a shared understanding of L3s.

Takeaways

What are L3s?

If L2s are the onchain hubs, L3s can be thought of as “onchain servers” that have isolated state environments & fee markets but settle to an underlying L2 & tap into their onramp / distribution mechanisms. This provides apps their own customizable blockspace that they control, while still leveraging the existing liquidity & user bases of L2s.

• Cost: Up to 1000x cheaper costs due to a combination of: (1) Lower onboarding costs (onboard directly from CEX to L2), (2) slightly cheaper settlement/execution costs (as transactions settle to an L2 vs. L1), & most importantly (3) alternative data availability (“DA”), which is how chains verify data accuracy (DA is 95%+ of total cost for L2s that use ETH L1 data). Gas fees are also more predictable as L3s have their own fee markets (e.g., on L2, surging activity on one app raises fees for all others)

• Customizability: L3s are held to a lower decentralization standard than L2s, which unlocks ability to experiment with new tokenomics (i.e., custom gas tokens), virtual machines (i.e. Solana VM on ETH L2), & alt-DAs (i.e. Celestia instead of ETH L1)

  

How are L3s different from L2s?

L3s are rollups and therefore share many similarities to how people will understand L2s.

• Settlement: Similar to how L2s settle to L1s, L3s settle to an L2

• Bridge: Similar to how assets are bridged canonically (or 3rd-party) from L1 to L2, same from L2 to L3

• Virtual Machine: The software stack that an L3 utilizes does not necessarily need to run on the same stack as its underlying L2. For example, many of the L3s in production run on Arbitrum Nitro, but settle to Base (which runs on OP Stack).  In addition, most L3 stacks are modifications to existing popular L2 stacks. For example – Arbitrum (Nitro) and OP Stack have launched modified stacks tailored to needs of L3 builders

• Data Availability: This is the largest difference. L3s will opt to use alternative DA layers (ex. Celestia, EigenDA, Arbitrum AnyTrust) while L2s have to use ETH L1 for alignment / decentralization purposes. As a result, L3s achieve extremely low cost gas environments.

How do you launch L3s?

• As L3s are predominantly leveraging permissionless / open-source tech stacks, developers can either (1) run the stack / infra themselves, (2) leverage a Rollup-as-a-Service (“RaaS”) provider (i.e. Conduit, Caldera) that provide managed services to deploy & host your L3, or (3) consult with a white-label service provider (i.e. Syndicate) that “sub-contracts” out to various infrastructure providers (i.e. RaaS, Bridges, DevTools) under the hood.

Will there be L4s?

• As L3s offer dedicated blockspace & the ability to natively bridge into L2 “hubs” with liquidity / users, we believe this will cover all material onchain use cases. 

• L3s are likely the “last” frontier for vertical scaling (i.e., no L4s), even as L2 transaction costs come down

  • Integration to an L2 – the core premise for L3s is the ability to leverage the underlying L2 “hubs” with liquidity / users. Building at an “L4” is further in proximity and defeats the purpose. 

  • No cost improvement – the alternative DA is the reason for the cost delta. Moving up the stack will not meaningfully change the settlement / execution cost component. 

• If an L3 reaches scaling limits, rather than scaling further vertically (“L4”), they will likely spin up another L3 that settles to the same L2 (linked through native bridge). The end result is that L3s will likely scale horizontally rather than vertically

Ecosystem Implications

L3s will become another preferred direction for onchain builders potentially resulting in a handful of L2 “hubs” with millions of L3 “servers”

• L3s represent a potential paradigm shift for onchain developers as they break the subcent barrier and reduce the threshold for building mainstream-scale onchain apps, leading to potentially the “app store” moment w/ millions of L3s. 

• L3s offer an experimental playground for builders and are perfect for high throughput / low cost applications – which can then tap into the underlying L2 hubs for liquidity / onramps / distribution 

• There is a potential outcome where there are tens~hundreds of L2 hubs, while there are millions of L3s. 

L3s may be the potential “AWS” moment from a cost perspective

• One observation is that L2s are becoming their own onchain hubs. The cost profile to operate an L2, due to its L1 proximity, is generally high and can range anywhere from 7~8 figures of USD per year.

• L3s on the other hand operate a much lower cost profile, and annual cost of operating an L3 can range anywhere between $25~50K. 

L3s developers will drive popularity of frameworks beyond Solidity / Vyper resulting in multi-VM environments

• There are projects experimenting with bringing alternative frameworks (e.g. MoveVM, SolanaVM, Arbitrum Stylus) deployed on Ethereum. The goal is to expand the set of developer offerings, while leveraging the existing network effects, liquidity, and onramps of Ethereum.

• This will likely manifest first at the L2 level – but we can expect these frameworks to be deployed as L3s that want to be purposeful on leveraging L2 hubs like Base. 

• The net result is that an L2 can attract the widest TAM of developers at the L3 level while maintaining its own chain on the EVM (vs trying to integrate multi-VM into the L2 directly).

L3s value flows will rely on the application layer

• The KPI for individual L3s are users and transactions and token utility, rather than sequencer fees. The average value created by an individual L3 will likely be small – but as the number of L3s multiply this will create network effects.

• Growth of L3s will generally benefit on value creation on the software side (ex. Developer Tools, Rollup As A Service) and on the protocol side (Data Availability, Chain Abstraction), but will only scale at large quantities of L3s.

• We can expect a single issuer / project potentially launching multiple L3s, resulting in their own L3 ecosystem. For example – an onchain gaming ecosystem might have a single L3 for each game, and spin up additional L3 for another game – and the emergent ecosystem will provide residual value that is accrued and shared with other stakeholders. 

L3s will require smoother interoperability and chain abstraction to succeed

• If the intended purpose of the L3 is to tap into the L2 user’s UX, and we expect a growing number of L3s per application use-case, then interacting with these L3s needs to become seamless at the user level

• Similar to L2s, L3 bridging can be achieved in two ways: natively, if the L3 settles to the L2, or through a 3rd-party provider. 3rd-party providers are better suited for L3s due to the experimental nature of the L3 stack, potentially resulting in a non-uniform and flexible bridging layer (see State of Bridging).

• At the same time, L3s might only prioritize interoperability with their canonical L2 settlement chain rather than aiming for full interoperability with all other chains. As a result, they will focus on enhancing the feature set of the bridge, such as reducing latency and providing one-stop liquidity, to improve the overall user experience.

• Orthogonally, there is ongoing protocol R&D around how to introduce native concepts at the sequencer level (see Based Rollups)

Future Outlook

In conclusion, the L2 ecosystem should expect to see the growth of L3 builders that will want to create isolated onchain application experiences while tapping into underlying L2 hubs. 

Within the L3 landscape, Coinbase Ventures is investing in new use-cases that emerge. If you’re building in these areas, we would love to hear from you – Ryan Yi’s DMs are open!

This material is for informational purposes only, and is not (i) an offer, or solicitation of an offer, to invest in, or to buy or sell, any interests or shares, or to participate in any investment or trading strategy, (ii) intended to provide accounting, legal, or tax advice, or investment recommendations or (iii) an official statement of Coinbase.  No representation or warranty is made, expressed or implied with respect to the accuracy of the information contained herein.  Coinbase may have financial interests in, or relationships with, some of the entities and/or publications discussed or referenced in the materials.  Coinbase does not endorse or approve links or third-party websites that may be provided in the materials.

Disclosures and footnotes: Coinbase Ventures portfolio company backed projects are denoted with an asterisk (*) when first referenced in the article below.   

TL;DR: 

• EigenLayer* is a protocol built on Ethereum that introduces restaking, a new primitive in crypto-economic security that has emerged as a leading narrative within the Ethereum community. 

• Restaking via EigenLayer enables developers to leverage Ethereum's existing economic security infrastructure (i.e., validator set and staked ETH) to bootstrap new Actively Validated Services (AVS).

• Compared to how traditional cloud platforms and SaaS solutions were transformative to web2 development, we believe the emergence of EigenLayer and its burgeoning ecosystem of AVSs unlocks a "verifiable cloud" paradigm for web3. 

• As restaking and shared security models evolve, their impact on blockchain ecosystems will become increasingly evident, driven by growing demand from stakers and developers seeking to unlock new opportunities onchain.

What is EigenLayer?

EigenLayer is a protocol built on Ethereum that introduces restaking, a new primitive in crypto-economic security. At its core, EigenLayer consists of a series of smart contracts that allow users to opt-in to "restake" their staked ETH or liquid staking tokens (LST) to bootstrap new proof-of-stake (PoS) networks and services within the Ethereum ecosystem in return for additional staking yield/rewards. 

EigenLayer's core objective is to unlock a new era of permissionless innovation and free-market governance by reducing developer complexity when building and bootstrapping these networks from scratch. This is done by leveraging Ethereum's established trust guarantees and economic security infrastructure. 

EigenLayer launched in 2023, enabling users to restake their staked ETH or LSTs. As of May 14, 2024, more than 4.9M in ETH (worth ~$15B+) has been restaked into the EigenLayer protocol. 

Source: EigenLayer Whitepaper

Why does it matter?

The Ethereum network utilizes a proof-of-stake (PoS) consensus mechanism, in which node operators stake their ETH and run validator software to secure the network (i.e., store data, process transactions, add new blocks to the beacon chain, etc.) in return for rewards (i.e., share of network fees). If a node operator fails to perform their validation function or misbehaves, they risk losing their staked ETH (i.e., slashing).

Now, developers seeking to build a protocol on top of Ethereum that requires external operators would typically need to bootstrap and secure their own PoS network. Doing so is an arduous undertaking that requires developers to design/launch a token, incentivize node operators to stake the token and run validator software, and implement fair reward distribution and slashing mechanisms. Additionally, per EigenLayer, forcing each new protocol to bootstrap its own PoS network fragments the security of Ethereum and siphons value (i.e., in the form of staked tokens) away from the beacon chain.

How does EigenLayer Work?

EigenLayer sought to solve the challenges above by enabling developers to leverage Ethereum's existing validator set and staked ETH from day one via an approach it calls "shared security." Not only do shared security and restaking mechanisms promise to lower entry barriers for developers and foster rapid innovation within the Ethereum ecosystem, but they also aim to create novel avenues for Ethereum stakers to actively participate in multiple networks that require crypto-economic collateral and external operators, thus maximizing their reward potential. 

EigenLayer's protocol architecture consists of four key components: restakers, operators, actively validated services (AVS), and AVS consumers.

• Restakers: individuals or entities who restake their staked ETH or LSTs to extend security to services in the EigenLayer ecosystem, known as Actively Validated Services (AVS).

• Operators: entities that run specialized node software and perform validation tasks for AVSs built on top of EigenLayer in return for pre-defined rewards. Operators register in EigenLayer, allow restakers to delegate to them, and then opt-in to provide validation services for various AVSs. It's important to note that operators are subject to each AVS's slashing conditions.

• Actively Validated Services (AVS): any system that requires unique distributed validation methods for verification. AVSs can take several forms, including data availability layers, shared sequencers, oracle networks, bridges, coprocessors, applied cryptography systems, and more. 

• AVS Consumers: end-users or applications that utilize the services provided by EigenLayer.

The "Verifiable Cloud" for Crypto

Sreeram Kannan, Founder of EigenLayer, is often quoted as saying, "EigenLayer is the Verifiable Cloud for Crypto," but what exactly does this mean? In traditional cloud architectures, centralized entities provide computing, storage, and hosting services to various web2 SaaS solutions. These SaaS solutions are often segmented into two categories: Horizontal SaaS (i.e., software solutions that are generalizable and usually target a broad audience of end-users, regardless of their industry) and Vertical SaaS (i.e., software solutions that target a specific niche, use case, or industry standard). 

Compared to how cloud platforms and SaaS solutions were transformative to web2's development, we believe the emergence of EigenLayer and AVSs offers a similar paradigm shift for blockchain ecosystems. EigenLayer aims to provide crypto-economic security services to AVSs (e.g., "web3 SaaS"). Similar to the emergence and broad adoption of SaaS solutions in the web2 context, we see a similar trend of AVSs emerging, driven by increased demand from protocols and dapps.

Overall, EigenLayer's "shared security system" aims to drive rapid innovation onchain while offering enhanced decentralization, trust, and transparency, thus redefining the future of "verifiable cloud" computing. 

The EigenLayer AVS Landscape (Today)

On April 9, 2024, EigenLayer launched its Operator and AVS modules on mainnet and is now home to a vibrant ecosystem of operators (200+ as of May 14, 2024) along with a growing pipeline of AVSs expected to launch in the coming months (11 live today). Similar to the traditional SaaS landscape, we expect AVSs to naturally segment into distinct categories (i.e., horizontal and vertical-specific).

This landscape is not exhaustive and contains Coinbase Ventures portfolio companies.

With the above framing in mind, we see the EigenLayer AVS landscape (today) as follows:

"Horizontal" AVSs

• Developer Services: frameworks and tooling that help developers build and deploy PoS networks (e.g., AVSs, L1s/L2s, etc) that require shared security infrastructure (e.g., Othentic*, Blockless, Ethos)

• Operator Services: services that help AVS operators manage their node infrastructure, validator tasks, and/or staking operations (e.g., Supermeta)

• Payment Services: services for managing payment (i.e., AVS rewards) delivery to restakers and operators (e.g., Anzen)

"Vertical" AVSs

• Rollup Services: enables the development of foundational services that scale Ethereum (e.g., rollups) while inheriting security from Ethereum’s trust network. Examples include: Data Availability (e.g., EigenDA, NearDA), Shared Sequencing (e.g., Espresso*, Radius), Rollup-as-a-Service (e.g., Caldera, AltLayer), or Interoperability (e.g., Omni*, Polymer*, Hyperlane, Polyhedra)

• Decentralized Networks: networks that require distributed validator mechanisms. Examples include Oracles (e.g., eOracle), Proof Verification (e.g., Aligned Layer), DePIN (e.g., WitnessChain, OpenLayer), Security Monitoring (e.g., Drosera), or Smart Contract Policy Engines (e.g., Aethos)

• Coprocessors: services that provide developers with cost-effective and verifiable offchain computing capabilities. Examples include Database coprocessors (e.g., OpenDB), ZK coprocessors (e.g., Lagrange, Brevis, Space and Time), Trusted Execution Environments and Encryption Coprocessors (e.g., Automata, Fairblock), or AI Inference (e.g., Ritual)

• Applied Cryptography: services for creating robust cryptographic systems. Examples include Fully-homomorphic Encryption (e.g., Fhenix), Multi-party computation (e.g., Silence Laboratories), or Threshold Cryptography (e.g., Mishti Network)

• MEV Management: emerging services that allow block proposers to make additional credible commitments on block inclusion and ordering

Application Layer

• Atop the AVSs, we expect new onchain apps to emerge that seek to harness EigenLayer's unique economic security properties. 

• Emerging examples include Rollups, Liquid Restaking Tokens (LRTs) and associated LRTFi apps (i.e., DeFi protocols that use LRTs as an underlying source of collateral), social and gaming applications, decentralized physical infrastructure networks (i.e., DePIN), and identity / privacy-preserving apps.

Future Outlook

As restaking and shared security models evolve, their impact on the blockchain ecosystem becomes increasingly evident. The growing demand from stakers / validators seeking to maximize their yield potential and developers seeking to accelerate innovation at the infrastructure level has the potential to unlock new opportunities onchain. Additionally, while EigenLayer was the first to launch a restaking protocol, we are seeing the emergence of similar mechanisms across other ecosystems: Bitcoin (e.g., Babylon Chain), Solana (e.g., Solayer, Cambrian, Fragmetric), IBC (e.g., Picasso Network*), Omnichain restaking (e.g., Exocore), and Multi-asset restaking (e.g., Karak).

That said, while restaking and shared security models open up many exciting opportunities onchain, restakers need to understand the risks that may occur from smart contract security risks or unintended slashing events. It's worth noting that EigenLayer's slashing and payments (i.e., AVS rewards) mechanisms are not live as of this writing but will launch later this year.

Overall, Coinbase Ventures is excited about the potential of restaking and shared crypto-economic security. If you're building AVS management platforms (i.e., think API management-like platforms for developers to manage their AVS endpoints), AI coprocessors, or MEV management-related AVSs (on EigenLayer or other restaking protocols), we would love to hear from you. JK's DMs are open!

Related work

• Coinbase Institutional Research: Restaking: Everything Old is New Again, April 2024

• Coinbase Cloud: Guide to EigenLayer, April 2024

This material is for informational purposes only, and is not (i) an offer, or solicitation of an offer, to invest in, or to buy or sell, any interests or shares, or to participate in any investment or trading strategy, (ii) intended to provide accounting, legal, or tax advice, or investment recommendations or (iii) an official statement of Coinbase.  No representation or warranty is made, expressed or implied with respect to the accuracy of the information contained herein.  Coinbase may have financial interests in, or relationships with, some of the entities and/or publications discussed or referenced in the materials.  Coinbase does not endorse or approve links or third-party websites that may be provided in the materials.

Disclosures and footnotes: Coinbase Ventures portfolio company backed projects are denoted with an asterisk (*) when first referenced in the article below.   

"Smart Accounts" (or “Smart Wallets”) – which we define as smart contract wallets (SCW) with “Account Abstraction” features – have become a top-of-mind conversation among crypto developers. Account Abstraction (“AA”) launched in the EVM ecosystem in Q1-2023 and is beginning to see an uptick in adoption. This document explains the value proposition, adoption inflection, and implications for the broader ecosystem. 

TL;DR

• AA defines a standard for meta-transactions such that users can transact and have them executed by a 3rd-party. 

• AA may help usher in a 10x in user experience through sponsored gas + bundled transactions + Passkey adoption. 

• AA enables the ability for developers to experiment with sponsored onboarding for a net new user – customer acquisition cost (CAC).

• Ecosystem adoption is picking up and mindshare is growing. Value proposition is still “nice to have” but with tech/cost improvements, new use-cases, and onboarding education – AA may become a table-stakes “must have” infrastructure offering for users.

Smart Account Summary 

AA 101

• What is AA? “Account Abstraction” (or ERC-4337) launched in Q1-2023 to the ETH / EVM ecosystem. AA defines a standard such that users can transact on Ethereum without initiating an ETH transaction themselves (and have it executed by a third-party). 

  • Example in practice: a user signals an intent to purchase an NFT by creating a transaction request, but the actual gas + onchain settlement is handled by a 3rd-party.

• Why is AA important? Today we have self-custodial wallets (like Coinbase Wallet) and MPC/embedded wallets (managed keys). To date, SCWs (smart contract wallets) have had interesting security features (multi-sig, spending limits) and non-security features (batch transactions) mostly targeted at onchain DAO treasury use-cases – but had limited consumer adoption due to gas cost. With AA, smart contract wallets have a new value proposition because there is a path for gasless transactions that is interesting to a lot of apps, and the gas-cost downside of SCW has been mitigated by L2s. These SCWs are also described as “Smart Accounts.” The community believes that AA features will help usher in a 10x in user experience for dapps because of the following attributes:

  • [1] Sponsored Gas: users do not need to incur gas cost to “load their wallet” for the first few transactions.

  • [2] Passkeys: users can utilize their Apple / Google device security to sign transactions. This will also require improvements on the ETH protocol level (EIP-7212).

  • [3] One-Click Transactions: one transaction sometimes takes multiple “clicks” – this can all be bundled.

  • [4] Security: users do not need to save one seed phrase, it can split across multiple keys / hosts.

AA Flow

• [0] Dapp / Wallet creates a UserOp, a data structure that can have any signer and describes the transaction + gas logic. This UserOp can be sent to an offchain set of nodes / networks / relayers. E.g., “I want to swap for this NFT”.

• [1] Bundlers are Nodes that handle the UserOps, and functions similarly to an offchain block builder. They look onchain as a wallet making a transaction because the bundles are sent to the global smart contract known as the EntryPoint contract, which orchestrates the execution and payment. 

• [2] EntryPoint ensures that a wallet has funds to pay gas cost, and/or it validates against the Paymaster if the UserOps’ gas wants to be sponsored. It also facilitates paying the Bundler the gas owed from the account. If all the logic checks out, the transaction is executed onchain with validation + execution on the SCW contract. There are other optional add-ons like signature aggregation.

• The ERC-4337 defines the UserOp structure and the EntryPoint interfaces mentioned above. Alternatively, prior to the ERC, there were implementations that were non-standardized but effectively resulted in similar product experiences. Under-the-hood, it was an offchain account with a trusted relayer set-up.

How do you adopt AA?

• A dapp has to enable the flow in their application and with their contracts. Generally, whoever owns the developer relationship begins at the Smart Account level, and then specifies the Bundler + Paymaster. Some options allow for mix/match on Bundler/Paymaster; some options offer the entire solution. 

• Practically, the dapp developer will likely want the full-suite. An “AA” product is basically a form of an “All-In-One” developer offering that spans across the lifecycle of offchain (nodes, signatures) and onchain (contracts, gas, keys). The go to market for an “AA” provider is to offer the full-suite of “Bundler + Paymaster + SCW” as a single tool-kit. As a result, if you are a dapp and you have lock-in with an existing developer product, chances are you will likely be upsold into their AA toolkit or their partner’s. 

• From the AA provider’s point of view, they will likely begin with their “core competency” and then branch to offer other services:

  • Coinbase offers various products in this area such as an Account Abstraction Kit, embedded Wallet-As-A-Service, and Smart Wallets.

  • Bundler/Paymaster: developer platforms that provide node services may lean into Bundlers first as it is a node-adjacent product. They can then support Paymasters and “Smart Wallet SDK” which offers the suite of Bundler/Paymaster/SCW.

  • SCW: Safe* (formerly Gnosis Safe) is the leading provider of multi-sig wallets. They now offer an “AA SDK” which allows integration with other providers on the Bundler + Paymaster side.

  • MPC Wallets: Companies like Privy may offer Smart Account Kits via partners.

• The economics will depend on the positioning of the provider – though generally speaking the user is paying the gas cost of UserOps (which is collected / broadcasted to the Bundler) and the Paymaster can sponsor the gas which is pre-loaded with a budget by a client. Some examples of business models today include:

  • % Fee: user pays gas cost in the UserOp – Bundler handles the operation + charges a fee

  • Bundled SaaS: company will charge a month-end total “product fee” to the developer team based on % per Bundler API call + up-front gas sponsorship.

• To date, most of the “sponsored gas” programs are being achieved by custom offchain relayers. While this is popular in the short-term, this leads to a less composable path to adoption because each developer would need to adjust per use-case – and we expect them to transition to an open-source variant.

Smart Account Adoption

What is AA actually useful for? How is AA being adopted? 

• Sponsored Gas: The model enables a network participant besides the end user to pay for a gas fee. The transaction of a Smart Account may be slightly more expensive than with a self-custodial wallet but it is able to be subsidized by a 3rd-party. User transactions like onboarding / bridging over their funds can be covered by the interested stakeholder and result in a user “getting” to the dapp. 

• One-Click Tx: A user can “sign-in once” via session keys (vs multiple signature approvals), make multiple calls with a single transaction via batching, onboard various signature schemes allowing different devices to “sign” transactions via arbitrary verification logic (vs wallets which only support ECDSA signatures)

• Passkeys: With a SCW, a Passkey (on an Apple or Google device) can sign a transaction for a user. Users benefit from the Apple security model (e.g., biometric, physical device-specific authentication) 

“What is the current state of AA adoption?”

• Total Accounts: 3.2M, Total UserOps: 12.7M, Total Gas by Paymasters: $1.7M [Source]

  • Total Accounts are the number of AA-compatible SCWs created – they can be auto-created within the wallet interface or created indirectly through a partner app.

  • Total UserOps are the number of transactions powered by AA.

  • Total Gas by Paymasters are the total lifetime dollars of gas paid by 3rd-parties.

• Mindshare: Large developer players (ex. Alchemy*, ThirdWeb*, Circle*) as well as new startups have emerged to tackle the AA segment. 

What is holding AA back?

• Cost-Benefit Analysis: 

  • [1] Smart Account value proposition: The gas sponsor + transaction batching are currently “nice-to-haves.” Over time, as this becomes more normal and web3 consumer apps go more mainstream, this should transition to “must have” as a status quo because the bar for consumer “UX” will have been raised to match those standards. 

  • [2] Costs relative to existing options at scale: The current norm for consumers is through a self-custodial wallet or an MPC wallet – where creating a wallet is free and tx are submitted + signed by the user, but users pay the gas per transaction. For SCWs, interacting thru AA (via a Bundler) is a bit slower (anecdotally 2~5 seconds slower) – and also the cost-to-deploy at scale is another limiting factor. 

    • Anecdotal datapoints include anywhere between ~$0.15-0.45 per account on an L2 (ex. Base). Therefore, for a dapp with 1M users this can come out to ~$150K-450K (and $7~$10 per account on ETH mainnet). These costs may go down with future EIPs (4844).

• Passkey Adoption: Passkeys are becoming more popular and becoming more normalized as part of crypto user UX – but the cost of validation is still expensive at the ETH protocol layer. EIP-7212 attempts to address this issue.

• “Chicken and Egg” Cold Start: If a dapp wants to offer sponsored transactions, they will likely opt for an MPC wallet → create account for users → manage keys, and then optionally create a private relayer to cover gas cost. There is no mass AA offering (yet) but this may change once costs become more affordable. Today’s status quo is for a dapp to use an MPC wallet → create an account for users → and manage keys – which is cumbersome for dapps. We expect MPC wallet providers to eventually add support for AA in their developer offerings, assuming gas costs come down.

• Developer / Product Education: The conversation around 4337 is highly technical and the marketing of SCW / AA needs to be product / UX-forward in terms of the benefits. There are already AA-powered wallets that can connect to any dapp – which aligns it into the existing crowd of self-custody and MPC wallets. We expect self-custody wallets to add more support for SCW over time.

Smart Account Ecosystem Implications

1. AA adoption is starting but there is no breakout success case yet. Stars are aligning for the product-market-fit to happen. 

The two biggest issues for onboarding a new user onto a dapp are that users typically do not have [i] a pre-configured wallet or [ii] an ability to pay for initial transactions. A breakout moment for [i] happened last year with mobile in-app onboarding with simple social login / verification (no “Connect Wallet” button) powered by application embedded MPC wallets (ex. Privy for FriendTech). The demand for [ii] is still percolating but we believe now is the time for AA to shine for a couple of reasons.

• The biggest barrier to SCW adoption was gas cost (on ETH L1). With L2s the cost has come down significantly + SCW transactions can happen a lot more cheaply – but is still expensive at scale. 

• Developers are building consumer apps for the non-crypto-native user. As a result, the focus on onboarding matters a lot more. 

• Sponsorship for gas makes sense now because the recipient of transaction fees are the L2 teams themselves. For example – an L2 may be willing to sponsor gas for select dapps because they want to drive transaction fees for their underlying sequencer.

• Orthogonal tech trends like Passkeys will benefit the Smart Account adoption. Passkeys (i.e. FaceID to create a wallet + sign transactions) is an additional tailwind for consumer UX.

• We expect self-custodial wallets to explore Smart Accounts. 

We expect product-market fit will be achieved when costs come down (EIP-7212, EIP-4844), the industry aligns around open-source standards (vs closed relayer models), case-studies for successful gas subsidy programs emerge, and there is willingness and budget from dapp developers to target and spend to acquire users.

2. AA enables the ability for developers to experiment with sponsored onboarding for a net new user – customer acquisition cost (CAC).  

The first step of UX has been solved with the advent of L2s – cost of transactions / gas has significantly improved. The next step is for developers to enable AA because users now want seamless transactions.

The idea is once a user is onboarded, they will use the app and initiate the concept of lifetime value (LTV). So long as the LTV > CAC, it is worth it for the developer to explore the CAC (ex. $ of sponsored gas) enabled by AA. Any stakeholders that want to sponsor an onchain transaction can opt to do that action (whether an L2 or dapp).

• Dapp POV: the hurdles to onboard a user from zero-to-one have been massively improved via embedded MPC wallets. AA should help complete the “first onchain transaction” bridge and ultimately lead to an instant onboarding experience (no gas cost for first X transactions, no “click per action” UX, no wallet set-up). Early examples are concepts like “Asset Led Onboarding” – where a dapp will provide a user with a Smart Account + sponsored gas / dust for the first 5 transactions, knowing that the dapp will make a break-even ROI on the 6th transaction. 

• L2 POV: L2 wants to drive users / activity / sequencer fees and is willing to spend “$X” in CAC for sponsored gas powered by AA. Examples include Linea Gas Pass.

3. AA is a first-mover advantage game and not uniquely differentiated from a technology perspective, but rather a GTM / use-case perspective. 

Because the tech configurations are all open-source, there is not much technology differentiation in the Smart Account stack (Paymaster, Bundler, SCW). The differentiation is being in the leveraged position to decide on how to route the user transactions. For example, because each transaction can only have one Paymaster – it is up to the transaction orchestrator to decide. 

The goal as an “AA” provider is similar to any developer platform, which is to own the relationship and sit between the user and the dapp. The thesis is that so long as a provider owns some piece of the relationship, they can find ways to get creative around monetization (e.g., tiered SaaS for dapp or volume-based revenue)

Outside of product positioning, the way to win is to define how to structure the “CAC” story for Smart Accounts. A Smart Account pitch might be to show the LTV/CAC story – “it costs users 1 cent to transact, but your dapp makes $3 on every trade.” For example, if a dapp was built with Smart Accounts, new users could transact instantly (no keys, no gas), with higher cost associated with SCWs (deployment, function calls, etc.), that would be offset and surpassed by blended lifetime value of new users.

4. AA may help bridge the prevailing narratives around “One Wallet per dapp” vs “Homepage for Web3.” 

To date, self-custody wallets have been built towards the “homepage for web3” direction where you have one wallet to access every dapp (collect, own, send, receive, bridge, etc.) 

The recent trend of web3 consumers is pointing in the direction of “one wallet per dapp” powered by MPC wallets. A user will download a mobile app, the key is provisioned and used in that dapp only. In the chance that a user is using the same embedded wallet provider (in the background) across multiple dapps, the embedded wallet provider is able to link wallets “offchain” based on the common data identifier and consolidate them to be shown as a single interface. For example, a user using the same email log-in across multiple dapps can see the consolidated view of the wallets across those dapps.

Smart Account architecture may help unify the above two threads by allowing delegation of key signing + tx orchestration across different wallets, assuming there is a safe + secure + simple way to “link” addresses together. 

• Self-custody wallets will be able to “link onchain” to other wallets that the user controls, and preserve the “homepage” interface experience while allowing the user to manage more than one wallet.

• Embedded wallets allow users to “link offchain” but users are only in control of wallets on a per dapp basis. A user can export the embedded wallet keys and utilize AA to link those wallets onchain. This helps transition the embedded wallet consolidation from “link offchain” to “link onchain” which results in a global embedded wallet that the user controls. 

That said, AA wallets are likely best suited for single network use cases. For dapps that allow multiple networks, the pain of having to deal with SCWs deployed to multiple networks may not be worth it. Today AA development and adoption is mostly EVM focused – but other networks like Solana are also investing into AA adoption (ex. Squads Protocol). 

5. Smart Accounts are at an early stage but maturing every week. 

The pieces of the “Smart Account” infrastructure are there but market timing is still a factor.

• Standardization (ERC-4337) only happened earlier this year and L2s only started picking up mindshare in Q2-2023. 

• Self-custodial wallets such as Coinbase Wallet and Trust Wallet have begun offering Smart Account products.

• The norm for dapps is still to use self-custodial or MPC wallets (which are good enough) + the benefits are siloed by per dapp per sponsored tx per wallet. There needs to be a huge number of web3 onchain consumer apps that end up changing the consumer onboarding flow enabled by Smart Accounts from a “nice to have” to a “must have”. So far, while the concept of sponsorship enables “freemium” behavior for consumers, “freemium” behavior has not manifested en masse yet. 

• Passkeys still need to mature before implementing into Smart Accounts.

6. Standards are useful in bolstering AA adoption by making sure the ecosystem is aligned 

Historically, many “sponsored gas” programs were being achieved by using custom offchain relayers. Without standards, many dapps would have followed this set-up and this would have led to a narrower path to adoption because each developer would need to adjust their set-up per use-case. Because the set-up is not generalizable, each contract would have needed to support the relayer (Relayer → Contract → User) and transactions could have broken since the contract caller is the relayer (and not the user). 

Now that a standard has been set, ecosystem participants can align around how to build together. The jury is still out as to whether Smart Accounts will follow the ERC-4337 specification religiously, or if there will be modifiable plugins / specs (or even new EIPs), but the concept should follow some variant of the standard. Going forward, the main benefit is the standardized definition of the meta-transaction. This helps drive an industry-wide movement towards the benefits of Smart Accounts and creates a best practice for developers + infrastructure providers that handle it (e.g., a developer can choose between 10 different bundlers). 

Where we are headed

In conclusion, Smart Accounts will continue to be a top-of-mind trend as wallet infrastructure improves to achieve a web2-like user experience.

If you are a developer exploring Smart Accounts, the Smart Wallet solution by Coinbase Wallet can be used across many apps. It’s a free, self-custodial, user-ready solution for creating a wallet in seconds directly from any dapp with just a passkey. This Smart Wallet is available on Base Sepolia testnet. Coinbase Cloud’s Account Abstraction Kit can also be used to sponsor gas and bundle transactions, available with Base Node. 

Within the AA landscape, Coinbase Ventures is investing in new use-cases that emerge. If you’re building in these areas, we would love to hear from you – Ryan Yi’s DMs are open!

This material is for informational purposes only, and is not (i) an offer, or solicitation of an offer, to invest in, or to buy or sell, any interests or shares, or to participate in any investment or trading strategy, (ii) intended to provide accounting, legal, or tax advice, or investment recommendations or (iii) an official statement of Coinbase.  No representation or warranty is made, expressed or implied with respect to the accuracy of the information contained herein.  Coinbase may have financial interests in, or relationships with, some of the entities and/or publications discussed or referenced in the materials.  Coinbase does not endorse or approve links or third-party websites that may be provided in the materials.

Disclosures and footnotes: Coinbase Ventures portfolio company backed projects are denoted with an asterisk (*) when first referenced in the article below.   

The two most important technologies created in crypto/web3 are the concept of blockspace and cryptographic keys/wallets. Wallet technologies have now expanded beyond self-custodial wallets, and we believe within the next 5 years wallets will change dramatically – marking crypto’s “iPhone” moment. In this part, we will cover the various wallet technologies. In the future parts, we will cover related trends like how data and identifiers will be attached to wallets.

TL;DR

• The crypto ecosystem’s infrastructure is converging on a state that is ready to service everyday mainstream applications. While most of the attention has been on innovations in blockspace (lower fees and higher throughput with L2s and alternative L1s), there has been an equal step-up in the wallet infrastructure space as well. 

• To date, self-custody wallets have been the primary form factor of interacting with crypto / web3 applications and networks. Going forward, the wallet landscape is going through a major shift in technology innovation with the advent of embedded wallets (also known as MPC or WaaS [Wallet As A Service]) and Smart Accounts. 

• These advances will have major implications on how users interact with crypto apps, application adoption, and positioning of various wallet providers.

If we start at the core – wallets are new identity primitives.

• Wallets are identifiers on a public-key level [0x…] but are cryptographic secured guarantee of ownership

• With a wallet, you can sign an onchain transaction or an offchain transaction. 

  • Onchain = requires gas → this will pop up on a block explorer like Etherscan

  • Offchain = no gas required → this is a signature (ex. to “sign into” a session on a Dapp’s front-end) → this will not pop up on a block explorer like Etherscan

Era of Self-Custody
How It Works

• In the self-custodial world, users are responsible for key custody, transaction signing, and recovery. Popular wallets include Blockchain.com*, Trust Wallet, Coinbase Wallet, Metamask*, Rainbow Wallet*, and Phantom.

• From there, Dapps need to enable connections to the wallets via various SDKs. These SDKs are either native to the wallet or open-source (WalletConnect*). This is important because it’s critical in surfacing the viable options in the user’s journey. We equate this similar to the ability for a web2 app to surface “Log In With” via Okta Auth0. 

• Dapps can define a set of approvals either offchain or onchain for the user who then starts transacting.

  

Observations on Self-Custodial Wallets

• Superapps: Wallets are adding multiple features so users can access the entire crypto ecosystem from their core wallet. Examples: Send / Receive; Swap; Bridge; Message; Notify

• Distribution is usually application-led. Recently, popular web3 apps are deciding that given they own the user's attention and mindshare – it’s a natural segue into offering a wallet directly. Examples: MagicEden*, Aave, Uniswap*. 

• Ecosystem: Wallet providers might choose to claim ground in new ecosystems in order to enshrine their first-mover advantage. This allows them to build out the relationships + tech integrations to be successful. Examples: Phantom on Solana or Keplr on Cosmos.

Era of Embedded Wallets and Wallet-As-A-Service

How It Works

• In the embedded (MPC/WaaS) wallet world, a user can log-in with their web2 credentials (Email, SMS, Twitter, etc). 

• The keys themselves can be split between the Dapp, the user’s device, and/or a 3rd-party (centralized or decentralized). The Dapp utilizes a 3rd-party service that handles various parts of the keys / SDK / Auth experiences. User devices can leverage Passkeys under-the-hood.

• Because the Dapp manages the user flow, the SDK / Auth live in the back-end and are implicitly approved.

• Dapps + embedded wallet provider can also see a CRM-style dashboard of the keys + related social log-in data of the users. 

Observations on Embedded Wallets

It is still extremely early days of the embedded wallet trend – but the UX improvement, particularly for non-crypto native early adopters, speaks for itself.

• User Opt-Out: For embedded wallets, the user still has full control over their wallet. A user can choose to “export” their keys, and can transition back to a fully self-custodial wallet, or can transition to a Smart Account (see below). While many non-crypto native users might not use this function, this allows users the opt-out that is important to mitigate the centralization risk that is commonly associated with web2 data silos.

• Wallet “Linking”: If multiple Dapps are onboarded onto a single embedded wallet provider, and a user is logs into those Dapps with a similar log-in method, the embedded wallet provider can associate that those disparate wallets belong to the same user and can expose that in an interface to the user. As a result, for an embedded wallet provider, winning as many Day-1 mandates can be an important wedge. 

• Data Foundation: Dapps can now leverage the database of their user-set and tie in other digital footprints, further transitioning the web2 datalake into web2.5 utility. Example: a Dapp might want to run a DevRel campaign and can see the users who have OAuth’d their Github and track their PRs / Commits.

Era of Smart Accounts

How It Works 

Smart Accounts are smart contract wallets with “Account Abstraction” features. These allow users to define transactions to be executed by 3rd-parties.

Observations

For a full breakdown on Smart Accounts – we will cover this in a future Coinbase Ventures blog post. 

• We consider Smart Accounts / Account Abstraction as complementary to the above trends

• Self-custodial wallets can join / mint Smart Accounts and “link” to other wallets / keys that the user owns

• Embedded wallet providers can surface Smart Account options as a service to the Dapps that want to provide benefits like gasless experiences and so forth.

Takeaways / Implications

Auth / Data: The path dependency of wallet adoption will have implications on how authentication / authorization play out. The authentication / authorization layer defines a user session, data read/write interactions, and security parameters. The stakeholders are the wallets, the authentication layer, and the Dapps themselves. Whomever emerges will have won the race to build + leverage a distribution network effect and productized around that network effect.

• Today: Wallet / Auth / Data are all separated. User downloads wallet, connects to OpenSea*, via an auth flow.

  • Wallet providers generally know nothing about the user's identity beyond what is onchain on Etherscan.

  • The auth layer will collect various pieces of information such as the address, the session data, and other related disclosed data (IP address etc). 

  • Dapps likely have the best idea on who the user actually is – example is OpenSea will have a user fill in their email / twitter / social data stored in OpenSea’s server. OS knows that [0x…] = John Doe, but the auth layer will only know that [0x…] interacted w/ OpenSea. 

• Future: Embedded wallets bundle all three. User logs into OpenSea via the embedded wallet provider. 

  • The embedded wallet solution takes care of the key + auth layer – they are bundled together. You don’t need to log-in to the Dapp via a separate auth, it just gets done / abstracted when you sign in via WaaS. Dapp can also see this in their interface with the embedded wallet partner. 

  • The embedded wallet solution may own the data and may surface it to Dapp if needed. For example – I logged into OpenSea with my Twitter OAuth (powered by WaaS) – both should see the associated keys and the social log-in. 

  • The embedded wallet solution can then see a consolidated view of keys across their data store – Dapp 1 might not care who Dapp 2’s users are – but the WaaS provider sees all the overlapping user socials and can surface the common interface. This is assuming the user has provided data permissioning when he or she has authenticated using recognizable credentials.

Paths of Adoption: To date, self-custody has been the primary wallet option for consumers. That said, new technologies present viable alternatives and have major implications on wallet adoption. Ultimately, we believe that the result will depend on the first Dapp or use-case that a user is exposed to and the corresponding wallet technology.

• User Type: To date, users of crypto apps only had one viable option which was self-custody. With the emerging wallet technologies described above, there will be multiple options available. This should also help onboard net new users (who may be non-crypto native users) who are already familiar with an “OAuth” style onboarding. 

• Geographic: Potential regulatory hurdles on self-custody in certain geographies may pose an insurmountable cost for users to adopt the self-custody option. Conversely, it is unknown whether embedded wallets (who hold a piece or shard of a key) might be classified as a custodial service. 

Business Models: Wallets can structure monetization in different ways. For embedded wallets, it is likely operating at a freemium or SaaS model – but we expect that over time as their positioning between the user and the actions will allow them to have direct exposure to the growth of onchain actions.

Wallet Form Factors: Will we have one user per wallet, or one wallet per Dapp?

• One Wallet To Rule Them All: Self-custody wallets have taken on a form factor of “One Person → One Wallet ←→ Superapp.” Users can create another wallet within the same interface but the vision stays the same. 

• One Wallet For Every App: Because embedded wallets are hidden in the back-end of the application, the form factor looks/feels like a Dapp (similar to an app on your iPhone). This ends up resulting in “one wallet for each Dapp.” 

• Linking Wallets – Somewhere In The Middle: Rather than one outcome vs. the other, we believe a middle ground is the most likely outcome. Wallets can be “linked together” as long as there are common identity identifiers. The onchain version can be manifested through Smart Accounts – which can delegate control across wallets. The offchain version may be common identifiers that live behind an embedded wallet’s API (Example – “john@gmail.com” OAuth’d across multiple Dapps can be a common identifier.)

Closing

We believe the number of crypto-enabled wallets will grow exponentially over the next decade. Since inception almost a decade ago, the total unique ETH addresses hover around ~250M (5 years to reach 100M uniques, and only another 2 years to reach 200M uniques). This was in an era of expensive blockspace, and self-custodial wallets. 

Looking forward, we believe the advent of embedded “Wallet As A Service” (or WaaS) + Smart Accounts should lower the onboarding friction and cost of wallet creation to near-zero, and the emergence of L2 and related low-cost blockspace technologies will lead to greater usage in crypto-enabled actions and wallets will be the primary method of engaging with these use-cases. 

In the next piece, we will cover “Smart Accounts”in detail.

Coinbase offers various products such as a self-custodial Coinbase Wallet (self-custody), Coinbase Wallet-As-A-Service (embedded wallet), and Base is supportive of Smart Accounts. If you are a builder exploring the mind maze of the future of wallets like us, we'd love to hear from you.  Ryan Yi’s DMs are open!

Tl;dr

• The importance of bridges have grown as the # of assets + # of chains are continuing to grow in the crypto ecosystem.

• The main use-case for bridges continues to be in asset transfers (tokens in one chain versus another) + swaps (trade token on Chain A for token on Chain B). Bridges compete on various aspects of differentiation such as distribution, product features, and security profiles. 

• Looking to the future, primary multichain issuance technologies (like CCTP), go-to-market, and overlap with oracles will have implications on the usage and popularity of bridges.

Disclosures and footnotes: Coinbase Ventures portfolio company backed projects are denoted with an asterisk (*) when first referenced in the article below.   

Bridges have emerged as core infrastructure for protocols, service providers, and users in accessing crypto use-cases. This report is meant to capture the current state of the bridging landscape, the future trends in bridging, and the implications for the broader crypto ecosystem.

Current Takeaways / Learnings

1. Taxonomy: the types of bridges can be thought of across 3 categories: Native Bridges, 3rd-Part Bridges, and Bridge Aggregators. 

• Native Bridges: are generally the canonical contract that a user will interact with to deposit / withdraw assets. These can be operated by a set of trusted participants, or through decentralized consensus. Chains / L2s that operate on compatible open-source stacks may also leverage bridge compatibility with first-party security. Examples include Optimism OP Stack*, Arbitrum Nitro*, Cosmos IBC, Superbridge.

• 3rd-Party Bridges: are networks / validators that sit between the chains and act as “middle-men.” Most bridges follow a variant of this design. Examples include Axelar*, Wormhole*, LayerZero (Stargate)*.

• Bridge Aggregators:  integrate the first two bridges listed above and provide the best route across bridges for an end-user / enterprise partner. Examples include Socket*, Li.Fi*.

2. The main purpose of a bridge is to service the delta between the (ledger / chain / location) of data / assets and the intended execution destination of data / assets. The main use-cases continue to be in asset transfers (tokens in one chain versus another) + swaps (trade token on Chain A for token on Chain B). 

• Asset Transfers: There is an asset (ETH) on “Chain A” that is not natively issued on “Chain B”. Bridges can service sending that asset from “Chain A” to “Chain B.” For example, bridging USDC from ETH L1 to Zora L2 thru the Zora Native Bridge*.

• Swaps: There is a trade for ($ETH) on “Chain A” for ($ATOM) on “Chain B”. Bridges will send the token and then execute the swap. Examples include [1] Squid Router “swap” and built on top of Axelar “bridging”; [2] Matcha by 0x* takes care of “swap”, and integrates Socket to take care of “bridging.” 

• Other: These may include any type of call data or contract ownership, such as governance or multisig ownership. For example, the Uniswap v3 contract is deployed on many EVM chains, but the core governance contract lives on ETH mainnet. Uniswap Foundation* would rather have a single contract and execute a message as “one-to-many” to the other chains (vs. creating a governance contract on every chain). [source]

3. Bridges are usually measured by onchain AUC (or TVL) as a sign of liquidity / usage. 

• Native Bridges traction is directly tied to success of the underlying usage of the L2 itself. The bridge contract will hold funds and can serve as a way to measure the bridged TVL to the L2. According to L2 Beat, TVL of Rollups are anywhere from ~$50M all the way to ~$8B. 

• Notable 3rd-Party Bridges are LayerZero, Wormhole, and Axelar based on traction of TVL, volume, and chain coverage. 

  • LayerZero: TVL: ~$304M; Volume: ~$23.9B; Transactions: 34.5M [source]

  • Wormhole: TVL: ~$850M; Volume: $30B; Transactions: 1.7M [source]

  • Axelar: TVL: ~$224M; Volume: $7B; Transactions: 1M [source]

• Bridge aggregators generally route transactions so a volume metric is more appropriate. Distribution among consumers and enterprises (winning logos) is the key metric. Leading providers include Socket and Li.Fi.

4. Bridges compete on various aspects of differentiation and there will likely be multiple winners depending on the set of use-cases and distribution.

Security: The security nuances will depend on the demand side’s preference. Most consumers who use bridges seem to prefer speed / latency + cost over security above a minimum viable threshold. 

• Smart Contracts: Most hacks in bridging have happened at the smart contract level. In most bridges, a user locks funds in Chain A’s contract → bridge reads Chain A contract → mints on Chain B contract to the user’s funds. Misconfigurations around withdrawal access in the contracts can lead to hacks. 

• Multisig: Control over the contracts are delegated to a set of trusted participants. These are usually operated by the project team and other trusted sets of stakeholders.

• Relayer + Oracle: The Dapps / developers can whitelabel their own relayer + oracles for their set-up. They can also choose from a menu of options of other relayer + oracle set-ups that are live. 

• PoS Chain: Security is achieved by consensus in a Proof-of-Stake manner. 

Distribution: Bridges will try to utilize existing partner channels as well as taking a back-end infrastructure GTM. 

• Wallets: Bridges will try to become the powering infrastructure / API behind existing wallets / portfolio aggregators’ bridging features. Examples include Phantom partnering with Li Fi and Coinbase Wallet partnering with Socket. Portfolio front-end / wallets will all have some form of bridging support (ex.  Zerion* / Zapper* / Metamask*).

• B2C Front-Ends: Bridges will often set up a website portal where any user can connect a wallet + bridge funds. Examples include Stargate.Finance (LayerZero), Bungee.Exchange (Socket), Jumper.Exchange (Li Fi), and Squid Router (Axelar).

• Dapps: Dapps themselves will include a “deposit” function which uses bridging under-the-hood so users do not have to hop back to L1 and then to the L2 to use the application. Think of this as an abstracted version of the “B2C” mentioned above but natively supported by the developer into the application interface. Examples include Aevo*.

• Developer Platforms: Many bridging companies will utilize a developer platform’s existing distribution to get enabled. Examples include Conduit RaaS, Microsoft Azure + Axelar, Google Cloud + LayerZero.

Ecosystem: While all the major 3rd-party bridges cover all the same chains, they will try to get first-mover advantage by dedicating resources to claim ground in a specific chain / developer ecosystem. The reasoning is that as the set of product features need to be more advanced in order to differentiate, it is easier to scale within an ecosystem’s VM / smart contract framework.

• EVM: Socket is dedicated to the EVM rollup ecosystem (OP Stack, Arbitrum*, Polygon* CDK). L2s like Aevo and Lyra are existing users. 

• Solana: Wormhole’s ecosystem coverage is strong given their early involvement. DeBridge is also finding growth in traction. 

• Cosmos: Axelar’s ecosystem coverage is strong given their ability to offer IBC compatible transactions. One datapoint is that new chains utilizing IBC (ex. Celestia*) get Day-1 coverage.

• Other ecosystems can be serviced by most providers. 

Product / Feature Set: Because Bridges are in the “abstraction” business, they will often need to do bespoke smart contract work that enables specific use-cases. As a result, bridge teams often end up carving a niche to find dedicated verticals / domains. Examples include NFT / Payments (ex. Decent), Gas Abstraction, and Swaps.

What We’re Paying Attention To

CCTP (Circle’s multichain USDC standard) will be an important datapoint on implications on bridges. CCTP is a standard by Circle* to help with multichain issuance of USDC.

• Pre-CCTP: When a new chain launched, it would use a bridged version of USDC due to lack of support for native USDC (because Circle would have to approve and add support for each new chain’s native version of USDC on their roadmap). Because the chains want to have Day-1 DeFi support, USDC would be bridged from ETH L1 and a bridged version of USDC became the standard on the new chain. 

  • Example: An example might be axlUSDC by Axelar or the USDC.e on Arbitrum – USDC on ETH L1 that is bridged through Axelar and the Arbitrum Bridge, respectively.

  • Implications: This leads to liquidity fragmentation because Chain A bridged USDC vs Chain B bridged USDC builds a dependency on the individual bridge operators. Individual ecosystem DeFi protocols will integrate it as an asset and it becomes harder to unwind. 

• Post-CCTP: When a new chain launches, it will deploy a USDC token contract that conforms to the CCTP Circle standard. When Circle is ready to go live on the chain, it can take over the implementation that CCTP supported. Basically new USDC contracts have backwards compatibility to conform to a standard down-the-line.

  • Example: NewChain is a new L2 that goes live and it doesn’t have native USDC yet. NewChain deploys USDC contract which conforms to the standard. NewChain supports bridged USDC in short-term – but importantly it can be taken over by CCTP and bridged USDC can become native USDC. 

  • Implication: If you are a developer, you would usually have a dependency on the bridged USDC and be locked-in to any liquidity program tied to the asset and the bridge . With CCTP, you have a transition to enable USDC natively, and you can hit the CCTP API to enable the x-chain transfer for USDC. 

Adoption of CCTP has consequences around the long-term defensibility of bridges. 

• Bridged USDC (that is non CCTP) is locked in DeFi pools and will remain so until it is unwinded or becomes a minority of the asset mindshare on the chain.

• While CCTP will work with bridges (given their distribution) to help support CCTP, CCTP adoption should naturally result in a higher share of native USDC issuance and a lower share of bridged USDC. Bridged USDC as an asset locked-in various DeFi pools should naturally unwind in the long-term.

  • Example: Bridged-to-Native USDC ratios are: Arbitrum: [57% – 43%]; Base: [33%–67%]; Optimism: [80%–20%]; Polygon: [77%– 23%]. 

• The story of CCTP will be an important lesson for bridges in terms of approaching asset issuers and locking them into a multichain-first approach at the technology level. Bridges will have to compete in other areas of differentiation such as latency, security, and distribution.

Bridges will continue to find usage as long as the # of chains and the demand for UX abstraction increases.

• This year, movements in the blockspace settlement trend (modularity, rollups, data availability, and so forth) will have implications for how users execute transactions + move assets – and bridges will be the popular choice in enabling this UX. 

• Over time, native protocol and technology improvements should help users obviate withdrawal periods (7 days in current Optimistic Rollup designs) and get “fast-track” sends / receives.

• Verified wallets and users that hold an onchain attestations (like Coinbase Verifications) in the future might be able to interact onchain with centrally-managed liquidity bridges.

• Application-hosted wallets (and self-hosted wallets) will continue to bake in “Bridge Plus” efforts – where instead of “Swap” and “Bridge” as two different transactions, they will be combined as one transaction for better UX outcome.

Bridges and oracles will eventually compete for rights to data issuance. 

• Bridges are trying to move to win 1st-party issuers to utilize / use their infrastructure. CCTP shows that the native issuer wants to build compatibility that lessens dependency on any single bridge. Some projects are experimenting with issuance of token-standards to be multi-chain as well. While CCTP is USDC-focused, how a token gets issued natively can differ alot. Example: $OP was launched natively on Optimism chain; most ERCs were issued natively on ETH L1. Connext has a token standard called xERC (think CCTP for any ERC20)

• Oracles can be thought of as “bridges” but for offchain data issuers. Chainlink takes offchain data (prices for crypto on CeFi) and brings it onchain – though they do not natively own the data itself, it has monetized by providing this as a third-party. Conceptually this is similar to how bridges are positioned today. Both oracles + bridges will continue to service the delta that exists between those that demand data / assets and those that can bridge it over. Eventually they will need to become tooling for 1st-party data issuers in order to maintain a long-term moat / defensibility. Chainlink has their own bridging product called CCIP which is further evidence of overlap.

In conclusion, Bridging and Interoperability will continue to be a top-of-mind trend because in an environment where the number of chains are growing, in order for protocols and users to meet the demand for abstracted UX, bridges will emerge as compelling service providers. Within the Bridging landscape, Coinbase Ventures is investing in new use-cases that emerge from bridging. If you’re building in these areas, we would love to hear from you – Ryan Yi’s DMs are open!

TL;DR

• Zero-Knowledge Proofs (ZKPs) and the resulting tech are a breakthrough area of cryptography that is largely seen as the endgame for blockchain design concepts.

• Today, ZKPs are increasingly becoming a promising solution set for unsolved problems in web3, including 1) blockchain scalability, 2) privacy-preserving applications, and3)  trustless interoperability.

• In 2023, just over ~$400M was invested into ZK tech, with a predominant focus on scalability of Ethereum L1/L2 protocol layers and emerging infrastructure and developer tools

• The ZK landscape can be divided into 3 layers: 1) Infrastructure (i.e., tooling/hardware  for building protocols/applications on top of ZK primitives), 2) Networks (i.e., L1/L2 protocols that leverage ZK proving systems), and 3) Applications (i.e., end-user products that leverage ZK mechanisms).

• While still in its early stages, the rapid development of the ZK ecosystem promises to usher in a new era of secure, private, and scalable blockchain solutions.

Zero-Knowledge Proofs (ZKPs) and the resulting tech have largely been seen as the endgame for blockchain design, especially as it relates to offering a solution for onchain applications to verify information with minimal trust assumptions. At its core, a Zero-Knowledge Proof is a cryptographic technique that allows one party, known as the prover, to demonstrate to another party, the verifier, that a computation is valid without exposing any of the underlying data used in creating the computation. Originating in 1985, ZKPs have evolved from theory to practical utility, overcoming decades of lag through recent advancements in software tooling and hardware. 

Today, ZKPs offer promising solutions for web3’s biggest challenges, including: 

1. Blockchain scalability: one of the biggest challenges facing Ethereum L1 is scalability. However, L2 networks have emerged to enable faster and cheaper transactions without compromising Ethereum’s security or decentralization. While optimistic rollups remain dominant given a higher degree of EVM compatibility and developer friendliness, ZK rollup adoption is steadily increasing. ZKPs help to summarize complex computations offchain, thus enhancing L2 designs for rapid and cost-effective onchain verification and settlement.

2. Privacy-preserving applications: to date, work on privacy in the blockchain context has been mostly limited to obfuscating transactions. However, researchers are progressively working towards enabling full transactional anonymity and confidentiality on public blockchains. Importantly , novel privacy-preserving concepts leveraging ZKPs  are emerging that aim to break perceived trade-offs between preserving user privacy and enabling compliance (i.e., deterring illicit activity). 

3. Trustless interoperability: existing blockchain interoperability protocols rely on trusted systems (e.g., multisigs or incentivized validator sets).  ZKPs can help replace crypto-economic trust assumptions with cryptographic guarantees, opening avenues for more secure and robust cross-chain communication. However, among the primary applications of ZKPs, interoperability is the most nascent. 

According to Messari’s deal screener, over ~$400M was invested into the ZK landscape in 2023, emphasizing scalability of Ethereum L1/L2 layers and emerging ZK developer infrastructure. Despite the relative nascency of ZK, its rapidly accelerating ecosystem foresees convergence on best practices for more secure, private, and scalable blockchain applications. With this framing in mind, let’s take a closer look at the ZK landscape layer-by-layer to explore key players and emerging concepts.

Infrastructure

Any form of a ZKP must be written in arithmetic circuit language, which has limited expressions, and it’s complex to translate most blockchain functions to circuit form. Limitations in developer tooling and advanced hardware meant real-world use cases of ZK were slow until recently. Today, we are seeing an array of systems and tools emerge that empower developers to build protocols and applications on top of ZK cryptographic primitives.

Programming Frameworks & Tools: Domain Specific Languages (DSLs), such as Leo, Noir, Cairo,  and o1js are programming frameworks for developing ZK-provable programs within specific L1/L2 ecosystems (e.g., Aleo*, Aztec*, Starkware*, and Mina* respectively). Additionally, generalizable frameworks such as Elusiv* and Hinkal, are emerging with the aim of allowing developers to define specific criteria for how transaction data can be shielded onchain but verified using ZKPs. Growing adoption is expected, meeting potential developer and end-user demand for ZK-powered applications.

ZK Coprocessors: ZK coprocessors provide developers with cost-effective and trustless offchain computing capabilities, while eliminating the need for developers to engage with complex ZK-related components in their tech stack. Teams like RiscZero, Axiom, and Herodotus provide verifiable computing platforms that generate a proof attesting to the execution and validity of arbitrary programs or enable smart contracts to store, access, and verify historical onchain data without imposing additional trust assumptions. Over time, ZK coprocessors are poised to become essential for increasingly advanced onchain applications.

Proof Networks / Markets: Today, the majority of ZK networks and protocols rely on a centralized proving process. Subject to ZK adoption growing over time, we expect that teams will seek to decentralize their proving layer to improve their liveness and censorship resistance. Emerging proof networks and markets, such as those provided by =nil; Foundation, RiscZero, Gevulot, and Lumoz, aim to allow applications to outsource their proving mechanisms to third-party operators, thereby lowering the overhead for operating ZKP infrastructure.

Hardware Acceleration: ZKPs are expensive and computationally-intensive to produce given the large number of mathematical operations required. However, we are seeing significant advancement in the usage of specialized hardware like Field Programmable Gate Arrays (FPGAs) and Application Specific Integrated Circuits (ASICs), which are helping to improve proof generation and verification times. Specialized hardware providers like Ingonyama, Cysic, and Fabric, are at the frontier of providing FPGAs and ASICs for ZK proof systems and we expect to see increasing innovation and investment in ZK hardware design going forward.

App-chain Infrastructure: Rollup-as-a-service (RaaS) providers like Spire, ProtoKit, and Lumoz provide low-code tooling for developers to build, test, and deploy general-purpose or app-specific L2/L3 chains that leverage ZK proving mechanisms. Sequencers, such as Espresso*, Radius, and Madara, provide infrastructure for accepting transactions from users, determining their order, and posting blocks to the L1 consensus and data availability layers. We believe the next-generation of Ethereum scalability is poised to be powered by modular L2 rollup stacks, which may create demand for these providers in the short-to-medium term.

Interoperability & Bridging: Bridging systems become more trust minimized as they remove the need for users to rely on humans (e.g., multisigs or incentivized validator sets) and replace trust with code (e.g., Light Clients, Relays and ZKPs). Teams such as Polyhedra, Lambda Class, and Polymer Labs* are exploring this topic. Among the primary applications for ZKPs, interoperability is the most nascent, but we expect to see more innovation in bridging design concepts as access to ZK primitives accelerates.

ZK Machine Learning (ZKML): ZKML, a frontier field of cryptography, focuses on proving the correctness of onchain machine learning (ML) model inferences using ZKPs. By adding ML capabilities, smart contracts can be made more autonomous and dynamic, allowing them to make decisions based on real-time onchain data and adaptable to various scenarios, including those that may not have been anticipated when the contract was initially created. Teams like Modulus Labs, Giza, Zama are pioneering unique ZKML use cases, which may offer a promising synergistic balance at the intersection of AI and crypto.

Networks

Some blockchains face limitations in processing high transaction volumes, leading to slower transaction times and increased costs during peak demand. Additionally, popular blockchains, such as Bitcoin, Ethereum, and Solana are built on open, public ledgers, but the lack of privacy raises concerns for mainstream participants that are likely to require full transactional confidentiality and anonymity. New L1 and L2 networks are emerging with ZK proving infrastructure to  solve the problems related to blockchain scalability and  onchain privacy.

Privacy-focused L1s: Emerging L1 networks like Aleo, Mina, and IronFish offer privacy-first smart contract capabilities powered by ZKPs, providing application-level privacy for dapps within their respective ecosystems. L1 networks such as Fhenix and Inco employ fully homomorphic encryption (FHE) to make it possible for developers to write private smart contracts and perform computations on top of encrypted data, thus enabling complete transactional anonymity and confidentiality. Given that many of the L1s above are undergoing incentivized testnets and require developers to learn new  programming languages, signs of mass adoption and value capture are likely 1-2 years out. 

ZK-EVMs: ZK-EVMs leverage zero-knowledge proofs to make cryptographic proofs of execution of Ethereum-like transactions. There are different types of ZK-EVMs such as zkSync Era*, Polygon zkEVM*, Linea, Scroll, and Taiko, that each have varying design tradeoffs between EVM compatibility and  performance (i.e., proof production times). We expect ongoing innovation in this segment for scaling Ethereum and Ethereum-based ZK-rollups.

ZK-Rollups: A zero-knowledge rollup is a L2 scaling solution that moves computation offchain and proves state changes onchain using ZKPs. ZK-rollups like Aztec* provide a “privacy engine on top of Ethereum'', which aims to encrypt transactional data while ensuring costs remain low. Zeko is an upcoming ZK-rollup stack built on top of Mina that enables apps to recursively verify and compose with each other, while ImmutableX* and LayerN are app-specific ZK-rollups for gaming and high-performant DeFi use cases, respectively.  While optimistic-based rollups command roughly ~90% of the total L2 market share, ZK-rollups are poised for increased demand as the underlying tech becomes more accessible.

Applications

Atop the ZK infrastructure and network layers sits an emerging crop of end-user applications that leverage ZKPs for onchain payments, identity, private yet compliant DeFi, and consumer use cases. 

Teams like Elusiv*,  provide user-friendly interfaces for private payments and DeFi transactions through shielded addresses, while also employing compliance mechanisms to decrypt transactions by identified illicit actors. In identity, zCloak*, ZKPass, and zkp-ID employ ZKPs to allow users to prove verifiable data to third parties without exposing personal information. 

DeFi protocols like Lumina and Panther focus on building private yet compliant decentralized exchanges. Renegade employs both multi-party computation (MPC) and ZK to offer dark pool trading, an onchain trading venue that conceals the orderbook and allows large institutional or whale traders to execute orders without alerting the wider market to their activity. 

Consumer apps like Sealcaster and Dark Forest utilize ZKPs in social and gaming apps, shielding user identities and gaming strategies from other onchain participants.

The future of ZK

The future of ZK involves novel zero-knowledge proof designs prioritizing speed, reduced hardware requirements, improved developer tooling, and support for decentralized proof generation. While both Optimistic and ZK scaling solutions serve to verify rollup transactions, each with associated design tradeoffs between security, latency, and computational efficiency, we see a convergence of the two stacks, in the medium-to-long term, to accommodate a versatile range of onchain applications.  Lastly, the ZK app layer is nascent today, but likely poised for growth as end-user demand for privacy-preservation on public blockchains grows over time. Additionally, it’s worth noting that ZK research is primarily explored in the Ethereum context. However, emerging concepts such as Solana’s Token22 program with Confidential Transfers (i.e., a privacy feature that utilizes ZKPs to encrypt token balances and transfer amounts for SPL tokens), showcase the adaptability and potential of ZK beyond specific ecosystems.

In conclusion, the transformative potential of ZK is unfolding, promising a future marked by heightened security, privacy, and scalability in blockchain solutions. Within the ZK landscape, Coinbase Ventures is investing in emerging ZK developer infrastructure (e.g., coprocessors, proof markets, app-chain infra)  and applications (e.g., private payments and DeFi) that unlock new forms of onchain utility and led by teams with top ZK cryptography talent (a rare/small talent pool). If you’re building in these areas, we would love to hear from you - JK’s DMs are open!

— 

Disclosures and footnotes

*The following Coinbase Ventures portfolio companies appear in the above landscape: Aleo, Anoma, Aztec, Consensys, Espresso, Elusiv, Mina, Polygon, Polymer Labs, Starkware, Sunscreen, zCloak, zkLink, zkSync

• The immutable nature of the blockchain and culture of open-source development provides an opportunity for web3 security to be proactive and prevention-focused.  

• We are seeing novel security solutions for web3 infrastructure, smart contract code, protocol logic, and ecosystems to prevent and mitigate security threats.

• Investing in these solutions and the teams building them will help to ensure the security and integrity of web3 while supporting its continued growth.

By Jonathan King, Steven Willinger

The web3 application ecosystem is made up of interoperable protocols, powered by smart contracts, that rely on the underlying infrastructure of the host blockchain and the internet. As the web3 ecosystem continues to grow,  security solutions need to keep up with the pace of innovation. Those needs include security solutions that can protect against infrastructure attacks, smart contract code vulnerabilities, and protocol logic errors. Additionally, there is a need for solutions that can help to mitigate the impact of ecosystem attacks, such as real-time threat detection and incident response systems.

With that, let’s explore the growing web3 security stack and core security considerations at each stage of the web3 development lifecycle.

Security in web3 Cybersecurity involves a range of technologies, processes, and policies that are used to protect data, systems, devices, and networks from attack, damage or unauthorized access. In web3, data is stored on the blockchain's immutable ledger, so if an attack is recorded on the blockchain, it usually cannot be reversed. Also, many web3 applications are open-source, which creates an opportunity for malicious actors to analyze the code for vulnerabilities and plan exploits well in advance.  Given that context, we can categorize the most common web3 security attack surfaces into four layers: infrastructure, smart contract language, protocol logic, and ecosystem.

Source: Kofi Kufuor, The State of Crypto Security (Oct 2022)

With this framing in mind, let’s take a (non-exhaustive) look at the evolving web3 security stack layer by layer (* denotes Coinbase Ventures portfolio company).

Infrastructure

At the very beginning of the web3 developer lifecycle (i.e., system design), it’s important for developers to identify and prioritize potential security threats. Once developers decide which blockchain protocol to build on, the next step is to decide how their application will securely interact with the underlying blockchain. This is where infrastructure primitives come into play.

Wallet & Private Key Management: Recently, there’s been increasing adoption of cryptographic wallet security solutions like multi-party computation (MPC). MPC wallets help eliminate the risk of storing private keys in one single place. Rather, the private key is broken up into shards, encrypted, and divided among multiple parties. These parties will independently compute their part of the private key shard they hold to produce a signature for authenticating transactions without revealing their encryption to the other parties. Companies like Coinbase, Fireblocks and Fordefi offer MPC wallet infrastructure that allow consumers and institutions to transact in DeFi across multiple chains while keeping their assets secure.

Access Management: Access management is a security process that enables developers to regulate which users or wallet accounts can sign and execute transactions. Companies like web3auth* and Moralis* provide developer tooling for authenticating and verifying the identity of a user. Companies like District Labs help developers automate permissions and control who has access to a wallet or smart contract capabilities.

Consumer Security: Consumer security is an emerging primitive consisting of solutions that scan, simulate, analyze, and protect user interactions with web3 applications. Companies like Harpie*, ChainPatrol*, and Blowfish integrate with blockchain wallets to provide “firewall-like” capabilities to detect fraudulent transactions and prevent hacks, scams and theft.

Monitoring & Observability: Monitoring and observability is another emerging primitive consisting of platforms that continuously analyze the health, reliability, and uptime of the underlying infrastructure services  powering their web3 applications. Companies like Tenderly*, Metrika*, and Scale3 offer a variety of tools for monitoring the performance of blockchain networks, analyzing user interactions with smart contracts or identifying bad method calls to RPC node infrastructure.

Smart Contract and Protocol Logic

During the development, testing, and deployment phase, developers should make use of existing smart contract standards and evaluate the security assumptions of protocol integrations. It’s also important to create comprehensive documentation of the code and set up test environments with easy-to-run test suites to simulate production behavior. Finally, developers should dedicate time to discovering bugs in their code through internal and external code reviews and consider creating programs that incentivize their user community to improve security on open source codebases.  The following primitives help to facilitate these processes and mitigate potential vulnerabilities within the smart contract code or protocol logic.

Security Testing Tools: Security testing tools consist of frameworks and solutions designed to help developers perform blockchain security testing more effectively. For example, Mythril and Slither are static analysis frameworks that detect vulnerabilities in smart contracts written in the Solidity coding language. OpenZeppelin provides reusable, battle-tested smart contract templates so developers don’t have to build security mechanisms from scratch. Companies like Pwned Nomore provide automated bug-hunting engines that automatically search for potential vulnerabilities in a developer’s codebase. 

Formal Verification: Formal verification involves a range of technologies and processes that use algorithmic logic to check smart contract properties against specific inputs for the purpose of  exploring all possible behaviors of the code. This is an emerging primitive, in which companies like Certora* and Runtime Verification offer services and tooling to developers for proving the security and correctness of smart contracts prior to deploying to production.

Audit Service Providers: Audits are external security assessments of a project codebase, typically requested and paid-for by the project team. Audits detect and describe (in a report) security issues with underlying vulnerabilities, potential exploit scenarios, and recommended fixes. Companies like  ChainSecurity, Halborn, and Trail of Bits routinely perform audits of smart contracts and protocol upgrades across various blockchain ecosystems. As testing frameworks and security tools mature, we expect audit service providers, like Certik*, to begin externalizing their in-house tools as SaaS applications for self-service consumption.

Bug Bounty Platforms: Bug bounty programs incentivize security researchers to discover and responsibly disclose vulnerabilities in open-source smart contracts and web3 applications. Security researchers typically receive a reward from project teams based on the severity of the vulnerability. Companies like Immunefi and Code4Arena provide bug bounty hosting, consultation and program management services to web3 project teams.

Ecosystem

Finally, once a smart contract or protocol is deployed to production (i.e., mainnet), it’s important for developers to implement systems that can monitor those smart contracts and critical operational components for suspicious activity based on known threat models. In the event of any security issues, developers should make use of solutions and processes that enable an immediate response. The following primitives help to facilitate real-time  security monitoring, incident forensics and emergency response.

Protocol Risk Management: Protocol risk management solutions offer tooling for automating risk management, optimizing capital efficiency and simulating protocol performance against extreme market conditions. Companies like Chaos Labs* and Gauntlet Network* offer platforms that leverage simulation tools to optimize a protocol’s key parameters to improve capital efficiency while minimizing risk.

Threat Intelligence: Threat intelligence is data that is collected, processed, and analyzed to understand a cybercriminal’s motives, targets, and attack behaviors. For example, Forta Network* and Apostro* aggregate and monitor events and activities happening on smart contracts or blockchain protocols that may indicate potential security threats or vulnerabilities. They then generate alerts based on triaged incidents and potential attack patterns to help developers prevent or minimize loss of funds.

Blockchain Forensics: Blockchain forensics involves processes and technologies for detecting, investigating, containing and remediating cyber security threats impacting blockchain networks or web3 applications. Chainalysis and TRM Labs offer blockchain intelligence and risk management solutions for monitoring, detecting, and investigating cryptocurrency fraud and financial-related crime.

The future of Web3 Security

The infrastructure, smart contract, protocol logic and ecosystem solutions mentioned above make up the growing web3 security stack. Although the framework and layers we highlighted will likely remain unchanged, we continue to see new security primitives emerge and expect the entire stack to evolve in the coming years.  

It’s critical for developers and protocol teams to choose solutions and implement robust security measures that best prevent and mitigate security threats. While there’s no silver bullet to eliminating all potential threats in web3, we expect the industry’s security posture to drastically improve over time as these solutions mature, new standards emerge and gain adoption, and project teams increasingly shift towards a security-first culture.

Coinbase Ventures will continue to invest in exceptional founders who share Coinbase’s mission of creating more economic freedom in the world. In the web3 security stack, we want to invest in teams with deep web2 or cryptonative security expertise who are building scalable solutions that ensure the security and integrity of the web3 ecosystem. Specifically, if you’re building developer tools that automate security testing and audit processes, monitoring platforms that enable proactive threat detection and prevention, or tools that enhance identity management and access control mechanisms, we would love to hear from you - JK’s DMs are open! 

— Disclosures and footnotes

*The following Coinbase Ventures portfolio companies appear in the above landscape: Apostro, Cashmere Finance, Certik, Certora, ChainPatrol, Chaos Labs, Dynamic, Gauntlet, Forta, Gnosis Safe, Harpie, Metrika, MinervaAI, Momentum Safe, Moralis, Tenderly

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TLDR

• Web3 social networks give users ownership and portability over their data, identity, and relationships, while enabling permissionless development.   

• The web3 social stack consists of four layers: hosting, social primitives, profile, and applications.

• One example is Farcaster: a Twitter-like social app built on top of an open social graph reminiscent of the protocol that powers email (SMTP).

• By separating the underlying protocols from the apps themselves, we may one day see social networks that accrue wealth and power in new and more distributed ways.

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Social networks are applications that allow people to connect, share information, and communicate. They’ve brought humanity together in unprecedented ways while creating massively influential companies with user bases larger than most countries. 

Today’s “web2'' social giants exist as “walled gardens” where all user interactions take place within a closed ecosystem controlled by a single corporation. They own users’ identity, data, and even the relationships they create. Additionally, they dictate who can join and what developers are allowed to build on the network. This top-down control has created significant barriers for new competition, high switching costs for users, and in certain respects, power that rivals that of some governments. 

In contrast, there’s a new flavor of “web3'' social networks in their infancy. By leveraging decentralized databases and smart contracts, they enable social interactions while giving users ownership and portability of their data, identity, and relationships across applications. They also allow developers to build without permission. By separating the underlying protocols from the apps themselves, they may ultimately lead to the rise of social networks that accrue wealth and power in new and (hopefully) more distributed ways.  

With that, let’s unpack the web3 social stack, followed by a case study into Farcaster*: a “sufficiently decentralized” social protocol.  

The web3 social stack 

We subdivide the web3 social landscape into 4 layers: hosting, social primitives, profile, and applications. Note that this landscape is illustrative, and not exhaustive.

Hosting - At the bottom of the stack is the hosting layer, comprised first of blockchains upon which primitives that power social applications are run and where decentralized properties are derived. Second, decentralized storage protocols where certain (but not all) critical data is stored.

Social primitives - Next are social primitives: the foundational building blocks that provide a representation of individuals, the components of their identities (e.g. actions they’ve taken and assets they own), and their relationships between others.

Profile -Wallets can be thought of as a proverbial passport that allows users to bring their data to their application of choice, serving as the foundation for their "profile" for web3 social.

Applications - At the top of the stack are user-facing social applications. They leverage a combination of blockchains, storage protocols, and social primitives to create interfaces that end users engage with.

Applications can be categorized by the type of interaction they facilitate between users:

• Many-to-many (think Twitter) 

• One-to-one (think WhatsApp) 

• One-to-many (think YouTube) 

To understand what it all looks like in practice, let’s take a look at Farcaster: a Twitter-like social app built on top of an open social graph reminiscent of the protocol that powers email (SMTP). 

A web3 social case study: Farcaster 

At first glance, Farcaster is a user generated content feed resembling Twitter, but with a more decentralized server architecture, built on an open protocol, that leverages Ethereum for decentralized identity. 

The above is the Farcaster client, which interacts with a server hosting user data. Where Twitter’s lone client interacts with Twitter’s centralized server, Farcaster will allow anyone to host a server* and offer different features users can choose from. Unbundling the client from the server can prevent any single entity from accruing too much power, since users have options over where their data is hosted. This is similar to how you can export your Gmail contacts into Outlook, or how you can move assets from one cryptocurrency exchange to another. 

Beneath the Farcaster client is the Farcaster protocol, where things start to get interesting. You can’t take your Twitter followers to Instagram because Twitter’s competitive advantage comes from owning your social graph. The team building the Farcaster client is doing so on Farcaster’s open social graph protocol. Their true ambitions lie in attracting developers to build new and even competing clients on the same protocol. This is similar to how competing services (Substack, Mailchimp) are all built on simple mail transfer protocol (SMTP). 

Farcaster’s initial application has been selectively rolled out to around 6K users, but you can already see early signs of what’s possible with open social graph protocols. For example, someone built a client called “InstaCaster” that indexes all images posted by Farcaster users in an Instagram-like feed. Another built a client for search (SearchCaster). Building these clients requires unrestricted access to Farcaster data via APIs and isn’t currently possible on Twitter, where API access is restricted.

Farcaster from a user’s perspective 

So far what we’ve described is an open-source protocol with a more distributed server architecture that doesn’t necessarily need blockchains/crypto at all. That changes once a new user wishes to join Farcaster. 

Farcaster leverages the Ethereum blockchain to create a decentralized registry. When a new user joins, Farcaster generates an Ethereum wallet address mapped to their username. The username itself is an NFT that represents a user’s identity and can be mapped to any application on the network. Just as no entity can revoke an NFT held in your wallet, no one can revoke your identity or the connections you create with it. 

The team refers to this approach as sufficient decentralization. By decentralizing key components like identity, Farcaster can guarantee that users can always claim and post messages under a username that can’t be revoked. From there, most other actions are done off-chain, so the user experience isn’t held back by requiring users to pay gas costs for every action. 

Putting it into context 

Farcaster’s approach is just one way to utilize the web3 social stack. While others like Lens and DeSo are taking different approaches all transform and structure raw on-chain data into a form that Dapps can build upon, while offering two key value props that web2 networks can’t:

1. Users own a direct relationship with their audience 

2. Developers can permissionlessly build apps on the network

When Twitter deplatforms you, you lose all your valuable followers or subscribers in the process. If there were multiple clients building on an open Twitter social graph, you could simply switch clients just like switching email providers and bring your network with you. 

A developer choosing to build on the Farcaster protocol can tap into Farcaster’s existing social graph to circumvent the cold start problem of starting a network from scratch. This would allow, for example, a developer to create an app similar to TikTok that can be distributed to users on the Farcaster protocol from day one. This dynamic promotes competition and innovation at the application layer while preventing any one company from single-handedly capturing all the value social networks create. 

Returning power to the user  

The more people that join a social network, the more useful and valuable it becomes. Web2 companies who own the entire network can monetize the data users generate through ad sales, creating a powerful network effect and highly valuable businesses in the process.   

This captive model has led us into the precarious position where individual companies can influence what information billions of people see. Recent events suggest corporations or single individuals aren’t equipped to wield that kind of power, as well intentioned as they may be.  

When users can freely switch between social apps, much like taking your email contacts from Gmail to Outlook, it’s difficult for any single application to become disproportionately powerful through accumulating network effects. If 1B+ were to use Farcaster or similar protocols, value would accrue not to one company, but to the underlying social graph protocol itself. 

As value accrues to the social graph, it will flow to users. Imagine you could take your Twitter followers to YouTube, TikTok, Facebook, and a thousand other social apps of the future. Your social capital would become portable and monetizable across many applications that all innovate and compete for your attention. 

It’s too early to say how web3 social networks play out and it’s possible that the network effects of incumbents prove too large to overcome. However, it appears that decentralized social networks are an idea whose time has come and that alternatives to the web2 goliaths are worth building.

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Disclosures and footnotes

* The creators of Farcaster, Dan Romero and Varun Srinivasan are former Coinbase employees.

* The following Coinbase Ventures portfolio companies appear in the above landscape: Zapper, Gallery, Taki, Farcaster, Nansen, DeBank, Syndicate, Highlight, Bonfire, Rally, Zerion, Metamask (via Consensys), Deso, XMTP, WalletConnect, Spruce, Disco, Snapshot, Yuga Labs, Mirror, Polygon, Arweave, Livepeer, Ceramic.

* The “Hubs” feature is expected to be live in January 2023

*Farcaster is currently on Ethereum’s Goerli testnet with plans for mainnet migration in 1H 2023  

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.

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TLDR: 

Venture landscape: 

• Venture funding conditions tightened for another quarter, with Coinbase Ventures making 9 new investments; our slowest quarter since Q2 2020.

• In this environment, we narrowed our focus and wrote larger average checks on a fewer number of investments while doubling down on existing portfolio companies. 

• Capital availability has declined, traditional VCs have taken a step back from crypto, and deals are taking longer to come together. High quality founders are still able to raise, while others struggle to close rounds.

• VC “dry powder” remains at all-time highs, however there’s a chance some of the funds get returned to LPs should fund managers deem it the fiduciary responsible thing to do. 

Themes; investments: 

• Web3 developer activity is showing healthy growth alongside a more robust developer toolkit; we invested inThirdWeb which is building a range of developer solutions and exhibiting impressive traction.  

• Proof-of-stake networks are generating $8B in annual staking rewards with estimates of that figure hitting $40B by 2025; we backed Alluvial, which is an institutional-grade liquid staking protocol that can unlock more institutional inflows into crypto. 

• “Application-specific” chains on Cosmos are growing in popularity due to the customizability they afford teams; we added DeFi focused Sei protocol to our stable of Cosmos portfolio companies in Q3. 

• Move is the programming language developed by Facebook’s Diem. When Diem shut down, the core teams productized Move in the form of Aptos and Sui (Mysten Labs); we’re excited about the potential of the Move ecosystem and have backed each of these new layer-1s. 

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Overview

Worries surrounding the overall health of the economy have set in and continue to weigh on the venture funding landscape. Similar to Q2, both global venture and crypto funding conditions slowed considerably in Q3.

Despite sideways token prices and the slowing pace of venture funding, the broader industry pressed forward. Developer activity remains healthy and the tools available to web3 developers grow more robust by the day. Ethereum’s “merge” signified a monumental technological achievement, and set the stage for the next era of ETH applications, including a massive institutional business around proof of stake. Cosmos and “application-specific” chains are picking up momentum while new layer 1’s that evolved out of Facebook’s Diem (Aptos & Sui) are coming to market. The quarter also saw large players like BlackRock and Google make inroads into the space while NFTs garnered more mainstream adoption. 

In this quarter’s recap and market outlook we’ll provide an overview of what we’re seeing in the venture landscape, along with on the ground observations from the Coinbase Ventures team. 

Venture landscape  

In Q2, total venture funding dropped 23%, which at the time marked the largest dip in a decade. Then in Q3, total venture funding dropped another 34%, from $112B to $74.5B, setting a new record for quarterly decline. 

According to data from The Block, crypto venture funding slowed in lockstep with the broader venture landscape over the past two quarters. Following a 22% drop in Q2, total crypto funding dropped another 35% in Q3, from $9.5B to $6.2B.

Coinbase Ventures made 9 investments over the quarter; our lowest quarterly total since Q2 2020. In this slower environment, we took the opportunity to narrow our near-term focus areas and concentrate activity on a fewer absolute number of investments. We also doubled down on support for existing portfolio companies. 

This resulted in a notable increase in our quarterly average check-size and follow-on investments in Messari, Mysten, and WalletConnect.   

Crypto venture landscape observations 

Capital availability has declined, and as a result, there’s a lower number of companies actively raising and deals getting done. While crypto-native venture firms remain active, capital from more traditional firms has dried up considerably as they shift to a more incremental and measured approach to crypto.   

Deals are still getting done, but we’re in an environment of “haves and have nots.” Highly sought after founders are able to raise at lofty valuations while others are having trouble pulling together a full syndicate and have been forced to reset valuation expectations. Some of these teams are resorting to raising smaller bridge financing rounds at flat or down valuations.   

The deals that are getting done are taking longer to come together; particularly when compared to the fervent pace observed in 2021. In an uncertain macro environment, investors across the board are being more patient in deploying capital. There’s also been fewer VCs stepping up to lead deals due to pricing uncertainty, further contributing to the overall slowing pace. 

While the amount of capital firms are willing to deploy in this environment has declined, there’s still a record amount of “dry powder” that needs to find a home eventually. However, there’s a chance we see some of it returned to LPs if fund managers decide that’s the responsible thing to do as a fiduciary. In the meantime, funds are dedicating more time and resources to supporting their existing portfolio founders and building out their own operational functions.

Now before we get into some of the things we’re excited about from Q3, some brief housekeeping matters. 

Evolving our venture practice 

Coinbase Ventures was launched in 2018 as a passion project run by a few dedicated employees in addition to their full time roles at various corners of Coinbase. Over the years, we’ve added full time staff and have matured our Ventures practice – establishing deeper connections between our portfolio companies and product teams within Coinbase. Additionally, we’ve begun staking and earning yield from our liquid token investments while recently launching new media channels (subscribe to our newsletter and follow us on Twitter!). 

Going forward, this continued evolution may include reducing our positions in certain companies or projects that we believe have reached maturity and are beyond our investment mandate. This will allow us to focus our efforts and reinvest capital in new companies and projects that we feel we’re best positioned to support. 

With that, let’s get into some themes we’re currently excited about, including: web3 developer activity, institutional staking, and the Cosmos and Move ecosystems.

Web3 dev rising  

Prices are down, but looking at web3 developer activity you wouldn’t know it. As Alchemy’s* Q3 Web3 developer report showed, despite a 70% drop in the price of ETH, smart contract deployment on Ethereum increased 40%. Further, Q3 showed sizable year-over-year gains in metrics measuring developer activity on the industry’s largest smart contract blockchain. 

Beyond Ethereum, the report also shows healthy growth in developer activity across Polygon*, Solana, Arbitrum*, and Optimism*. Key infrastructure projects like The Graph*, Alchemy*, ENS*, and WalletConnect* are all showing increased usage and installations as well. We think this is all a sign that the buildout of the web3 developer stack is bearing fruit. While it’s still not as easy to build in web3 as web2, it’s getting easier by the day, leading to a rise in web3 developer activity. 

One company building on that front that we backed in Q3 is Thirdweb - a platform that provides developers with libraries of pre-built and battle tested smart contract templates, software development kits (SDKs), and dashboards for monitoring deployed contracts. These solutions can be leveraged to launch everything from marketplaces, token-gated clubs, DeFi protocols, DAOs, NFTs, and blockchain based games across seven chains.  

Thirdweb is showing impressive traction with developers, including many inside Coinbase. Thirdweb SDKs already power NFT drops on Coinbase NFT, like this recent drop with the Chicago Bulls. With this partnership, Thirdweb joins 0x as CBV portfolio companies helping power Coinbase NFT. 

Liquified stake 

Blockchains need to come to “consensus”, or agree on the state of the blockchain at any given time to function. Participants who commit resources to validate new transactions and help bring a network to consensus through a process called staking are rewarded in a network’s native token.

Staking is already a multi-billion dollar business, and with the completion of Ethereum’s Merge, the industry’s largest smart contract blockchain is now secured by Proof-of-Stake consensus. Rather than commit electricity to proof-of-work mining rigs, validators simply lock or “stake” tokens into the network to participate in consensus and earn token rewards. Staked digital assets in PoS networks are now generating $8B in annual revenue with some estimating that figure will hit $40B by 2025.

Staked tokens are locked up for a certain period and are essentially illiquid. Liquid staking protocols have risen to address the capital inefficiency of traditional staking. These protocols issue receipt tokens that represent a claim on staked digital assets (like Coinbase’s cbETH for example). Receipt tokens accrue rewards, but can also be sold and can be used to actively participate in compatible DeFi protocols. At present, there is nearly $10B in ETH locked in liquid staking pools offered by Lido, Coinbase, Rocket Pool and others. 

While both staking and liquid staking are already big businesses, it’s presently difficult for institutions to participate. This stems from the higher levels of security and compliance standards they need to satisfy. Enter Alluvial’s Liquid Collective: an enterprise-grade liquid staking protocol launched with support from industry leaders including Coinbase Cloud, Figment, Kraken, and others. At maturity, stable, liquid staking rewards could be viewed as web3’s risk-free rate of return, presenting a compelling opportunity for institutions, while unlocking massive inflows into the cryptoeconomy. 

Cosmos & the App-chain Gang

Today, “monolithic” L1s like Ethereum and Solana have thousands of Dapps operating on a single blockchain. This allows Dapps to interoperate, but Dapp teams sacrifice the ability to fully customize and control their own domains, and must compete with other Dapps for blockspace. But what if you could launch your own fully customizable “application-specific” chain while still remaining interoperable with other Dapps?  

The idea isn’t new, but has been picking up momentum, particularly on Cosmos. Instead of being a one-stop-shop blockchain, Cosmos is a collection of tools for launching standalone blockchains capable of interoperating with one another. Today, there are over 60 Cosmos chains. Some of the largest exchange chains and tokens, such as Binance, Crypto.com, and Huobi, as well as the now defunct Terra have also been built using elements of the Cosmos toolkit.

Electric Capital showed that at the end of 2021, Cosmos had the third most active developer community after Ethereum and Polkadot. Since then, it seems more developers are seeing the light. Popular DeFi applications like DYDX have recently opted to launch an  “app-chain” on Cosmos, citing the customizability they’re afforded. Following the collapse of Terra, we’re also seeing former Terra projects opting to relaunch on Cosmos (Delphi Labs, for example). There’s also excitement around “ATOM 2.0” - an update of Cosmos’ tokenomics which should lower the cost of launching app-chains, as projects can leverage existing validators rather than have to bootstrap their own network.  

Coinbase Ventures has backed many Cosmos-based projects to date including  Axelar, Evmos, Kyve, Polymer, Umee, and in Q3, Sei. We’re excited to see Cosmos’ introduction of EVM and SolanaVM (Nitro) modules, which will pave the way for existing Ethereum and Solana applications to be deployed in Cosmos. Further, it’s been interesting to see IBC - the tech that enables Cosmos interoperability - adopted by ecosystems like Polkadot and Near, led by Composable Finance*.  

More broadly, Cosmos’ momentum underscores, that between L2s and app-chains, that the future is multi-chain (if that weren’t already clear).

MOVE’in on up 

Remember Diem? The blockchain-based payment system headed up by Facebook. While Diem ultimately never fully got off the ground (mainly due to regulatory complexity), a key piece of the project lives on in the form of Move. 

Underlying every smart contract blockchain are computer languages that developers write programs in. Ethereum has Solidity. Solana has Rust. Diem had Move. Before Facebook (now Meta) had to shutter the project, they poured a tremendous amount of resources into the development of Move to create a blockchain capable of supporting Facebook levels of users activity. Once Diem shut down, rather than call it a day, the core teams spun out to productize Move. 

The two new L1s leveraging Move that you’ve likely been hearing about lately are Sui and Aptos. The Move language has been touted as highly developer friendly, well-suited for designing software around data and objects (i.e. tokens & NFTs), allowing for maximum code reusability and developer efficiency. Given that Move was inspired by Rust but with built-in decentralized storage capabilities, it’s becoming increasingly popular among Solana developers.  

We participated in the early rounds of both Aptos and Sui and have been investing in Move infrastructure projects to be announced at a later date. Becoming a dominant general purpose L1 remains one of the largest prizes in crypto and with the emergence of Aptos and Sui, it's clear that the incumbents will continue to be challenged by new competitors innovating at the programming layer.

Concluding thoughts 

It’s a bit of a crypto cliche that, “bear markets are for building”; but some cliche’s exist simply because they’re true. Much of the madness associated with bull markets subsides, tourists leave, and those that remain can put their heads down and build the next cycle of innovation. 

The 2018 bear market in which Coinbase Ventures was founded yielded projects like Uniswap*, USDC, Polygon*, Solana, and OpenSea*. These all played major roles in the subsequent bull cycle, paving the way for DeFi, NFTs, DAOs, and web3 gaming. We expect this down cycle to birth similar innovations that come together in new and unpredictable ways. 

The key difference now, however, is that the industry is standing on a much stronger foundation. User experience has vastly improved, L2s are ready, developer tooling is more robust, and key infrastructure has matured. On top of that, as evidenced by Coinbase’s recent partnerships with both Google and Blackrock, the size and sophistication of participants continues to grow. Meanwhile NFTs continue to make mainstream strides with adoption from Starbucks and most recently, the successful launch of Reddit NFTs, which quickly reached 3M active wallets. 

This all sets the stage for the next cycle of innovation to make a far greater impact than any before it. 

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Disclosures

* denotes Coinbase Ventures portfolio company

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.

Special thanks to Mike Armstrong, Aaron Henshaw, Michael Atassi, Steven Willinger, and Shan Aggarwal for helping to inform this article.

***

Despite the rise of Bitcoin and Ethereum, along with the emergence of new categories like DeFi, NFTs, GameFi and DAOs, web3 developers represent less than 1% of the 31.1M software developers globally.*

So why are there so few developers in web3 today? For one, the tools and infrastructure available to web3 developers are much less robust than that of web2. This simply makes it more difficult to get started building, experimenting, and deploying in web3. That’s all quickly changing however, as the number of monthly active web3 developers hit all-time highs at the end of 2021. And to support this growing contingency, is a vibrant ecosystem of teams working to simplify the entire web3 developer journey, which will ultimately help unlock the next stage of web3 growth and innovation.

In this edition of Around The Block, we’ll explore the growing web3 developer stack.

The Web3 Developer Stack

Building in Web2 vs Web3

Software development is the process of building computer programs. There are three main components to a given program:

1. The front-end (what users interact with)

2. The back-end (what users don’t see)

3. Database (where critical data is stored)

The front-end that a typical user interacts with through a mobile or desktop browser is basically the same in web2 and web3. A web3 app like Uniswap looks similar to a typical web2 app because both front-ends are mostly created using React — a popular developer framework for web and mobile apps.

It’s under the hood where web2 and web3 differ. The backend frameworks and types of databases that make web3’s defining characteristic — user-defined ownership — possible are new and unique.

Where web2 applications largely rely on centralized databases, web3 applications are built on decentralized databases (blockchains). This requires entirely new backends and new primitives like wallets.

The tools that aid in the creation, deployment, and maintenance of web2 applications are incredibly developer-friendly, thanks to decades of cumulative development. Out of the box solutions, mature infrastructure, shared code libraries, and easy to use frameworks largely make building in web2 a breeze.

Web3 on the other hand still requires specialized expertise to interface with complex infrastructure and commonly involves many redundant processes given that the stack is less developed, leaving teams to have to reinvent the wheel. That said, the tooling that will help onboard the next 1M+ web3 developers is rapidly improving.

Let’s take a (non-exhaustive) look at the evolving Web3 developer stack layer by layer (* denotes Coinbase Ventures portfolio company).

Protocol layer

The first decision a web3 developer has to make is which blockchain protocol to build on. Building on Bitcoin is entirely different from building on Ethereum, and Solana differs from Ethereum, etc.

For faster and lower-cost applications, developers might want to build on a layer2 protocol — Optimism*, Arbitrum*, etc. For applications that need to port value from one chain to another, developers will want to leverage cross-chain bridges like Hop* or Synapse*.

Once these decisions are made, developers can start to incorporate building blocks that make user applications possible.

Infrastructure primitives

The next thing a developer needs to figure out is how their application will ultimately interact with the underlying blockchains. This is where infrastructure primitives come into play.

Node infrastructure — Nodes are where an app’s interaction with a blockchain “happens.” They’re computers that read the state of the blockchain and write updates to it once a user interacts with an application. Node infrastructure providers like Coinbase Cloud, Infura*, and Alchemy* let developers easily set-up, manage, or access blockchain nodes, saving developers considerable time and resources.

Wallet & Key Management — Blockchain wallets, like Coinbase Wallet, allow users to manage the private keys needed to perform transactions within web3 applications. Wallet and key management providers like Web3Auth* or Pine Street Labs*, enable developers to build secure connectivity between blockchain wallets and user-facing applications.

Identity — protocols like ENS* serve as a user’s identity across applications. Spruce* provides frameworks and toolkits that developers can use to verify user credentials to authenticate actions on Ethereum. For example, developers can use the Spruce ID toolkit to empower users to sign into apps with their ENS accounts. Additionally, companies like Lit Protocol provide developer tooling for granting access to content, software, and other data utilizing their tokens or NFTs.

Decentralized compute — Compute resources provide processing power that applications rely on to carry out computational tasks. Currently, most of the web’s compute is provided by centrally owned providers like AWS. Decentralized compute is a shift towards community-owned networks, in which compute resources are distributed in a permissionless manner at low-cost. Companies like Akash Network and Aleph.im have emerged to provide peer-to-peer compute resources that are highly-performant and optimized for smart contracts and blockchain applications.

Decentralized storage — Storing every piece of data associated with a given web3 app directly on blockchain nodes is costly. Rather than storing data on a centralized database, web3 developers can use peer-to-peer data storage protocols like IPFS, Arweave*, and Ceramic Network* for certain data. For example, web3 blogging site Mirror is built on Ethereum, but stores actual blog content on Arweave.

Oracles — For a typical Ethereum application, the blockchain stores transaction history and “state” (balances, smart contracts, and other variables). It can’t, however, natively store and interact with data from external sources — i.e. transaction history from other blockchains or “real world” data like the weather in San Francisco. That’s where oracles like Chainlink or Flux*come in, connecting blockchains to on-chain and off-chain data sources.

Interoperability — many different blockchains exist but few have the ability to exchange value and make use of information cross-chain. Interoperability protocols like LayerZero*, Axelar Network*, and Astar Network* provide SDKs and APis for developers to build apps that are portable and can communicate with different blockchains.

Developer tools

Atop the infrastructure primitives that allow applications to interact with blockchain networks are tools that allow developers to more seamlessly interact with the above-named primitives.

Frameworks & IDEs — Developer frameworks consist of libraries of code that other developers have created that make development easier. Web3 frameworks like Truffle, Moralis*, Tatum, and ThirdWeb*, let developers leverage existing code for smart contract applications so they don’t have to build everything from scratch. They also let developers test and deploy applications. Integrated development environments (IDEs) like Foundry and HardHat combine common source code editors, and build automation and debugging tools into a single, easily accessible interface.

Low-code / No-code — These platforms enable user-facing applications to be quickly designed/deployed entirely via drag-and-drop interfaces. Companies like Settlemint provide developers with smart contract templates for NFTs to prevent web3 developers from having to reinvent the wheel.

Index & query — Data indexers help people locate and access specific data within an underlying database. In Web2, Google search is the most popular data indexing service that allows users to query data stored in online databases with sub-second response times. In Web3, decentralized indexing services are emerging to help app developers fetch, process, and query blockchain data. The Graph Protocol*, Covalent*, and Coherent* all provide APIs for extracting and making use of data from decentralized data storage providers and EVM-compatible blockchains.

Test, simulate, & monitor — It’s important to test and simulate web3 applications before they’re released into the wild. Companies like Tenderly* and Kurtosis* offer a variety of tools for simulating how smart contracts and transactions will behave once live, as well as tools for debugging any issues. Blocknative* provides dashboards and tools for monitoring transactions before they are submitted on-chain.

Security & audit — Given the potential for smart contract exploits, these platforms let developers apply security and audit best practices to their applications. OpenZeppelin, Forta*, Certik*, and Certora* all provide a variety of services, frameworks, and monitoring tools for developers to mitigate potential security risks and vulnerabilities.

Messaging — Web3 apps often involve sending various communications to end users. For example, a crypto wallet may want to push a user alerts regarding transaction confirmations. Companies like XMTP Labs* and EPNS are building secure messaging protocols and decentralized communication networks that drive user engagement and power these notifications within Web3 applications.

Analytics — There’s a host of platforms and services that let developers explore, analyze, extract, and visual blockchain data. Dune*, Nansen*, and Messari* each offer a variety of APIs and reporting capabilities to build data visualization features within web3 apps. Flipside Crypto* offers SDKs (software development kits) and APIs to create and share data insights on various crypto projects.

App Enablement Layer

App Enablement LayerThe application enablement layer ties all of the above layers into specific web3 uses. NFTs, DAOs, DeFi, and gaming each have their own bespoke developer solutions.

NFT focused tools offer infrastructure for creating and managing NFT assets. DAO tools offer solutions for DAO creation (Syndicate*, Samudai*), governance (Snapshot*), and treasury management (Utopia Labs*). DeFi focused tools offer APIs that let developers access various DeFi primitives. Gaming focused tools ( Venly*, Joyride*, Horizon Blockchain Games*) provide solutions for creating virtual worlds and blockchain based games.

The ever-evolving dev stack

The protocols, infrastructure, and developer tools mentioned above make up the nascent, yet evolving web3 developer stack. The modular and interoperable nature of web3 means that the stack can be combined in endless ways to create new and interesting applications.

While the framework and layers we highlighted will likely remain unchanged, we continue to see new developer tooling primitives emerge and expect the entire stack to evolve dramatically in the coming years.

Coinbase Ventures will continue to invest in the next generation of platform and developer tooling that will ultimately onboard millions of developers into web3. If you’re as dedicated to building out the web3 dev stack as we are, we would love to hear from you — JK’s DMs are open!

***

Further Reading

• A simple guide to the Web3 stack, by Angie Wang, Connor Dempsey, and Justin Mart

• Electric Capital Developer Report 2021, by Electric Capital

• The Architecture of a Web 3.0 application, by Preethi Kasireddy

***

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.

In the 13 years of its existence, Bitcoin has risen from obscurity to $1 trillion highs, settling over $60 trillion in total transfer volume along the way.

Despite these feats, Bitcoin’s decentralized design limits it to a mere 7 transactions per second. In times when demand to use the network exceeds 7 transactions, users experience long wait times and fees as high as $60 per transaction at the extreme. Even with fees recently hovering between $1–2, the network remains unsuitable for buying that proverbial cup of coffee.

Enter the Lightning Network: a layer-2 protocol built on top of Bitcoin that can theoretically scale to millions of instant transactions per second that cost pennies to send. If it gains traction, it can even undercut the fees of giants like Visa and Mastercard, along with the entire global remittance market.

But will it?

Lightning 101

As with most layer-2 solutions, Lightning seeks to increase transaction throughput and lower costs while retaining sufficient decentralization by moving activity to a second network. Once BTC is on the Lightning network, it can be transacted instantly typically at fractions of a penny.

Rather than expensively sending each transaction over the Bitcoin blockchain, users deposit BTC into the Lightning Network and then transact inexpensively through payment channels. As with most networks, the more people and companies that join, the more useful it becomes.

Obviously at <1 cent fees, Lightning transactions are cheaper than using the Bitcoin network. More intriguing however, is that Lightning has the potential to replace existing payment processors for fiat transactions without the consumer knowing that BTC was used as the underlying settlement layer. We’ll explain.

Disrupting the payment giants

Visa and Mastercard are the world’s dominant payment processing networks. By collecting 2–3% transaction fees everytime someone swipes a debit or credit card, they pulled in $24B in 2021. Payment processors leveraging the Lightning Network could undercut that.

Let’s say you want to make a $100 payment to a merchant. Using your credit card would cost the merchant $3, which is then passed along to you via hidden costs. Now what if you converted $100 USD into BTC, transferred it over the Lightning network for less than a penny, before converting the BTC back to $100 USD. A service called OpenNode is able to leverage the Lightning Network to do just that, for a 1% fee. A similar logic can be applied to the $40B global remittance fee market, which averages 6.4% per cross-border transaction.

However economic it may be to replace Visa/Mastercard and international remittance companies with Lightning, it’s easier said than done. The incumbents enjoy large network effects, and like any young network, Lightning faces a cold start problem.

So how’s adoption looking to date?

Lightning adoption

Where the potential to disrupt the incumbents is there, current Lightning adoption is still tiny (but growing!). Arcane Research estimated that in Q1 22, Lightning facilitated $20–30M in monthly payments. That’s a 4x YoY increase, but a far cry from the $866B Visa facilitates each month.

The main way that Lightning growth is measured is by “public node capacity” — essentially how much BTC is locked in public Lightning channels. An estimated 30% of channels are private, making it difficult to state the true value in the network. What we can see however, is that public capacity is growing.

When measured in USD, the network has taken a predictable hit with the overall BTC price decline. However, encouragingly, the amount of total Bitcoins in the network is hitting new all-time highs at over 4,500 BTC (around $100M).

More importantly, as adoption ticks upward, the ecosystem around Lightning is growing as well.

The Lightning stack

The Lightning protocol sits atop of Bitcoin. On top of Lighting, sits core infrastructure. On top of the core infrastructure, are a growing number of payment and financial services, as well as consumer applications.

Core infrastructure consists of Lightning implementations and node & liquidity services. Lightning implementations are the software programs that individuals and businesses can run to connect to the Lightning network — the largest being Lightning Labs’ LND with 70% of the market (as of 2020). Node and liquidity services host hardware, provide user-friendly interfaces, and help manage Lightning payment channels (running your own node is complex).

Built on top of the core infrastructure are a range of payment and financial services as well as consumer apps. For example, Strike is built on an LND implementation that lets users buy and sell BTC, tip creators on Twitter, and allow Shopify merchants to accept BTC.

Also built on core infrastructure, are a growing number of budding consumer use cases. Mash, for example, aims to disrupt the creator subscription model via streaming micropayments — think paying your favorite Twitch streamers a couple cents each minute you watch, rather than buying a one-size-fits-all subscription. Zebedee uses Lightning to enable in-game economies that reward players with small amounts of Bitcoin.

Growing accessibility & momentum

As the Lightning ecosystem steadily grows, so has the access that users have to the network. Between Cash App’s Lightning integration and El Salvador’s rollout of the Chivo wallet, access has exploded from 10M to 80M users (the success of El Salvador’s rollout has been mixed, with research suggesting that only 5% of sales in the country use BTC).

26 exchanges support Lightning as well, with Kraken, Bitfinex, and Bitstamp being among the most prominent. Robinhood also recently announced an integration for 20M+ users, and P2P marketplace Paxful offers support for its 7M+ users. Users of these exchanges can instantly and inexpensively deposit and withdraw bitcoin to and from any Lightning wallet, increasing the speed and lowering the cost compared to a typical BTC transaction.

Funding is picking up as well with OpenNode raising a Series A at a $220M valuation and Lightning Labs raising $70M for its Series B. Notably, former head of Meta’s crypto initiative David Marcus’s Lightspark, raised a Series A at an undisclosed amount to build Lightning infrastructure for companies, developers, and merchants.

Hurdles to adoption

The potential, funding, and momentum is there, however significant hurdles remain. Principally, the lack of developer tooling, demand for payment use cases, technical hurdles, onboarding challenges, as well as compliance and regulatory issues.

Developer tooling still needs to be built out to enable more user friendly applications. With most still treating BTC as an investment, we’re yet to see broad demand to use it for payments (use of Lightning rails for fiat payments remains a compelling opportunity). Despite progress from infrastructure companies, Lightning is still cumbersome for new users and merchants. Additionally, onboarding low income users in developing countries remains a major challenge to fulfilling the promise of Lightning remittances.

Lastly, the lack of compliance and regulatory frameworks limit the ability for existing payment and banking service providers to onboard and serve a global customer base.

Early days

After launching in 2018, it’s still early days for Lightning. With about $100M locked in the network, its size pales in comparison to Ethereum’s billion dollar layer-2 networks, Arbitrum and Optimism. Lightning payment activity, however, is more indicative of real world utility when compared to the more speculative activity driving much of the growth on smart contract platforms.

Humble beginnings aside, the potential to turn crypto’s most valuable asset into a true medium of exchange has the power to bring greater financial inclusion to anyone with a smartphone. The ability to cost effectively route fiat transactions over Lightning rails without users ever knowing they’re using Bitcoin can disrupt $150B+* a year industries.

What Visa/Mastercard is for fiat currencies, Lightning can be for Bitcoin. The combination of a universally accessible payment network atop the world’s first open-source protocol for money can help Bitcoin evolve into a true global reserve currency. Should it happen, look for developing countries with high inflation and more smartphones than bank accounts to lead the way.

When Coinbase?

This article should not be construed as an indication that Coinbase has imminent plans to add support for Lightning. Rather, a few employees at the company simply found its potential compelling enough to research, write, and share.

With that said, it’s hard not to be encouraged by the growth that the Lightning Network is showing — particularly over the past six months. It’s noteworthy that this growth is coming in a bear market, where Bitcoin fees are relatively low. In a future bull market, we could see Lightning activity spike as fees on the base chain rise, sending users looking for cheaper ways to transact.

If growth of the Lightning Network continues, it will have major implications on the future utility and value of the world’s oldest and most valuable digital asset.

*

H/T Nick Prince, Kevin Choe, and Yash Parikh for also helping inform this article.

For deeper reading on the Lightning Network, check out:

• The State of Lightning Volume 2, by Arcane Research

• A Look At the Lightning Network, by Lyn Alden

*$150B is comprised of fee revenue for credit card and international remittances for both commercial and consumer sectors that we think Lightning is most primed to disrupt. Source.

*

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.

TLDR:

• Coinbase Ventures deal activity reflected the overall pace of the venture landscape, down 34% QoQ. Activity remained up 68% YoY, reflecting the steady growth of our venture practice over the past year

• Among the key trends observed, we believe that Web3 gaming will onboard the next massive wave of crypto users, with experienced founders from Web2 gaming continuing to pour into the space

• We’re excited about Web3 user applications working to upend the captive models of Web2 and give users control over their audiences and communities

• The Solana ecosystem continues to show impressive momentum and developer traction

• Massive UX improvements are coming to crypto that will obfuscate away complexity and deliver experiences on par with Web2

• The United States continues to be home to the bulk of companies in our portfolio, with Singapore, UK, Germany, and India all establishing impressive innovation hubs

• Where CeFi lenders faltered this year, DeFi lending platforms were resilient

• Current price action aside, we remain convinced that the opportunity within crypto and Web3 are far greater than most realize.

***

The first half of 2022 was turbulent for all markets. The Dow and S&P had their worst first halves since 1962 and 1970. The NASDAQ had its worst quarter since 2008. Bitcoin had its worst quarter since 2011, DeFi TVL ended down 70% from its high, and June NFT sales slumped to levels not seen in a year.

A core part of the crypto market chaos stemmed from the collapse of the $60B Terra ecosystem in May. This contributed to the implosion of a $10B crypto fund (Three Arrows Capital) that had leveraged exposure to Terra along with a few other trades that moved against them (GBTC, stETH). Next, it was revealed that Three Arrows Capital had borrowed heavily from some of the largest centralized lenders in crypto. Unable to recoup these loans, several of these lenders were forced into bankruptcy.

The macro market downturn seeped into the venture landscape as well.

Venture landscape

The broader venture market began to show signs of cooling in Q1, with total funding dropping for the first time since Q2 2019. That trend continued in Q2, with total venture funding dropping 23%, marking the largest dip in a decade. The quarter also saw later stage companies like Klarna raising down rounds; a further sign of the times.

Crypto venture funding still saw a record Q1, but as we wrote in our last letter, we’d already begun seeing signs of a slowdown that we expected to surface in Q2. Sure enough, data from John Dantoni at The Block showed that crypto venture funding dollars decreased 22%: the first down quarter in two years.

In Q2, Coinbase Ventures continued to rank among the most active investors in crypto, but also saw deal place slow, with the total count decreasing 34% QoQ, from 71 to 47. Despite the slowdown compared to the fervent pace of late 21 and Q1 22, our Q2 activity still increased 68% YoY; indicative of the overall growth of our venture practice.

The decline largely reflected the overall market conditions — with volatility in the markets, we saw many founders rethink or put their rounds on pause, particularly at the later stages. We’re seeing that many companies are foregoing a fundraise unless absolutely necessary, and even then, only if they feel confident that they can show the growth needed to justify a new round.

Gloomy macro environment aside, there are still plenty of high quality founders raising at the seed stage, where we’re most active. Looking beyond the price action at the areas that we invested in shows the range of real utility that’s continuing to be built and paints a promising picture of the future: one with a vibrant array of Web3 user applications, improved UX, robust DeFi markets, scalable L1/L2 ecosystems, and all of the tools developers need to build the next killer app.

Here’s how our activity broke down over Q2.

Now, let’s look at some themes that stood out. (* denotes Coinbase Ventures portfolio company)

The coming era of blockchain gaming

With the meteoric rise and subsequent fall of Axie Infinity activity, many pundits have been gleefully quick to dismiss blockchain gaming as a passing fad. As we wrote in September, Axie was experiencing a positive feedback loop that could turn negative should the fervor driving the game die down, which is ultimately what happened. Regardless, Axie posted nearly $1B in sales in a single month and attracted 2M DAUs with essentially zero marketing budget. This put the entire gaming world on notice to the power of this new vertical.

With an estimated 3.2B+ gamers in the world, we strongly believe that Web3 gaming will onboard the next massive wave of crypto users. Web3 gaming remained a sector of heavy investment in Q2, with The Block estimating that $2.6B+ was raised. Our activity over the last few quarters only strengthens our conviction.

As we saw in Q1, founders with strong track records in Web2 gaming continue to embrace this category. For example, Azra games*, was founded by the creators of the $1.4B+ mobile blockbuster Star Wars Galaxy Heroes. Their goal is to build a combat RPG game with a robust in-game economy that can still garner mainstream appeal. The space has also attracted Justin Kan, co-founder of the game streaming platform Twitch, which was sold to Amazon for $1B. Kan’s new company, Fractal*, is building a marketplace for NFT gaming assets.

Companies like Venly* will add fuel to the fire with a suite of tools that let Web2 game developers seamlessly make the leap into Web3. Established gaming powerhouses are even starting to come around, with Fortnite creator Epic Games now allowing NFT based games into its game store.

It will take some time for this sector to mature, but it’s growing increasingly clear that blockchain gaming will be a massive category in the future. Expect an increased focus on sustainable economics and gameplay that infuses NFTs with more familiar Web2 gaming experiences.

Rewiring Web2

Beyond gaming, the next generation of Web3 user applications are working to upend the captive models of Web2 and to give users control over their audiences and communities. One company we’re particularly excited about is Farcaster*: a sufficiently decentralized social network founded by Coinbase alumns Dan Romero and Varun Srinivasan. Their early product resembles Twitter, but with the key difference of letting users own the relationship with their audiences.

Farcaster is an open protocol, similar to email (SMTP). While Farcaster has built the first social app on the protocol, other developers can build competing clients, just like we have Gmail and Apple iCloud. While you can’t take your Twitter followers with you to TikTok, someone could build a TikTok equivalent on the Farcaster protocol, and Farcaster users can take their followers with them to a new, differentiated platform. Not only can users maintain better ownership of their audience, but it also opens the door for more aligned monetization. Where most advertising spend goes directly to Twitter, Instagram, etc, Farcaster users with large followings can monetize their audiences directly across platforms.

Another investment we’re excited about is Highlight.xyz*, which sits at the burgeoning intersection of Web3 and music. Highlight will let musicians create their own web3-enabled fanclubs / communities (no coding necessary), complete with token gating, access to NFT airdrops, merchandise and more. Highlight joins other CBV portcos like Audius*, Sound.xyz*, Mint Songs*, and Royal*, all offering musicians new avenues for connecting with and monetizing their fanbases.

All told, we remain excited about Web3’s potential to reimagine entrenched Web2 models for social media, music, and more, and ultimately return power to creators.

Solana sunrise

Noticeable in our Q2 activity was the continued momentum behind the Solana ecosystem. While Ethereum and the EVM remain king as far as developer traction and compatible apps, we’re noting a clear trend in early teams placing importance on Solana. All in, we did 10 deals building on Solana in Q2.

Source: Messari

Given that Solana smart contracts are coded in Rust as opposed to the EVM’s Solidity, founding teams often choose between building in one or the other. Increasingly, we’re seeing teams opt to support both the EVM and Solana from the onset — like recent additions in Coherent and Moralis. We’ve seen others start on EVM and opt to fully transition to Solana while the above mentioned Fractal opted to build on Solana from the onset.

Add in the fact that multiple large funds have publicly expressed support for the ecosystem, and it suggests that Solana’s staying power is real. Chain liveliness however (the ability for Solana to remain online) remains an issue that is paramount for the Solana team to solve.

The UX of Everything

An overall clunky and disjointed crypto user experience has long been a hurdle for adoption. Think of what a user has to do to execute a typical transaction: convert fiat to crypto, transfer crypto to a wallet, bridge crypto to their network of choice, and then finally execute a transaction.

In Q2, we’ve invested in multiple teams (not yet announced) working on streamlining and verticalizing the entire retail transaction journey. Soon developers building in crypto and Web3 will be able to deploy the entire transaction stack with a few simple lines of code and standard set of APIs.

The end result will be a future where, for example, a user can execute a DEX transaction in a single click. In the background, fiat will be converted into crypto, moved to a wallet, bridged to an L1/L2, before executing the swap and custodying the asset in their wallet of choice. All of the complexity will be obfuscated away and we’ll have user experiences on par with Web2 — a massive unlock.

Where are the buidlers?

This quarter we took a look at where the founding teams we’ve invested in are based. While crypto is a global industry, somewhat unsurprisingly, the largest concentration of our founding teams hail from the United States — home to 64% of our 356 portfolio companies; all the more reason for regulators to foster rather than inhibit this fast growing sector.

Singapore has established itself as the base of many of the teams building in Asia. Meanwhile, the UK and Germany are home to growing hubs, with policy makers proactively working towards regulatory clarity. We continue to be impressed by founding teams in India, who we expect to play a major role in the future of crypto adoption (CBV portfolio company Frontier, with 30 engineers in India has built a wonderful mobile-first DeFi aggregator supporting 20+ chains and 45+ protocols).

This quarter, we were also excited to back five teams founded by former Coinbase employees, including the aforementioned Coherent and Farcaster, as well as three others not yet announced. We’re proud to continue to support employees who receive a world class crypto education at Coinbase and go on to found world class companies and projects.

Wrapping up

While there’s plenty to be excited about in the future, there are also plenty of lessons to be learned in the present. The current crypto crises is similar to those we’ve seen play out in traditional finance. The opaqueness that centralized lenders and Three Arrows Capital operated under resulted in an inability for lenders to properly evaluate the risk of their counterparties. Lenders didn’t know how much the others had lent to 3AC, nor did they know how much leverage and risk 3AC was taking on. Investors didn’t know how much risk they were exposed to altogether. When the market moved against both the lenders and 3AC, lenders were left with massive holes in their balance sheets, and investors were left holding the bag.

However in contrast to the centralized lenders facing insolvency, it’s important to note that blue chip DeFi lenders Aave, Compound, and MakerDAO operated without a hitch. Every loan and its terms remained transparently on-chain for all to see. When collateralization levels fell below thresholds, collateral was sold via autonomous code and lenders were paid back. This same code also dictated that Celsius was forced to pay back $400M in loans to Aave, Compound, and MakerDAO — no court order needed (though overcollaterization played a role). All told, it served as a powerful proving point for decentralized finance.

That’s just to say that it may be easy to get discouraged by the current price action while forgetting just how far we’ve come in a short period. When the last bear market hit, the most popular user application was Crypto Kitties. These days, there are more profound, impactful innovations than we can count. DeFi, NFTs, a rich DAO ecosystem, all came about in the last two years, and even came together to make a real impact on the world stage. Meanwhile, layer2 scaling solutions are finally here, and can take us from the dial-up to broadband phase, capable of supporting a rich array of user applications with simple UX to boot.

As in previous downturns, detractors are once again confidently pronouncing crypto dead. However, from our seat in the industry, we’re invigorated by the brilliant founders we see working tirelessly to move this technology forward. As the entire financial system and world digitizes itself, we remain convinced that the opportunity within crypto and Web3 are far greater than most realize.

*

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.

Around the Block from Coinbase Ventures sheds light on key trends in crypto. Written by Connor Dempsey. Data by Mike Cohen.

TLDR:

• Central Banks and governments responded to the March 2020 COVID market shock with unprecedented interest rate cuts, money printing, and stimulus

• These easy money policies kicked off a multi-year bull run for equities and crypto, before eventually causing inflation that was further exacerbated by COVID supply shocks

• BTC, ETH, the NASDAQ, and S&P each peaked at the tail end of 2021, when it became clear that inflation was not under control and that Central Banks would have to unwind the same policies that propelled stocks and crypto to new heights in the first place

• This cycle crypto has been broadly correlated with tech stocks, and has traded like risk assets

• While not immune to Central Bank policy in the short run, the prospects of crypto and Web 3 in the long run remain stronger than they’ve ever been

*

Financial markets are, in essence, one giant information processing machine. A machine that responds to new information not directly, but as it affects the decisions of millions of individual buyers and sellers. Or as Benjamin Graham famously put it, “in the short run, the market is a voting machine.”

With the S&P 500, NASDAQ, BTC, ETH, and most crypto assets significantly off of their all-time-highs, that begs the question: what information has market participants predominantly voting to sell?

In this edition of Around The Block, we take a look at the overall macro downturn with an eye towards the crypto markets.

As of June 2022, US equities have shed roughly 20%, or $10 Trillion in value. For US stocks, the selloff has not yet approached the severity of other historically noteworthy downturns, but it’s certainly in the conversation.

Crypto meanwhile, has shed nearly 60%, or $1.7 Trillion. For comparison, it shed 87% of its total market cap after the peak of the 2017 bull run.

BTC, ETH, and the NASDAQ all peaked in November, with the S&P 500 peaking at the end of December. So what changed during the last two months of the year? To understand this market downturn, it’s helpful to start at the beginning of a historic bull run that both stocks and crypto experienced in 2020.

Entering 2020, Bitcoin was rallying from the depths of the 2018/19 crypto winter, from $7,500 to nearly $10,000. Meanwhile the S&P and NASDAQ each stood at all-time highs. Then COVID hit.

COVID shock of March 2020

On March 12, 2020, the World Health Organization declared the Coronavirus a pandemic and governments around the world placed entire countries on lockdown.

As the magnitude of COVID-19 set in, it became clear that our global economy was not adequately prepared to handle the shock, sending all markets into a panic. The S&P and NASDAQ each declined around 30%, with crypto markets getting hit harder (in absolute terms). When the dust settled, BTC briefly dropped below $4,000, shedding over 60% of its value.

In short, COVID sent panicked investors to rush for the safety of cash, sending all liquid markets down sharply. Then the US Federal Reserve stepped in.

The Fed response

As the Central Bank behind the world’s largest economy, the US Federal Reserve plays a unique role in financial markets. Mainly, it controls the supply of the US dollar, which is the world’s reserve currency.

The money printer and interest rates are the Fed’s main tools for supporting the economy in times of extreme turmoil. By digitally printing money and buying financial assets like bonds from financial institutions, they can introduce new money into the economy. By lowering interest rates, they can make it cheaper for other banks to borrow money from the Fed, which also introduces new money (in the form of credit) into the economy.

After COVID, the Fed dropped the cost that banks pay to borrow money from the Central Bank, known as the Federal Funds Rate, to essentially zero. This allowed banks to, in turn, lower the cost at which their customers borrow money. These cheap loans could then be used to finance homes, businesses, spending and other investments.

By digitally printing new money and using it to buy treasury bills and other securities from financial institutions (this is known as quantitative easing), an unprecedented amount of US dollars was introduced into the economy. Over the next two years, almost 6 trillion in new money was printed, increasing the broad supply of USD nearly 40%. Awash with cash, financial institutions compete to lend this fresh capital out, forcing them to lower interest rates to remain competitive. Again, availability of cheap credit encourages borrowing, which ultimately supports the economy.

The US wasn’t alone, as the European Central Bank, Bank of Japan, and Bank of England all lowered interest rates to near (or even below zero) and printed money at historic levels. All told, the world’s four major central banks printed $11.3 trillion, which is a 73% expansion since the beginning of 2020.

On top of all that, the US Government injected over $5 trillion of “stimulus” into the economy by taking on debt from public, private, and foreign entities. Similarly, China pumped another $5 trillion into its economy through the same methods. Basically, the world became awash with fresh cash.

Don’t fight the Fed

“Don’t Fight the Fed” is an old investor mantra which implies that given the Fed’s outsized influence, one should invest in lockstep with whatever direction the Fed is moving financial markets. This mantra rang true after COVID struck in 2020.

When new money is being printed at record levels, and interest rates are near zero, all of this money and credit needs a place to go. On top of that, when rates are low, conservative instruments like bonds are less profitable, pushing money into higher yield assets. In the aftermath of COVID, these forces caused massive inflows into stocks, crypto, and even NFTs, helping push asset prices to new heights.

From their COVID panic induced bottoms, the S&P500, NASDAQ, BTC, and ETH would soar 107%, 133%, 1,600%, and 4,200% respectively.

Enter inflation

When the system is awash with money, and assets are going up, everyone feels richer. People can spend more and companies can pay their employees more. When spending and incomes increase faster than the production of goods, you have “too much money chasing too few goods,” and the price of goods rise, or inflate.

With supply chain shocks stemming from COVID lockdowns, there were even fewer goods in the economy. More money chasing even fewer goods led to even more inflation. This started to become apparent in May 2021.

The consumer price index (CPI) measures the change in prices paid by consumers for goods like gas, utilities, and food. From March to May 2021, it shot up from a healthy 2.6% to 5%. By March 2022 it hit 8% — levels of inflation not seen in over 40 years.

Inflation makes everyone poorer, because people’s money no longer buys as much as it once did, so the Fed had to step in once again. To combat rising inflation, they turn to the same tools they used to support financial assets in the first place.

Reversing course

As we explained, low interest rates and newly printed money support both the economy and asset prices. When overdone, they can also lead to inflation. When that happens, the Fed flips the switch, raises rates and removes money from the market, setting the process in reverse.

Raising interest rates ripples throughout the economy. Since it makes it more expensive for banks to borrow from the Central Bank, they in turn charge customers more to borrow money. On top of it becoming more expensive for everyone to borrow money, the price to pay for money already borrowed also goes up (think if your credit card rate jumped from 5 to 10%).

Where quantitative easing involves injecting money into the economy by buying securities from financial institutions, quantitative tightening is the opposite. First, the Fed stops buying securities while letting existing securities expire, and eventually, begins selling them on the open market. This ultimately leads to less money in the economy. Less money to lend out causes interest rates to rise due to simple supply and demand.

With the cost of borrowing and paying existing debts more expensive, everyone slows down on the spending that caused inflation in the first place. With less money being pumped into the economy via asset purchases, there’s less money chasing inflated goods, and prices in theory should normalize. There’s also less money chasing investments, which brings the price of assets down along with it — something sophisticated market participants know all too well.

The machine reacts

When inflation was hanging around 5% over the summer, the line out of the Fed was that it was “transitory,” or non-permanent. On November 3rd, 2021, the Fed said that it would start to slow asset purchases, but would be patient with any interest rate hikes as it continued to monitor inflation.

When October’s CPI of 6.2% was announced on November 10th, it became clear that inflation was not under control and that the Fed would have to intervene. While the first interest rate hike wouldn’t come until March, the great information processing machine that is the market, seemed to react at first sign that they’d likely be coming.

Don’t fight the Fed rang true once again, as BTC and ETH each peaked on November 8th, the NASDAQ on November 19th, and the S&P at the end of December.

Even the CryptoPunks floor price (a proxy for NFT sentiment) and DeFi TVL peaked during this same period.

In a nutshell

Basically, in response to COVID, Central Bank and government intervention helped keep markets afloat with record low interest rates, money printing and stimulus. These easy money policies ultimately helped propel stocks and crypto to all-time highs before leading to inflation — inflation that was exacerbated by supply chain stocks stemming from COVID lock downs in China (and later on in 2022, Russia’s invasion of Ukraine).

When it became clear that inflation was persistent and that Central Banks would have to reverse course and bring an end to the policies that propelled many assets to new heights, the macro downturn began.

The great re-rating

While we started our story at the beginning of 2020, the era of easy Central Bank monetary policies started in the wake of the 2008 Great Financial Crisis. An era that saw the birth of crypto as well as a historic run in equities.

In the face of inflation not seen in 40 years, Central Banks have signaled that the easy money era has come to an end. Previous frameworks for valuing companies and assets are no longer relevant in lieu of this shift. The value of everything has been “re-rated”, which is the downturn we’ve all experienced over the course of the last six months.

When interest rates rise, bonds become more attractive investments. Meanwhile, “growth” stocks, or companies that aren’t expected to produce dividends until many years in the future get hit the hardest. With money tighter, investors preferences shift to investments that produce cash flows today, rather than far out in the future. Thus the tech sell-off.

Crypto selloff

But wasn’t crypto supposed to be an inflation hedge? It depends. If you bought Bitcoin in May 2020 after macro investor Paul Tudor Jones famously dubbed it “the fastest horse” in a post COVID environment, you’re still up over 200% and well ahead of inflation. If you bought after inflation started to rear its head, much less so.

Even with the correction, Bitcoin and ETH are each still up 500% and 1,000% respectively from their pandemic lows. Longer tail assets have not fared as well, however, and it’s hard to deny that this time around crypto more broadly has been highly correlated with stocks — particularly tech.

Tech stocks are considered risk assets. Given the correlation, it’s fair to say that most individuals are still treating crypto similarly. Risk assets carry high upside, as well as high downside risk. When money gets tight, which is what happens when Central Banks tighten up, risk assets are often the first to get sold. That, in a nutshell, explains the recent crypto market downturn.

The Fed giveth

Have you ever wondered why market participants hang on every word of the Fed Chair? It’s because they know that the direction in which the Fed turns its dials can significantly influence markets and the economy. It can make businesses succeed or fail, and home values rise or fall.

It’s not done with malice, but with the noble aim of keeping prices stable and people employed. However, the Fed’s tools are somewhat crude, and in the hands of well meaning, but inherently fallible groups of people. It isn’t unreasonable to think it strange that the unilateral decisions of a very small group of people remain so consequential for the average person.

While crypto prices are clearly not immune to Fed policy, it should also come as no surprise that it was among the best performing asset classes over this last market cycle. Easy money policies encourage speculation, and speculation has always accompanied paradigm shifting technologies: personal computers, the internet, smartphones, and even the railroads of the 1800’s.

Additionally, Bitcoin and its hard supply of 21 million that can’t be debased by a central authority continue to stand in stark contrast to Central Bank money printers. History tells us that all centrally managed currencies fail eventually, typically from mass inflation via economic mismanagement. While this cycle has also shown that crypto is still far from without its risks and shortcomings, it also further validated the need for decentralized systems free from the risks of single-party control to co-exist with centralized counterparts. While crypto prices will remain influenced by Fed policy in the short run, in the long run, crypto and Web3 remain more alluring than ever.

Looking ahead

If this is your first crypto market downturn, it can certainly be scary. It is however, not without precedent. This market has been pronounced dead in 2018, 2015, and 2013, only to come back stronger each time.

Like the internet before it, crypto innovation marches on regardless of market cycles.

h/t Chris Dixon

From our seat, crypto feels more inevitable than it’s ever been. Bitcoin has global adoption, now held by institutions, corporations, countries, and millions of individuals alike. DeFi has created the underpinnings of an internet based financial system with no single party in control. The foundations for Web3 and a user-owned internet have been laid. NFTs have birthed billion dollar industries across art and gaming with a diverse array of use cases on the way. DAO treasuries manage nearly $10B+ and are just getting started. Crypto’s real world utility has been showcased on the world stage, raising millions in aid for Ukraine following a Russian invasion.

Even the biggest detractors have come around. 9 out of 10 Central Banks are exploring digital currencies and analysts at JP Morgan have dubbed crypto a “preferred alternative asset class.” Facebook rebranded to Meta, Twitter, Spotify, TikTok and Instagram are integrating NFTs, while Google and Microsoft are each dipping their toes into Web3.

In the long run, it appears that the proliferation of the financial internet is a function of time, rather than Central Bank policy.

The weighing machine

As we mentioned, Benjamin Graham said that in the short run, the market is a voting machine. But he also said that in the long run it is a weighing machine. In the short run it’s a giant information processing machine subject to emotional swings when presented with distressing information. In the long run, it has a knack for weighing assets based on their true value.

Bitcoin and Ethereum have maintained their weight over past downturns. Many other crypto assets will be weighed accordingly over the current downturn. The job of the individual is to vote in the short run for whatever they think the market will weigh as valuable in the long run.

At Coinbase, our votes are cast on crypto, Web3, and the financial internet eventually being weighed as one of the most valuable innovations of our time.

*

Special thanks to Scott Meadows, David Duong, and Griffin McShane for the review!

*

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.

TLDR: Despite the market downturn, Q1 was another highly active quarter for crypto venture funding. On the infrastructure side, we’re seeing a ton of activity within cross-chain solutions and DAO tooling. New layer-1s are still being incubated. Familiar DeFi primitives developed on Ethereum are expanding into newer layer 1s, and Polkadot is picking up steam. NFT projects are focused on bringing more utility to the space, with Yuga Labs making serious waves over the quarter. The rise of Axie Infinity has attracted successful traditional gaming devs to build in Web3, with South East Asia emerging as a hotbed of activity.

By Connor Dempsey

After peaking in November 2021, liquid crypto markets fell into the new year and more or less treaded water in Q1. The private markets, however, kept up the torrid pace set last year.

According to data from The Block, Q1 2022 saw a record of $12.5 billion in venture funding — a figure that has increased for seven consecutive quarters. Coinbase Ventures was busy as well, closing 71 new deals in Q1, generally targeting early stage investments. We will note that we’re starting to see signs of a slow down, particularly with later stage investments, that will likely be visible in our Q2 activity.

Deal volume is a reflection of the continued influx of new companies and projects being formed in the space. This is aided by the low startup costs that crypto & Web3 companies enjoy thanks to open-source code and the ability to bootstrap or self-fund via token issuance.

CBV overview

As a refresh:

• Coinbase Ventures advances crypto & Web3 by partnering with exceptional founders who share Coinbase’s mission of creating more economic freedom for the world.

• We’ve been recognized as one of the most active corporate VCs in the world by deal count.

• Ventures partners with founding teams at the earliest stages and throughout their journey. We invest across all categories within the cryptoeconomy, seeking to align ourselves with the best and brightest minds in the space.

• To date, we’ve invested in 300+ teams building everything from layer 1 protocols, Web3 infrastructure, centralized on-ramps, decentralized finance, NFTs, metaverse technologies, developer tooling, and more.

We generally break down our investments across six categories. Within these six categories, here’s how our activity shook out in Q1 ‘22.

Given that we invest in projects in their infancy, our activity can offer a lens into what the industry has in store in the near future. With that, let’s dive into some of the trends and themes that we identified in Q1.

Cross-chain & Web3 infrastructure bloom

In the early days of crypto, Bitcoin and Ethereum dominated. With new layer 1s coming online in recent years, ecosystems outside of BTC/ETH have exploded, and there are now more than 10 chains hosting over $1B in value.

The growing value across multiple networks has brought an increasing need for value on one chain to flow to another. As such, we’re continuing to see cross-chain infrastructure being built out to facilitate activity between blockchains (CBV Q1 investments: LayerZero, ZK Link, LiFi, Foxchain, Socket, Composable Finance).

Even with the multi-chain future assured, we’re still seeing new experimental layer 1s in development. Our investments in Aptos (general purpose L1 from former Diem employees), Celestia (modular blockchains), and Subspace (Proof-of-Archival consensus) suggest that the industry is not done innovating at the base layer. It also begs the question — will the dominant layer 1s of today someday be usurped? Time will tell.

Further up the stack, there’s more tooling on the way to help DAOs and Web3 communities flourish. Solutions for payroll (Diagonal, Zebec), social engagement & networking (Taki, Backdrop, Bonfire), and commerce (Rain) all point to a future where these online communities can coordinate more seamlessly.

DeFi’s multi-chain proliferation

Speaking of the multi-chain world, we’re seeing familiar patterns emerge across these burgeoning layer 1 networks. Basically, Ethereum set the tone for the foundational apps and protocols needed for an ecosystem to thrive: an AMM (Uniswap), money markets (Compound/Aave), an oracle (Chainlink), and yield aggregators (Yearn.Finance) to name a few.

For an emerging layer 1 to compete, teams understand they’ll need those same foundational primitives. As such, it’s becoming common to see Ethereum’s DeFi building blocks replicated across layer 1s like Solana, Avalanche, NEAR, Polkadot, etc. Betting on these foundational protocols is a good way to gain exposure to a broader ecosystem: a playbook we followed in Q1.

For example, from our Q1 investments, Aurigami on NEAR and Solend on Solana resemble Compound. Katana and Francium on Solana resemble Yearn.finance. Redstone resembles Chainlink, leveraging Arweave for cheaper storage to offer oracle services to longer tail tokens and NFT data feeds. And while these projects resemble apps first created on Ethereum, they’re each innovating in unique and differentiated ways.

Polkadot Cometh

Elsewhere in DeFiland, we were particularly active in the Polkadot ecosystem in Q1. With the long-awaited launch of Polkadot parachains arriving at the end of 2021, we’re seeing momentum around DOT pickup steam.

You can think of Polkadot as a network that you can launch layer 1s on top of. Each of these layer 1s, called parachains, are capable of interoperating with one another. With parachains live, Polkadot is now capable of hosting user applications.

We’ve now invested in 4 of the 5 live parachains (Acala, Moonbeam, Parallel Finance, and Astar) and waded deeper into the DOT waters in Q1 with investments in Composable Finance, Satori, and Coinbase alum Luke Youngblood’s new project: Moonwell.

NFT expansion pack

After a breakout summer, NFT sales have come back down to earth a bit from their earlier highs. Below the surface, however, innovation is more vibrant than ever.

Where NFT activity in 2021 centered around simple buying and selling (aka flippin’ JPEGs), the next wave of projects are building utility around NFTs. NiftyApes and PawnFi, for example, are working to bring liquidity to NFT holders by letting them take out loans collateralized by their NFTs. Platforms like Cymbal aim to bring more community and social features around NFT ownership.

Yuga Labs, the studio behind Bored Ape Yacht Club, made waves this quarter by raising at a $4B valuation to build a BAYC branded metaverse. Next, they acquired the IP rights to NFT collections CryptoPunks and Meebits. They capped it off by announcing a movie trilogy (produced by Coinbase) where BAYC NFT holders can submit their NFTs to be cast in the films and get paid a licensing fee — an interesting new experiment with on-chain licensing.

GameFi 2.0

Blockchain based gaming had its coming out party in 2021 centered around the rise of Axie Infinity. Sales of Axie Infinity NFTs peaked at a staggering $848M in August before falling precipitously. (Note that despite the obvious trend reversal and a major hack, Axie still posted a respectable $30M in March NFT sales).

Axie’s multi-billion dollar run was enough to put the entire gaming world on notice and the next wave of blockchain based games have been quietly raising ever since. Notably, many of the teams raising have track records building highly successful mobile, web, and AAA games (Clockwork Labs, Block Tackle, Summoners Arena, Third Time, Avalon).

The blockchain based games of the future will infuse crypto NFTs into more familiar Web2 gaming formats — MMORPGs, FPS, MOBA etc. Other CBV portfolio companies like Joyride will make it easier for game devs to integrate crypto/NFTs into existing titles.

At present, South East Asia is establishing itself as the center of the crypto-gaming world, led by the Philippines and Vietnam, among others. We’re particularly excited by developments in this region and the progress of Vietnamese-based gaming guild and CBV portfolio company Ancient8.

Ventures outlook

Amidst a shaky macro picture, many crypto investors are on edge. More frequently, we’re getting asked how the market downturn will affect CB Ventures’ activity. To date, there’s no shortage of high quality entrepreneurs building in crypto and Web3. It isn’t however unreasonable to expect a slowdown should prices continue to sag, similar to what’s been observed in broader venture funding (down 19% QoQ). Regardless, our strategy won’t change much.

It bears reminding that some of the most successful projects of today were funded during the bear market of 2018/19. In that light, our early investments in projects like Compound, OpenSea, Polygon, Arweave, Starkware, Block, NEAR, and Messari among others come to mind. As such, we’ll continue to invest in quality founders and projects moving the industry forward regardless of broader market conditions.

It also bears repeating just how much the investible Web3 landscape has broadened: DeFi, NFTs, DAOs, metaverses, and gaming are all evolving across a rich array of layer 1s. Then there’s cross-chain infrastructure to stitch all together as well layer-2 solutions to help it all scale. Not to mention a thousand other ideas not yet dreamed up. In other words, there’s more than enough innovation taking place to keep the CB Ventures’ team busy indefinitely.

There’s a gravitational shift taking place within our industry. Since Russia’s shocking invasion of Ukraine, crypto has been:

• used to crowdfund tens of millions for the Ukrainian defense

• incorrectly speculated as a viable avenue for the Russian government to evade sanctions

• the focus of a historic Executive Order put forward by the Biden administration

At this point, one thing is clear: this technology is a major emerging force in the geopolitical landscape. In this edition of Around The Block, we examine crypto in a geopolitical context, along with the difficult questions the world is asking.

An email address for money

In the aftermath of Russia’s attack on Ukraine, crypto’s power for coordinating economic activity was put on full display once the official Ukrainian twitter account tweeted out a plea for aid, accompanied with two long strings of letters and digits.

These long strings of characters were the Bitcoin and Ethereum addresses of the Ukrainian government, and the tweet represents the first time a nation state has ever sought aid directly in crypto. At a time when the Ukrainian government and banking sites were being flooded with DDoS (denial of service) attacks, and crowdfunding platforms were deplatforming organizations raising aid for Ukraine, the utility of permissionless, borderless networks for sending money was vividly illustrated.

At this time of writing, the Ukrainian government has collected over $50M in Bitcoin, ETH, ERC-20 stablecoins, and in other assets like DOT, DAI, and even Dogecoin.

The Ukrainian government has said that it has been using the funds to buy military supplies including bullet-proof vests, drones, gasoline, and night vision goggles. What’s more interesting is that 40% of suppliers have accepted payment in crypto.

Many have pointed out the oddity of private citizens from around the world essentially crowdfunding a war effort. Yet another sign of just how unprecedented all of this is.

NFTs enter the fold

Fungible crypto assets weren’t the only donations to pour into the Ukrainian government’s crypto wallet. NFT enthusiasts also answered the call, donating over 200 pieces of digital art work and even ENS addresses. Most notably, a rare CryptoPunk worth an estimated $200,000 was donated.

What’s interesting is that since the ownership provenance of the CryptoPunk will forever be associated with the defense of Ukraine, this added historical significance could raise its value over the long term.

The NFT aid didn’t stop there, as they were also combined with another crypto primitive to support the defense of Ukraine: DAOs.

UkraineDAO

Decentralized autonomous organizations were cast into the limelight last year after ConstitutionDAO crowdsourced $40M in under a week in a bid to buy one of the original copies of the US Constitution. While the bid ultimately failed, it underscored the power that these software enabled organizations have for coordinating economic activity at the speed of the internet.

After a Ukrainian NGO (non-government organization) supporting the war effort called Come Back Alive was de-platformed from crowdfunding platform Patreon for supporting military activity, they also turned to crypto. Shortly thereafter, UkraineDAO was created to help support this NGO.

The DAO minted a 1:1 NFT of the Ukrainian flag and put it up on PartyBid, which allows groups to pool funds to buy NFTs. In essence, the DAO created its own NFT, crowdsourced as much money as they could to buy it from themselves and then donated the proceeds to Come Back Alive. All told, they raised $6.7M. They also distributed commemorative “valueless” tokens called LOVE to those who donated.

Crypto on the main stage

Between the Ukrainian government and various NGOs, over $80M and counting in aid has been raised. While in the grand scheme of things this amount is a nominal sum not likely to turn the tides of war, it’s also far from insignificant. The sum represents over 20% of the $350M pledged by the Biden administration and is a powerful display of the promise that decentralized, borderless money holds.

Slowmist, where we’re pulling this data, also noted that when you factor in other organizations and cryptocurrencies they’re not tracking, the full figure is likely over $100M. The Giving Block, for example, raised over $2.3M in crypto donations for over 20 non-profits supporting Ukrainian relief.

Beyond support of the Ukrainian government and organizations, crypto has also proven useful for individual Ukrainians affected by the crisis. One Ukrainian who fled to Kazakhstan reported that he lost access to his savings and that his credit cards were no longer functioning, leaving crypto as his only financial life raft: yet another example of the utility of permissionless finance.

At their core, Bitcoin, Ethereum, and the like are neutral technologies that anyone with an internet connection can use. While we celebrate the use of these neutral technologies to help a nation defend itself against a foreign invader and as a lifeline for refugees, it also begs the question: what about their use by those on the other side of the conflict? Principally, the Russian government.

The burning question

Western governments responded to Russian aggression with unprecedented sanctions against the Russian government. This coincided with widespread narratives surrounding the potential for cryptocurrencies to be used to circumvent those very sanctions.

Before we examine the fact or fiction behind these claims, it helps to understand what these sanctions entail.

Russian sanctions

Since Russia invaded Ukraine, governments around the world, including the U.S., have imposed sanctions targeting the Central Bank of Russia, major Russian commercial banks and companies, Vladimir Putin, Russian elites, among others. In aggregate, these sanctions cut targeted individuals and entities off from international banking and in many instances, freezes their assets.

Among the most substantial sanctions imposed was kicking major Russian banks out of SWIFT, which is the financial network used by over 11,000 banks and institutions to move trillions of dollars across borders. This severely limits Russia’s ability to receive payments for oil and gas: their main export. For context, when Iranian banks were banned from SWIFT in 2012, and sanctions were imposed on Iranian oil purchasers, Iran lost nearly half of its oil export revenue and 30% of its foreign trade.

The most drastic sanction is from the US, UK, and EU banning transactions with the Russian Central Bank. The Russian Central Bank holds roughly $630B in the form of the world’s major reserve currencies — the dollar, euro, pound, yuan — as well as 2,300 tons of gold. With this sanction, Russia suddenly has no one to sell its reserves to, rendering its entire stockpile useless.

Is crypto their answer?

We’ve seen public speculation on how crypto could be used to evade those sanctions. However, that speculation has been unfounded as the crypto market is simply not large enough to help Russia meaningfully circumvent them.

Consider the Russian Central Bank’s $630B in immobilized assets. That’s 80% of Bitcoin’s market cap and larger than the rest of the crypto market put together. Converting that much fiat into crypto would take 5–10x the total daily traded volume of all digital assets, so the liquidity just isn’t there.

Additionally, as our Chief Legal Officer previously pointed out, trying to obscure large transactions using open and transparent crypto technology would be far more difficult than other established methods (e.g., using fiat, art, gold, or other assets).

The Biden Executive Order

As crypto played a significant role in the defense of Ukraine, it was also cast into the fore of the American political system. Late last week, the Biden Administration published its long awaited Executive Order on digital asset regulation.

The Executive Order simply directed federal agencies to study the benefits and risks of digital assets, as opposed to putting any immediate legislation into action. On one hand, many were pleasantly surprised with the optimistic tone of the EO, as it acknowledged crypto and Web3 technologies as critical for the future of U.S. national economic competitiveness. On the other, the report focused more on the potential risks of crypto rather than its societal benefits.

The EO calls on a total of 23 federal government agencies, organizations, and White House Offices to assemble huge reports on the risks stemming from crypto. This outsized focus on risk, when compared to past EOs, has caused some people to worry that the Biden Administration doesn’t fully recognize the power and potential of digital assets, even as that power is being plainly demonstrated on the world stage.

While the EO may have felt like a milestone, it is ultimately the start of a long road ahead. One in which the whole of the US government will finally seek to fully understand the importance of this technology. It is critical that the government fully explores not only the risks, but also the benefits that digital assets bring, with enough transparency to allow the public to weigh-in on a federal approach to regulation.

Ultimately, this presents a tremendous opportunity for the industry to engage with regulators about how to best embrace the transformational nature of crypto and Web3 technologies.

Closing thought

To sum it all up, regardless of how you feel about crypto’s application in funding a war effort or the increased attention it’s receiving from the most powerful government in the world, it’s apparent that we’ve entered uncharted territory: this next phase of crypto adoption will look drastically different from the last.

ATB Podcast: Crypto’s Role in the Ukraine Crisis with Elliptic’s Dr. Tom Robinson

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This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.

The last time ETH Denver was held in person, ETH’s market cap stood at $30B, DeFi hadn’t had its breakout summer, and few people outside of the 6,000 attendees knew what an NFT was. Fast forward to 2022 and a 10x in ETH’s market cap, the rise of NFTs, a DAO resurgence, and a year where Ethereum did more transactional volume than Visa, a record crowd of 12,000 in Colorado were met with an entirely different energy.

What had historically been an event for hackers and coders received an infusion of artists and creatives, as well as a governor, a former presidential candidate, and a heavy dose of EDM — a reflection of Ethereum and crypto’s growing awareness within the mainstream.

Despite the new faces, ETH Denver retained its authentic quirky disposition, complete with bright neon colors and Vitalik dressed as a “Bufficorn”. Beyond a lone Doge Lambo, the main event was mostly free of flash and still felt authentically Ethereum.

Attendee sentiment

Even amidst a 50% market drawdown from late November highs and multi-hour long check-ins in the frigid cold, builder energy was sky high. Where Ethereum was still finding its footing during last ETH Denver, this year’s event featured heavy discussion across all of the new verticals thriving today: DeFi, NFTs, DAOs, gaming, and more.

It was also apparent just how much private capital is still flowing into crypto, undeterred by macro market headwinds: with seed stage deals raising at a minimum $50M and seed token rounds going for $100M+ (no shipped code needed), one might argue too much. In either case, it’s clearly a builders market.

Real Politik

In addition to investor and builder excitement, there was also a noticeable presence from mainstream politicians: most notably, Colorado Governor Jared Polis and the Forward Party’s Andrew Yang. With crypto and Web3’s growing popularity, it seems many in government are seeing the upside to embracing this emerging constituency.

In addition to posing with Vitalik, Gov. Polis announced during the conference that Colorado will accept crypto as payment for taxes in addition to making Colorado, “the first digital state” with favorable regulations for the crypto economy. This mirrors the positions of other crypto-forward governors like Miami’s Francis Suarez and New York’s Eric Adams.

Photo credit: Westword

In a surprise appearance, Andrew Yang took the stage with Bankless’s David Hoffman, sharing his thoughts on why Web3 represents “the biggest anti-poverty opportunity of our time.” His appearance came on the heels of his Lobby3 initiative, which will advocate for thoughtful regulation in Washington to support crypto innovation.

All of the while, Biden’s executive order on crypto regulation loomed large (however if you bumped into CoinCenter’s Neeraj he would have told you that the EO is nothing to panic over). Either way, it’s clear that crypto has entered the fore of the American political discussion.

NFT Mania

Beyond the bullish builder sentiment, private investor froth, and political participation, NFTs were everywhere in Denver. NFT art installations, musicians performing with their NFTs on display, and some events even requiring NFTs to gain entry (shoutout ecodao).

POAP (Proof of Attendance Protocol) NFTs, which give people digital mementos commemorating attendance of a particular event by scanning a QR code, were particularly pervasive. The inventive ways different projects found to engage via POAPs suggests that they may be the next mainstream crypto community use case.

If you were mingling at any of the NFT centric events, odds are you bumped into a former FAANG employee newly entering the NFT space. A sign that despite the macro market downturn, NFT mania is still in full swing and the brain drain from Web2 to Web3 continues.

Signs of DAObt

Following a year that saw ConstitutionDAO capture global attention, DAOs have regained much of the crypto limelight. Conference booths were packed with projects building DAO infrastructure and discussions on how decentralized autonomous can rewire the world were prevalent.

While DAO enthusiasm was evident, many noted that DAO participants were starting to show signs of fatigue with many DAOs struggling to retain contributors. Joseph Delong, former CTO of SushiSwap who notably left the decentralized project, gave a memorable talk on why DAOs simply need more structure to be effective (also discussed in our recent podcast with Orca Protocol’s Julia Rosenberg).

With over 1B in startup equity for DAO tooling and under 200 DAOs, it begs the question: is there enough DAO to go around?

The long term outlook of DAOs seems to be bright, but the industry is still grappling with how exactly DAOs should function. Given that there’s no standardization around DAO operation, it’s hard to know what tools they actually need. As such, the DAO infrastructure sector will likely see a lot of turbulence over the near to medium term.

The Merge

After years in the making, experts stated that Ethereum’s transition to proof-of-stake is expected to happen in Q2 or Q3 this year. As a quick refresh, Ethereum’s PoS chain (the beacon chain) has been operational since December 2020, however all applications still live on the proof of work chain. The merge basically consists of migrating these applications to the PoS chain.

As such, the merge was a major point of discussion for devs this year. If all goes well, ETH holders won’t have to do anything, but developers and infrastructure providers are in preparation mode. This includes running testnets and conducting dry runs in anticipation for the real thing.

The Ethereum ecosystem is making a big bet on PoS in conjunction with layer 2 scaling solutions (rollups). In a post-merge world, Ethereum will transition to become a settlement layer for large transactions while most user activity is pushed to layer 2. This will create an environment where all EVM compatible layer 1s compete with ETH L2s for users and developer mindshare.

Also prepping for the merge, is Coinbase Cloud, which powers a portion of Coinbase’s ETH staking product as well as node infrastructure for many players in the space. Cloud developers showed up in force hosting a hackathon, a variety of panels, workshops, and a party for over 500 attendees. Learn more about how Coinbase Cloud is thinking about client diversity ahead of the merge here.

A builders market

In the days since ETH Denver wrapped, the market drawdown intensified as Russia escalated the situation in Ukraine. While crypto has rebounded, markets will likely remain shaky given the uncertainty of the current geopolitical situation. Regardless, teams building the next generation of Ethereum and Web3 remain well funded and the building will continue.

As evident by the increased diversity of both projects and participants at this year’s conference, what gets built on Ethereum will keep venturing out in a myriad of new exciting directions.

Around the Block from Coinbase Ventures sheds light on key trends in crypto. Written by Justin Mart

Top Reads & talks from ETH Denver

• ETH Denver winners recap — Lane Rettig

• Andrew Yang with David Hoffman

• The road to Ethereum 2.0

• Ethereum’s Old Guard Meets the Newbies at ETHDenver — The Defiant

• 8 Things you missed at ETH Denver — Bankless

• The Case for Hierarchies in DAOs — Joseph Delong

• What devs discussed at ETH Denver — Tracy Wang, CoinDesk

Top tweets on ETH Denver

• DAO tooling to see heavy turnover — @carlcortright

• Talent and capital is flowing into crypto from Wall Street & Web3 — @VivekVentures

• ETH Denver observations — @davidsaidthat_

• No one knows what tools DAOs actually need — @QwQiao

• The state of DeFi — @SeanLippel

• How datablobs can enable 100x rollup capacity — @protolambda

This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.

Around the Block from Coinbase Ventures sheds light on key trends in crypto. Written by Connor Dempsey, Justin Mart, & Mike Cohen (WE’RE HIRING)

Only in crypto can a platform built by anonymous founders come out of nowhere to challenge an industry leader, all in a matter of weeks.

That’s precisely what happened with the launch of NFT marketplace LooksRare, whose $9B+ in January volume nearly tripled that of OpenSea. On top of that, within 30 days of launch LooksRare produced $307M in protocol revenue, vs OpenSea’s $110M over the same period.

Around the Block from Coinbase Ventures sheds light on key trends in crypto. Written by Connor Dempsey, Justin Mart, & Mike Cohen (WE’RE HIRING)

Only in crypto can a platform built by anonymous founders come out of nowhere to challenge an industry leader, all in a matter of weeks.

That’s precisely what happened with the launch of NFT marketplace LooksRare, whose $9B+ in January volume nearly tripled that of OpenSea. On top of that, within 30 days of launch LooksRare produced $307M in protocol revenue, vs OpenSea’s $110M over the same period.

• Listen on Spotify or Apple

The raw numbers don’t tell the full story, however…

In this edition of Around The Block, we’ll explore the LooksRare vampire attack of industry leading NFT marketplace OpenSea.

The OG vampire attack

Vampire attacks are purely a crypto/Web3 phenomena. At their highest level, a vampire attack refers to a method for sucking users out of an existing platform into a competing one by offering some kind of incentive (typically tokens).

The most notorious vampire attack occurred in 2020, when SushiSwap launched a near identical decentralized exchange to industry leading Uniswap with one key difference: users who migrated their liquidity from Uniswap to Sushiswap were given $SUSHI tokens. $SUSHI offered holders governance rights over the platform in addition to a cut of trading fees collected on SushiSwap.

The result? Uniswap’s liquidity temporarily took a nosedive, as users moved $1.2B in funds over to Sushiswap to cash in on the superior incentives being offered. Uniswap eventually recovered and responded with a token launch of their own, but a new DEX was bootstrapped over a relatively short period of time.

LooksRare’s vampire attack

LooksRare followed the typical vampire attack playbook which is as follows:

1. Identify industry leader

2. Build competing, yet strategically differentiated platform

3. Offer superior incentive for users who migrate over

The main difference between SushiSwap’s attack and LooksRare’s is that SushiSwap was a near identical copy of Uniswap’s code (known as a fork) with token incentives built on top. LooksRare appears to have built their own smart contracts (according to their documents); everything else in the playbook is the same:

1. Identify industry leader: in this case, it’s OpenSea by a country mile.

2. Build a competing, yet differentiated platform: looksrare.org.

3. Offer superior incentives for users to migrate: meet the $LOOKS token.

A $LOOK at the initial incentives

Due to the open-sourced nature of blockchains, the LooksRare team was able to identify OpenSea users who had traded at least 3 ETH worth of NFTs over the prior six months and airdrop them LOOKS tokens. However to claim these free tokens, users first had to list an NFT on the LooksRare exchange.

Airdropping tokens to an existing community of active NFT traders proved effective, as NFTs flooded onto the new marketplace. The LOOKS token would climb to nearly $7 just 10 days after launch, fetching a $1B marketcap in the process.

And the incentives didn’t stop there…

MOAR Incentives

Beyond the initial airdrop, users of the LooksRare platform could earn more tokens by staking their LOOKS and by trading NFTs on the platform. LooksRare charges a 2% fee for every sale (vs. 2.5% on OpenSea), and staking (locking LOOKS into a smart contract) entitles stakers to 100% of those fees. Stakers also earn additional LOOKS on top of trading fees.

At the time of writing, staking LOOKS earns an eye-popping 500%+ APR.

The trading incentives is where things start to get interesting. It’s pretty simple: buy or sell an NFT on LooksRare and earn LOOKS. Rewards are paid out daily, based on the % of that day’s volume. Currently 2.8M LOOKS, or just under $10M USD at current prices, are being awarded daily.

So far, a free airdrop was enough to get people to the platform, and a $10M daily reward has been enough to keep daily trading volumes outpacing OpenSea. However, when you look the total daily # of users, it’s clear that these volumes aren’t as impressive as they initially appear.

Wash trading

While LooksRare is doubling OpenSea’s volume on any given day, OpenSea has 20–40 times more active users than LooksRare. This suggests that LooksRare’s volume is fueled by a small number of traders gaming the incentive system to earn LOOKS.

There’s nothing stopping a user from swapping the same NFT back and forth between their own wallets at a high dollar amount. Since daily rewards are paid out as a % of the day’s volume, if, for example, someone can wash trade their way to 10% of that day’s volume, they can net $1 million in LOOKS.

The wrinkle here is that for every trade, users must pay a 2% fee priced in ETH. The math works out such that the fees traders are paying in ETH are roughly equal to the rewards being paid in LOOKS. As such, traders are basically swapping ETH for LOOKS, which will pay off should the price of LOOKS appreciate relative to the price of ETH.

Essentially, there’s an interesting bit of game theory in motion, as early adopters will be rewarded should the LooksRare platform succeed.

Beyond wash trading

At this point, no one would dispute that LooksRare’s staggering volumes are a result of their lucrative incentive scheme. However, that doesn’t necessarily mean that LooksRare is all hat and no cattle.

At the end of January, Crypto Slam estimated that about $8B of the $9B in January volume was washtrading. However, the remaining legitimate NFT volume is still more than what NFT marketplaces Rarible, SuperRare, Foundation, Makersplace, and Aysnc did in all of 2021 combined.

Even with washtrading eliminated, LooksRare’s launch can still be considered a success. Plus they offer other interesting and novel features such as no transaction fees for private sales and the ability to make a single offer across an entire collection of NFTs. Lastly, their “real volume” is continuing to grow.

Is it sustainable?

LooksRare’s trading rewards will wind down over the course of the next two years, at which point the marketplace will have to compete on its product and community alone. Whether it can continue to grow its market share without powerful incentives is up to the anonymous team behind it.

We can look to its vampire attacking predecessor, SushiSwap, for a glimpse into what the future may hold. SushiSwap by many measures has remained relevant after its initial rewards dried up. They continued to innovate and deploy across multiple chains, with nearly $5B in TVL today.

However, usurp Uniswap they did not. Uniswap eventually launched a token of its own (there’s speculation that OpenSea may one day do the same) and has maintained its standing as crypto’s dominant DEX with over $7.5B in TVL today. It’s also worth noting that no contentious hard fork (Bitcoin Cash, Ethereum Classic, etc) or vampire attacker (SushiSwap, Swerve, etc) has ever supplanted an incumbent.

While Sushiswap has enjoyed success, it has had its fair share of struggles as well. Community infighting between the core team and Sushi token holders led to the exit of several high profile team members, including the project’s CTO. Once LooksRare hands governance over to LOOKS holders, it will likely be reminded of how nascent and messy DAO governance truly is.

Lastly, for LooksRare users, it bears mentioning that anon teams always come with rugpull risk. On top of that, LooksRare’s smart contracts launched unaudited and without a public GitHub repo — so trader beware.

Top analysis on LooksRare and past vampire attacks

• How LooksRare Doubled OpenSea’s Trading Volume, by Yuga Cohler

• The Sushi Chronicles, by Connor Dempsey

• LooksRare Protocol Revenue leapfrog’s OpenSea, by Brady Dale

• Irregular sales fire up wild NFT market, by Elizabeth Howcraft

• Looks Rare analysis, from Bankless

• Fork Defense Strategies in DeFi, from Bankless

Top tweets on LooksRare

• Crunching the number on LooksRare incentives, by Yuga Cohler

• The game theory behind LooksRare, by Jordi Alexander

• LooksRare’s growing organic volume, by Dogetoshi

• Why LooksRare’s launch was a success despite washtrading, by AllNick

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This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.

As most of us were enjoying some R&R over Christmas break, Coinbase Cloud protocol specialist Elias Simos was scouring the web for the most interesting crypto charts of 2021: 69 of them to be exact.

In the latest Around The Block podcast, we sit down with Elias and discuss some of the most interesting data points from the year, and what it all means for the future. (High level takeaways below)

• Listen on Apple or Spotify

Metaverse and smart contract assets outperform

Price isn’t everything, but the two top performing assets in 2021 are indicative of broader trends throughout the year. 2021’s best performing assets were:

• Metaverse gaming tokens

• Smart contract platform tokens

The governance tokens of gaming worlds Axie Infinity (AXS) and The Sandbox (SAND) each posted 16,000 and 13,000 percent gains respectively. Meanwhile, platform tokens from Polygon, Terra, Solana, and Fantom, all posted 8,000% gains or more.

Given that play-to-earn gaming had a breakout year, and layer 1s not named Ethereum saw strong adoption, these trends should be of no surprise. Now let’s dig a bit deeper.

The state of Layer 1s

Ethereum’s native token (ETH) did a modest 2X over the year, while it was somewhat of a rough year for Ethereum DeFi blue chips, with the DeFiPulse index down 80% over the year vs ETH.

The price of DeFi assets doesn’t tell the entire story, however. TVL of Ethereum DeFi applications showed tremendous growth over the year, and the number of unique Ethereum addresses interacting with DeFi protocols 4x’ed.

Regardless, ETH killers and sidechains won the year when measured by growth of overall market share.

The great migration & the EVM standard

In May, there was $200M sitting in Ethereum bridges. That number climbed to $20B by the end of the year, underscoring the great migration of value from Ethereum to other ecosystems.

The flipside, however, is that despite this migration away from Ethereum, most value still sits in EVM (Ethereum Virtual Machine) compatible environments.

Remember that the EVM is essentially the brain of Ethereum that performs computations for the network. When other Layer 1s adopt the EVM, it makes deploying existing applications on new networks easier for developers, in addition to making it easier for users to migrate to these new chains.

The dominance of value on EVM compatible chains (Avalanche, Polygon, etc) suggest that a standard is forming around the EVM. This should ultimately keep Ethereum as the gravitational center of the smart contracting world, as ETH applications and assets will be natively interoperable with most other chains.

Rise of the app chains

While EVM chains still dominate the landscape, the end of 2021 saw a rise in value on Tendermint chains. Recall that Tendermint is a standard popularized by Cosmos, that lets developers build application specific blockchains that are capable of interoperating with one another.

Building app-specific chains in the past came with significant opportunity cost, because they were cut off from most liquidity and users. With the growth of Tendermint chains like Osmosis (AMM), Umee (lending), and Stargaze (NFTs), that’s becoming less of an issue.

Now that these app specific chains have a widening array of use cases and liquidity that they can interoperate with, look for more builders to take advantage of customizability that these chains offer in 2022.

The ENS airdrop + DAOs

In 2021, ENS reminded everyone of Web3’s native user acquisition strategy: the airdrop.ENS (Ethereum Name Service) addresses are best thought of as email addresses that you can send money to (e.g. Jimbo.eth). After 5 years in development, the project shifted to a DAO model, and airdropped ENS governance tokens to every user with an ENS address.

After the drop in November, awareness of ENS and registration of .eth addresses skyrocketed.

Since the ENS DAO treasury collects revenue from new .eth registrations, revenue for the newly minted ENS DAO treasury ramped up significantly: another testament to how much a well orchestrated airdrop can move the needle.

Beyond ENS, DAOs had a strong year, evident by the growing usage in key pieces of DAO infrastructure. Gnosis Safe, which is the most popular multisig wallet DAOs use to manage their treasuries, saw 3x growth in both the number of Safes and transactions executed in 2021. Snapshot, a tool that helps DAOs execute off-chain votes with on-chain verification, exhibited strong growth as well.

EN-EFF-TEES

Activity on the dominant platform for NFTs tells you all you need to know about the breakout year NFTs enjoyed.

OG NFT CryptoPunks saw 60x YoY growth, reaching a total volume of 650K ETH, or $1.7B at current prices. This figure however, includes a flashloan powered $500M wash sale — a powerful reminder of how much subjectivity there is in on-chain data.

The second most notable NFT project of the year was Bored Ape Yacht Club, which went from a niche community to the celebrity NFT of choice, including the likes of Steph Curry, Shaq, Justin Bieber, Jimmy Fallon, Paris Hilton, among others. At one point the BAYC floor (price of the cheapest NFT in the collection) momentarily flipped the CryptoPunks floor.

In the heat of new issuances flooding the market, and older NFT collections achieving billion dollar market caps, the average price of NFTs changing hands did a 150x from 0.1 ETH to roughly 15 ETH by year end.

Dune Analytics, Richard ChenOne of the most interesting NFT launches of the year was Loot (covered here), which let anyone mint 1 of 8,000 NFTs that could form the basis of a Dungeons and Dragon style RPG game. Initial excitement was skyhigh, before fizzling out as time went on.

While Loot’s flame may have dimmed, it was still a landmark year for NFT based gaming, with the breakaway success of Axie Infinity bringing play-to-earn and GameFi narratives to the forefront. As the data shows, Axie Infinity NFT volume dwarfs that of any prior NFT based game.

CryptoSlam and The BlockLastly, while Ethereum was the center of the NFT show, marketplaces appear to be springing up across multiple chains. The data shows that lower fee environments are enabling different types of user activity. Solana’s Magic Eden, for example, has more transactions than OpenSea since users are unencumbered by exorbitant gas fees.

More in Elias’s epic thread

Beyond being chock-full of illuminating data points on the year in crypto and Web3, the full thread underscores the beauty of on-chain data and the increased maturity of the industry. The ability for one person to put together a dataset this rich is a testament to all of the great data providers the industry now has at our disposal.

If you haven’t already, check out the full thread which covers Bitcoin, Ethereum, MEV, L2 adoption, ETH2, staking, Web3, memecoins, DEXes, stablecoins, and a whole lot more.

~Written by Connor Dempsey & Justin Mart.

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This website does not disclose material nonpublic information pertaining to Coinbase or Coinbase Venture’s portfolio companies.

Disclaimer: The opinions expressed on this website are those of the authors who may be associated persons of Coinbase, Inc., or its affiliates (“Coinbase”) and who do not represent the views, opinions and positions of Coinbase. Information is provided for general educational purposes only and is not intended to constitute investment or other advice on financial products. Coinbase makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information on this website and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Unless otherwise noted, all images provided herein are the property of Coinbase. This website contains links to third-party websites or other content for information purposes only. Third-party websites are not under the control of Coinbase, and Coinbase is not responsible for their contents. The inclusion of any link does not imply endorsement, approval or recommendation by Coinbase of the site or any association with its operators.