Dear Investor,

 

Web3 and the metaverse have dominated recent discussions within the crypto community. Debates over these applications will continue, but it remains clear that smart contract-based protocols are having an increasingly significant impact on the crypto ecosystem. 

 

In March, Axie Infinity and The Sandbox were added to the Nasdaq Crypto Index (NCI), elevating the status and visibility of metaverse- and Web3-related gaming. At the end of the month, Hashdex launched our Web3 ETF, WEB311, available on Brazil’s B3 stock exchange. The ETF gives investors access to the protocols we believe represent the future of the internet. In this month’s letter, we share our views on the smart contract infrastructure powering this future.

 

There was also a lot of crypto-related public policy activity in March. President Biden released the much-anticipated Executive Order on digital assets, the European Parliament rejected a proposal that would limit Proof-of-Work protocols, and several US Representatives sent a letter to the SEC asking for more clarity around the agency’s agenda for crypto businesses.  

 

The first quarter of 2022 was a busy one in the crypto space, and there are no signs this activity is slowing down. As always, we are here to answer any questions you might have about these markets. 

 

-Your Partners at Hashdex 

 

Market Review

 

March began with the crypto markets still agitated from news of the war in Ukraine. NCI opened the month higher relative to other risk assets, but this was quickly reversed. The index fell more than 10% early in the month, with Bitcoin dropping to around $37,000. However, the crypto markets responded favorably to the news of President Biden’s Executive Order, reversing losses from earlier in the month.

 

The second half of March demonstrated a clear, positive trend. Rumors circulated that Russia might accept bitcoin as payment for exported oil and gas and late in the month Luna Foundation Guard announced the purchase of bitcoins to back its stablecoin UST, which boosted the market[1]. Crypto markets retreated in the last few days of March, but the NCI still ended up 13.5%[2]. All NCI constituents had positive returns in March, led by Stellar Lumens, which rose 23.2%. 

Top Stories

 

President Biden signs executive order on digital assets

 

President Biden’s Executive Order (EO) was generally well received by the crypto community, due to its balanced approach, optimistic tone, and the recognition of the importance of the industry[3]. The document broaches a myriad of subjects including: consumer protection, financial stability, the mitigation of illicit and systemic risk, US leadership, equitable access, the support for technological development, and the possible development of a US Fed-backed digital dollar. The EO has no immediate regulatory impact, rather it directs government agencies to establish a more coordinated approach to the regulatory process for the crypto assets market[4]. Industry experts are hopeful that the unified approach will result in greater regulatory clarity, bringing more investors to the digital asset industry[5]. 

 

European Parliament rejects provision to limit Proof-of-Work protocols 

 

The European Parliament's Committee on Economic and Monetary Affairs rejected a provision to limit services for Bitcoin and other crypto assets that use Proof-of-Work (PoW) consensus mechanisms[6]. The March 14 vote stemmed from environmental concerns in the proposed Markets in Crypto-Assets (MICA) regulatory framework regarding Bitcoin’s electricity usage. Ethereum also relies on the PoW consensus mechanism, but its ongoing shift to a Proof-of-Stake model would exempt it from the environmental provision[7]. The EU Parliament will continue to discuss the environmental impact of digital assets that may still impact Bitcoin and other cryptocurrencies[8]. 

 

Congressional Blockchain Caucus questions SEC’s “burdensome” crypto reporting requirements 

 

Members of the Congressional Blockchain Caucus, a group of US legislators with favorable views on crypto, sent a letter to Securities and Exchange Commission (SEC) Chair Gary Gensler seeking greater clarity regarding the SEC's attempts to obtain information related to cryptocurrency and blockchain firms[9]. The bipartisan letter expressed concerns about the SEC requests, seeking information to ensure that inquiries do not become overburdensome, unnecessary, or stifle innovation. Chair Gensler has received criticism from the crypto community for his enforcement approach for the industry. Since November 2021, the SEC has rejected several spot Bitcoin ETF applications and Chair Gensler has referred to crypto as an asset class "rife with fraud, scams, and abuse,” comparing the market to “the Wild West”[10].

“We must reinforce United States leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets.”

• US President Biden’s Executive Order on Ensuring Responsible Development of Digital Assets, March 9, 2022

 

Update: AXS and SAND added to the Nasdaq Crypto Index

 

On March 1, two new crypto assets were added to the NCI[11]. Axie Infinity (AXS) is a gaming platform that uses a play-to-earn model to reward players for the time and effort they spend both playing the game and growing the ecosystem. The blockchain-enabled game allows players to collect and breed pets known as axies.

 

The Sandbox is a virtual world where players can build, own, and monetize their gaming experiences on the Ethereum blockchain using the platform’s utility token SAND. It uses a free-to-play and play-to-earn gaming model. The Sandbox virtual world is made up of digital pieces of real estate. Players can create digital assets in the form of NFTs, upload them to the marketplace, and then integrate them into games.

 

The addition of these two assets to the NCI underscores the growing importance of gaming- and metaverse-related applications to the crypto ecosystem. Both AXS and SAND have a market capitalization in excess of US$3 billion[12] with rapidly expanding user bases.    

 

Smart contracts and Web3: The next level of human collaboration

 

The level of human coordination in today’s world is unprecedented. Unfortunately, the conventional contracts that allow for many types of collaboration, such as business transactions or legal agreements, are expensive, inefficient, and time consuming. Smart contracts—self-executable and self-enforcing digital agreements that do not rely on an intermediary for execution—are providing an important alternative to this traditional system. 

 

Smart contracts enable decentralized assurance of ownership, with the underlying blockchain laying the groundwork for self-custody of assets and full verifiability of ownership by other network participants. Within a single digital wallet, one can store their savings, stocks, music, fine art, video game collectibles, domain names, and even pieces of their own real-world information. All of this can be done without resorting to a trusted third party, as the individual retains sole control and the unique ability to use the information via their private key. Similar to how personal computers and the internet completely transformed markets and conventional industries, smart contracts on blockchains are the catalysts for a new era of disruption.

 

Smart contract platforms, with an aggregate market capitalization hovering around US$460 billion[13], have demonstrated rapid growth. Smart contracts are powering many of the most promising crypto use cases, including decentralized autonomous organizations (DAOs) and decentralized finance (DeFi) applications. Smart contract platforms are also the necessary infrastructure for Web3, the focus of our letter this month. 

The dawn of Web3

 

In the early days of the internet (“Web1”), users could find information through web browsers like Netscape and use financial services and e-commerce platforms like PayPal and Amazon. Computing infrastructure was mostly decentralized but users could not interact with the web’s content and applications. In the 2000s, the next iteration of the internet—Web2—provided continuous connectivity for everyone in possession of a smartphone. A major breakthrough in the way people communicate and interact was propelled by the boom of social media, with Facebook, Twitter, and YouTube enabling new solutions and business models, allowing users to freely advertise their products and services, monetize their content, and stream news and information in the form of tweets. These companies’ big data and cloud computing services became the ideal way to ignite the information revolution. As a result, the internet became more centralized in the data centers of AWS, Alphabet, and Meta.

 

With digital ownership possible through smart contracts and decentralized blockchain infrastructures, users no longer need to rely on centralized companies to advertise, monetize, or sell their digital products and services over the internet. This is the beginning of Web3. In a decentralized marketplace, every content creator has the ability to sell or gain royalties on their songs and videos. Artists can create their own digital gallery and have other blockchain users come and buy some of the fine art they produce. Players have an additional incentive to spend several hours on their favorite video game, where fun in the metaverse is now aided by the possibility of earning rewards and monetizing their in-game collectibles for profits in the real world.

 

This transition to a new web, “owned by the builders and users, orchestrated with tokens,”[14] is already creating additional layers of value on top of tangible and digital assets from conventional markets. Irrespective of country, economic power, and any other external factors influencing the lives of people, smart contracts dematerialize value, agreements, and ownership, promoting the security of assets and unleashing their full potential. 

Web3 use cases 

 

Applications running on Layer-1s[15] are created as smart contracts in the form of protocols. Protocols are a set of functionalities and rules through which end-users interact, a game of incentives that motivates users’ activity and compensates them for services they provide. DeFi has captured much of the attention around smart contracts, but there are many other applications for this technology being developed. Here, we cover some of the ways in which smart contracts are being applied in Web3.  

 

Digital Culture: Non-fungible tokens (NFTs) are one of the key functionalities introduced by smart contracts, giving life to a novel concept of blockchain-based digital scarcity and allowing for the creation of collectibles as assets living inside a Layer-1. These collectibles may be part of a community of select users, in-game items for online games, or even songs and video clips of independent music producers.

 

 

Digital Art: Artists can use NFTs to create digital portraits and paintings, easily monetize them, and trade their creations in decentralized marketplaces. One important NFT feature is that an artist may continue to earn a share of their art’s value every time the piece is bought or sold, allowing them to receive royalties and generate long-term income. 

 

Play-To-Earn: As internet adoption continues to increase, the connectivity of online game players has grown significantly. Today, huge communities of active daily users exist for games like Fortnite, GTA V, and CS GO. Each of these ecosystems has their own set of in-game assets that may be earned or bought using real world money through microtransactions. 

 

Content Creation: DAOs and NFTs are introducing the possibility that decentralized platforms for content creation may finally be able to flourish. This approach is governed by users on blockchain-native assets. Creators can be rewarded by community-driven mechanics, without relying on centralized services to have their content published and distributed. Decentralized platforms also help creators avoid the risk of getting deplatformed without prior notice or for unsubstantiated reasons. 

Identifying an investment class based on smart contract technology is challenging. Smart contracts provide the infrastructure for a myriad of use cases and new applications, but as the sector has evolved and users have looked for alternative platforms, it has become evident that more than one player[19] will populate this portion of the crypto sector and each Layer-1 will find its own niche in the vibrant crypto economy. Digital art and gaming are two areas where some total addressable market parallels can be made between conventional markets and the new services offered by smart contract protocols. 

 

Digital art

 

With the fast transition to the digital world and the emergence of NFTs powered by smart contract technology, artists can now create a more open and vibrant digital art economy. This suggests there is room for a significant increase in the global art market. In 2021, the NFT market for digital art reached a total trading volume of more than US$23 billion[20], nearly half of worldwide sales for physical fine art and antiques in 2020 (US$50 billion)[21]. OpenSea, an NFT marketplace managed by a private group, recently reached a US$13 billion[22] valuation following its Series C funding. Rarible, another NFT marketplace, is a protocol with a suite of tools for creation and deployment of NFTs. Rarible has a total trading volume of US$274 million, with over 400,000 NFTs created and 1.6 million total users[23].

Figure 5: Weekly trading volume on the main NFT marketplaces[24].

 

Gaming 

 

NFTs have also found a major use case in the gaming industry, appearing in the form of rare collectibles and characters in brand new franchises. In early 2022, the blockchain gaming industry surpassed US$5 billion[25] in balances for the 10 applications with the highest number of users. The gaming industry, valued at more than US$170 billion in 2020[26], is a huge market. As a result, we believe there is still significant room for blockchain gaming market growth.

Figure 6: Total trading volume for the major play-to-earn games in Q4, 2021[27].

Challenges and potential risks

 

Similar to the adoption of other novel technologies, smart contracts come with their own set of inherent risks. If not addressed, these risks may be a major cause of financial losses for network users. While extreme transparency offers tremendous potential for replacing traditional intermediaries and automating delivery of services,[28] there are risks to keep in mind that include:

 

1. Developer risk: The implementation of smart contracts only requires someone with enough development skills to write a few lines of code. This means there might be vulnerabilities to exploit, either appearing in the form of backdoors included by a malicious developer or in a lack of proper auditing and precautions taken before the smart contract execution starts. 

 

2. Blockchain operation: Smart contract execution depends on the proper operation of the underlying blockchain. Because no central authority is responsible for system administration, the risk associated with using this infrastructure effectively falls on the end users. 

 

3. Dependence on centralized services: Due to the high computational requirements to run a full node in most smart contract platforms, not every user can send transactions and verify the current state of the blockchain without resorting to third-party service providers[29]. If one of these intermediaries fails, blockchain functionalities may be delayed[30] and transactions may even halt[31].

 

4. Governance: The majority of new projects issue tokens to reward the community involved in the initial development and raising of funds. Because the owners of governance tokens are eligible to vote for the update proposals of the protocol, some participants may have a disproportionate weight in the decisions, depending on the initial token distribution. This can lead to a more centralized portion of the community determining outcomes. 

 

5. Lack of regulatory clarity: Governments are rapidly trying to catch-up with innovations from this sector[32]. Many efforts so far have been to create frameworks for the application of international anti-money laundering (AML) and combating the financing of terrorism (CFT) policies to crypto services, but the ultimate path of regulatory intervention is unclear for the foreseeable future.

 

Looking ahead 

 

By providing services that range from financial applications to digital art, the technology of smart contracts has already proven to be a major driver of disruption in the traditional economy. 

 

Over the past few years, we have seen clear indications that the main platforms of Web3 will most likely evolve to a winner-takes-most scenario, with Ethereum likely to prevail as the dominant player, and a number of other key alternative Layer-1s providing additional grounds for security, high speeds, and low transaction costs. In the past, Layer-1s such as Algorand and Tezos that avoided adopting compatibility with the Ethereum Virtual Machine (EVM)[33] as a built-in feature were at a disadvantage to EVM-compatible competitors. This trend, however, has recently shown signs of reversal, with some alternative Layer-1s like Solana and Terra gaining popularity and considerable market share due to their very high transaction speeds[34] and cheaper transaction costs[35]. 

 

With a total addressable market that could exceed US$250 trillion,[36] the opportunities for this new global computing infrastructure are endless, with ample room for different contenders to claim their share of the ecosystem. There are certainly challenges, such as regulatory uncertainty and scalability issues, but we believe the road ahead is incredibly promising.

 

[1] CoinDesk. Bitcoin Holds Steady as Luna Foundation Guard Resumes Purchases. March 30, 2022.

[2] Nasdaq Crypto Index returns 2/28/22 - 3/31/22.

[3] Kiernan, Paul, and Andrew Duehren. “Bitcoin Price Surges on Biden's Crypto Executive Order.” The Wall Street Journal, DowJones & Company, March 10, 2022.

[4] Briefing Room. “Fact Sheet: President Biden to Sign Executive Order on Ensuring Responsible Development of Digital Assets.” The White House, The United States Government, March 9, 2022.

[5] Brooks, Khristopher J. “Biden's Executive Order Boosts Prospects for Cryptocurrency.” CBS News, CBS Interactive, March 11, 2022.

[6] “Cryptocurrencies in the EU: New Rules to Boost Benefits and Curb Threats: News: European Parliament.” European Parliament Press Room, March 14, 2022.

[7] Owie, Best. “Ethereum Closer to Proof of Stake as Last Testnet Completes the Merge.” Bitcoinist.com, 16 Mar. 2022. 

[8] “Cryptocurrencies in the EU: New Rules to Boost Benefits and Curb Threats: News: European Parliament.” European Parliament Press Room, March 14 2022.

[9] “Emmer Urges SEC Accountability in Crypto Regulation.” Congressman Tom Emmer, March 16, 2022.

[10]  Gensler, Gary. Remarks Before the Aspen Security Forum. U.S. Securities and Exchange Commission, August 2, 2021.

[11] Nasdaq Crypto IndexTM Joins the Metaverse. March 1, 2022.

[12] Messari.io data as of March 22, 2022.

[13] Messari, January 13, 2022.

[14] Chris Dixon, Why Web3 matters, 2021.

[15] A Layer-1 network refers to a blockchain, while Layer-2 refers to protocols used in conjunction with a Layer-1 blockchain.

[16] NFT Stats, accessed March 4, 2022.

[17] Messari, Axie Infinity, accessed February 10th, 2022.

[18] Messari, Audius, accessed February 10, 2022.

[19] Vitalik Buterin, My argument for why the future will be “multi-chain”, but it will not be “cross-chain”, accessed March 4, 2022.

[20] Finance Magnates, NFTs Trading Volume in 2021 Jumps to $23 Billion, accessed March 4, 2022.

[21] An Art Basel and UBS Report, Resilience in the Dealer Sector, accessed March 4, 2022.

[22] Art News, NFT Platform Opensea Gets $13.3 B. Valuation Following Series C Funding, accessed March 4, 2022.

[23]  Rarible, accessed March 4, 2022.

[24] Dune Analytics, NFT Marketplaces by Weekly $ Volume, accessed March 4, 2022.

[25] DappRadar, accessed March 4, 2022.

[26] Mordor Intelligence, Gaming Market - Growth, Trends, Covid-19 impact, and forecast (2022 - 2027) ,  accessed March 4th, 2022.

[27] The Block Research, accessed March 2, 2022.

[28] Nic Carter and Linda Jeng, DeFi Protocol Risks: The Paradox of DeFi, 2021.

[29] Moxie Marlinspike, My first impressions of web3, accessed February 10, 2022.

[30] The Block, Ethereum infrastructure provider Infura is down, crypto exchanges begin to disable ETH withdrawals, February 10, 2022.

[31] Be In Crypto, Solana Goes Down, Developers “Successfully Restart” Mainnet Beta, accessed February 10, 2022.

[32] President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, Report on STABLECOINS, 2021.

[33] The Ethereum Virtual Machine is an interface that gives developers access to application templates and other tools to build decentralized applications on the Ethereum blockchain.

[34] Solana developers allege that the network supports 50,000 transactions per second, against Ethereum PoW’s 13 transactions per second.

[35] Against the average Ethereum transaction fee, hovering around US$45 as of early 2022. Source: CoinMarketCap, accessed January 13th, 2022.

[36]  Amb Crypto, Raoul Pal says crypto market has “reasonable chance” of touching $250 trillion, accessed February 18, 2022.

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