Global Banking Practice

Web3 beyond the hype

While buffeted by the recent market downturn and bankruptcies,
digital assets and the technologies underlying them still have the
potential to transform business models across sectors.

by Anutosh Banerjee, Robert Byrne, Ian De Bode, and Matt Higginson

© MirageC/Getty Images

September 2022
 The past few months have been a rough awakening needs to overcome, and the implications for stake­
for many Web3 enthusiasts: the market prices of holders as it continues to evolve. Future articles
major cryptocurrencies have declined significantly, will look at more specific aspects and use cases in
the trading volume of non-fungible tokens (NFTs) greater depth.
has slowed, and, most importantly, some pioneers
of the space have declared bankruptcy because
of failed risk management and misuse of consumer Understanding the disruptive potential
funds. Yet even as the debris continues to fly, of Web3
business leaders shouldn’t confuse market The core distinctive feature of Web3 is the decen­
fluctuations or bad actors with the potential uses tral­iza­tion of business models. To that extent, it
of digital assets and the technologies that marks a third phase of the internet (hence “Web3”)
underlie them. and a reversal of the current status quo for users.
While the first incarnation of the web in the 1980s
While there are very real risks from this nascent consisted of open protocols on which anyone
technology and its uses, applications for the could build—and from which user data was barely
next generation of the internet continue to spring captured—it soon morphed into the second
up in a growing number of industries with iteration: a more centralized model in which user
potentially transformative effects. data, such as identity, transaction history, and
credit scores, are captured, aggregated, and often
The financial-services industry has largely led resold. Applications are developed, delivered, and
the way in adopting some of these nascent digital monetized in a proprietary way; all decisions related
technologies and assets—at its peak, the daily to their functionality and governance are concen­
volume of transactions processed on so-called trated in a few hands, and revenues are distributed
decentralized-finance exchanges exceeded to management and shareholders.
$10 billion.1 Volume has since dropped to about
$2 billion, largely in line with asset prices. Learnings Web3, the next iteration, potentially upends that
from the financial-services experience—both power structure with a shift back to users. Open
the ups and the downs—are helping to inform usage standards and protocols could make their return.
in other sectors, which now include real estate, The intent is that control is no longer centralized
gaming, carbon markets, and art, among others. in large platforms and aggregators, but rather is
widely distributed through “permissionless”
How far and how fast these technologies and their decentralized blockchains and smart contracts,
uses will spread remains to be seen; the journey which we explain later in this article. Governance—
is proving bumpy, with ongoing challenges ranging and this is one of the trickiest aspects of Web3—
from poor user experience to fraud. Crucially, the is meant to take place in the community rather than
regulatory picture for Web3 remains unsettled, with behind closed doors. Revenues can be given
calls for greater clarity on some assets and more back to creators and users with some incentives
consumer protection for funds held in custody. Yet to finance user acquisition and growth.
understanding the core features of this new digital
wave and the potential disruption it could bring What does this mean in practice? Essentially, it
remains important for business leaders in a wide could mark a paradigm shift in the business model
range of sectors. To that end, this article is a primer for digital applications by making disintermediation
on the fundamentals of Web3: what it is, the a core element. Intermediaries may no longer be
pillars on which it is built, what it can and cannot required with respect to data, functionality, and value.
yet do, the significant risks and challenges it Users and creators could gain the upper hand and,

1
The Chainalysis state of Web3 report, Chainalysis, June 2022.

2 Web3 beyond the hype

through open-source rather than proprietary Blockchains as open-data structures. In Web3,
applica­tions, would have incentives to innovate, test, application data are no longer stored in private
build, and scale. databases but rather on an open-data structure that
anyone can write to and read from. This open-data
structure is the blockchain. Blockchains operate as
The building blocks of Web3 public databases that store and secure all relevant
The disruptive premise of Web3 is built on three and transactional data. They are often referred to as
fundamentals: the blockchain that stores all data “distributed digital ledgers,” meaning that the core
on asset ownership and the history of conducted databases are duplicated and spread among multiple
transactions; “smart” contracts that represent participants in a network of computer servers called
application logic and can execute specific tasks “nodes.” The “blocks” in blockchain are individual
independently; and digital assets that can represent segments of data that are interlinked or chained
anything of value and engage with smart contracts together. As new data are added to the network, a
to become “programmable.” Each of these three new block is created and attached permanently
fundamentals has layers of complexity and nuance, to the chain. All nodes are then updated to reflect
and each is evolving in an effort to overcome start- the change. The lack of central data storage is
up troubles and structural weaknesses. In this a critical differentiator from traditional databases.
primer, we mainly cover the high-level aspects of Among other advantages, this means that the
these fundamentals (Exhibit 1): system is not subject to a single point of failure or

Exhibit 1

Web3 applications
applications and
and use
usecases
casesare
arebuilt
builton
ontop
topofofthree
threetechnology
technology
fundamentals: blockchain, smart
smart contracts,
contracts,and
anddigital
digital assets.
assets.

Illustrative and simplified

Web3 DeFi1 Gaming Social Art and Applications and use cases built on top of
applications media Web3 fundamentals; the connection of these
and use cases virtual experiences is sometimes referred to
as the metaverse

Web3
foundation 3 Digital assets and tokens Assets that represent verifiable and ownable
intangible digital items, including cryptocurrencies,
NFTs,2 stablecoins, real world assets, etc

2 Smart contracts Code or programs stored on a blockchain that

execute when conditions are met (eg, terms between
a buyer and a seller); governed by DAOs3

1 Blockchain Digital, distributed, decentralized public ledger that

exists across a network and facilitates the recording
of transactions

Decentralized finance.
1

Nonfungible tokens.
2

Decentralized autonomous organizations.

3

Web3 beyond the hype 3

 a single point of control or censorship. User data are — governance tokens, which are tokens that
no longer fragmented across platforms, nor are they represent voting rights on the functional
proprietary or for sale. parameters of smart contracts

Smart contracts as disintermediated functionality. — non-fungible tokens (NFTs), which are a unique,
Smart contracts are software programs stored on indivisible digital asset with provable ownership
the blockchain that automatically execute a verified
transaction based on predefined and agreed — digital assets that represent claims on real-world
parameters. They require careful preparation and assets such as commodities, real estate, or
setup because they are often deployed as immutable intellectual property, and are “tokenized” into
programs, but once in place, they can be executed divisible digital assets on the blockchain
rapidly and cost-efficiently without the need for
intermediaries and their extractive revenues. The While each digital asset has a specific functionality,
logic of an application is predetermined in the asset ownership information is no longer stored
contract and can be difficult to change once on private, regulated ledgers (such as those of a
deployed. These applications are often governed bank) but on the blockchain, enabling user-owned
by a decentralized autonomous organization (DAO), value that can be stored, verified, and transacted
a form of collective governance by users of the independently of third parties. In addition, these
application who own governance tokens of the smart assets can engage with smart contracts and be put
contract. If the DAO is set up correctly, no company to “productive” use—for example, earning yield
can unilaterally decide to change the parameters of for their owners as they are autonomously deployed
the application. This stands in stark contrast to Web2 by these contracts.
applications, which give companies sole discretion
over specific parameters like pricing.
Bringing Web3 to life: Automated
Digital assets and tokens as decentralized lending as an example of what
ownership. Digital assets are intangible digital items may change
with ownership rights. As such, they are supposed To illustrate the disruptive potential of Web3, it is
to represent verifiable and ownable digital values— best to start with the use case where Web3 found
although in many geographies, the legal framework its first product-market fit: financial services.
surrounding these digital assets and their ownership Remittances, asset swaps, trade finance, and
rights is not sufficiently clear yet. These assets insurance have all begun to employ smart contracts
exist on the blockchain across applications and can to achieve automation efficiencies. Lending may
engage with smart contracts. Broadly speaking, demonstrate one of the most compelling implemen­
there are currently five types of digital assets: ta­tions of Web3 to date.

— native tokens, which are the monetary incentives In today’s legacy financial services, lending relies on
used to compensate nodes for maintaining and the bank as the trusted intermediary to safeguard
updating the respective blockchain funds and originate loans (Exhibit 2). Depositors
provide funds in return for a small amount of interest.
— stablecoins, which are supposed to represent The bank then performs record keeping on a private
cash on the blockchain and are pegged to fiat ledger and assembles information about potential
currencies like the US dollar, or central bank borrowers to determine their creditworthiness and
digital currencies (CBDCs), which are regulated the price of their loan. Additional fees charged to
by a central bank 2 borrowers fund these activities and provide revenues

2
Some projects have marketed themselves as “stablecoins” even though they were reserved by other digital assets that have proved unstable in
value. For the purposes of this article, only stablecoins that are fully reserved by cash and cash equivalents are considered as such.

4 Web3 beyond the hype

Exhibit 2
Web3 could represent a paradigm shift in business models for
digital
Web3 couldapplications.
represent a paradigm shift in business models for digital applications.

Illustrative and nonexhaustive

Web2 deposits and loans: The familiar model Web3 deposits and loans: Decentralized model

Depositors Borrowers Depositors Borrowers

Interest Interest
Digital payments payments Digital
Data Assets Data Assets Interest Data
assets assets
payments

Service Service

Proprietary Public smart contract

Public blockchain
Private ledger credit and risk (automated credit
ledger
models decisioning)

Governance Governance

Corporation Decentralized autonomous organization

Management Shareholders Management Token holders

to the bank’s management. In recent years, however, are met. Borrowers still look for loans but can only
with rates at historic lows, very little interest was receive funds from the smart contract (which were
returned to depositors. originally provided by the depositors) after the
borrower has posted sufficient collateral. By taking
With Web3, depositors still seek to earn interest out a loan against collateral, borrowers can still
on their deposits, but instead of entrusting their enjoy potential price appreciation of the collateral
funds to a bank or nonregulated platform, they and create liquidity without incurring a taxable event
themselves hold their funds in a noncustodial wallet (which would occur when selling).
that represents an account on the blockchain. All
ownership and transaction data reside on the All terms of the loan, including the loan-to-value
blockchain rather than with the bank or nonregulated (LTV) ratio, interest paid, and liquidation thresholds,
entity. Customers no longer entrust their funds to a are predetermined by the logic in the smart contract
company to lend them out; instead, they can deposit and are available transparently to all participants.
their funds as liquidity into a smart contract. The Borrowers still pay interest rates on their loans, but
smart contract effectively escrows these funds and these interest rates no longer accrue to management
only disburses them when preestablished conditions and shareholders. In this instance, the contract

Web3 beyond the hype 5

 has neither management nor shareholders; it is insuring funds. And in recent months, as the price
governed by a DAO that often has no claim on any of of the underlying loan collateral has fallen, loan
the revenues. The interest on loans is paid into the liquidations have been triggered automatically by
smart contract and disbursed back to the original each smart contract without creating delinquencies
depositors of the liquidity. Credit risk is minimized associated with each loan.
because of overcollateralization requirements and
automatic liquidations. More than $200 billion in Web3 effectively enables traditional revenue streams
loans was disbursed last year from the largest Web3 to accrue to the users of a platform, enhancing
lending platforms—and cumulative bad debt the user value proposition relative to their Web2
is currently roughly $1 million, despite significant equivalents. The lending example also shows
volatility.3 Web3 lending platforms continued to how Web3 may enable services to be delivered
operate even during the market turmoil. No deposits more cost-effectively and 24/7 through shared
were lost or frozen, and withdrawals continued to infrastructure, compliance, and automation.4
occur. One prominent failed crypto lender even
continued to pay back its loans on Web3 platforms While deposits and loans were one of the first
to regain its collateral after it filed for bankruptcy. examples with product-market fit, other decentralized
finance (DeFi) use cases have emerged, most notably
This example underscores how the role of the bank swaps. A similar logic applies here: the Web3
as a custodian, central ledger, and credit decisioning implementation enables traditional revenues in the
engine can be disintermediated. The traditional form of trading fees to accrue to depositors (in other
interest payment revenues associated with this words, liquidity providers) of the smart contract
service accrue to the depositors, rather than to the instead of the traditional central-exchange company.
bank’s management and its shareholders. The Liquidity providers for some of the most popular
smart contract itself often accrues zero revenue, but swap pairs (such as Ethereum and USD Coin) were
sometimes will accrue a small spread used for averaging a trading-fee revenue of 30 to 70 percent

Web3 effectively enables traditional

revenue streams to accrue to the users
of a platform, enhancing the user
value proposition relative to their
Web2 equivalents.

3
“Lending markets bad debt,” RISK DAO, accessed August 8, 2022.
4
Yields have varied from 1 percent to 8 percent for stablecoin loans and have dropped recently to about 1 percent. Current rates are driven by
supply and demand for leverage, not by the risk-free rate. Rates were observed on the Aave and Compound websites, accessed August 11, 2022.

6 Web3 beyond the hype

 of the capital provided last year.5 Once again, the largest organizations to compete with this scale
the DAO that governs the smart contract earns no of global developer base and innovation, and the
revenue; all revenue accrues to depositors rather speed could accelerate as more users and
than to the management of a central exchange. While developers join.
past returns were relatively high, consider the return
on equity that organizations could make if they were
able to materially reduce trading administration Risks and challenges of Web3 that still
costs through a smart contract and outsourced their need to be addressed
infrastructure costs through blockchain, not Web3 is now spreading into many other sectors,
including essential risk-management and compliance including the social sector and carbon markets, art,
professionals. Web3 could lead to pricing-power real estate, gaming, and more. It is also a building
compression (in other words, lower fees) due to the block for an interoperable metaverse, an entirely
open-source nature of the protocols and automation. virtual parallel universe under construction that is
attracting massive investment from consumer
Product market uses have in some cases been companies and venture capitalists, among others.8
primarily speculative. Yet the growing range As with any new technologies billed as disruptive, it
of applications in financial services is indicative of remains to be seen just how revolutionary blockchain,
the meaningful innovation that Web3 can generate. smart contracts, and digital assets will prove to be.
Before the recent market downturn, more than While skepticism is significant among some parts of
$250 billion was actively put to use in smart contracts, the public, especially following the steep declines
yielding autonomous returns for its depositors.6 in the valuation of digital assets and the recent
bankruptcies of some funds and consumer deposit
As such, in DeFi, automated and programmable companies, user interest remains high and engage­
smart contracts for lending, trading, derivatives, and ment is growing, especially for younger generations.
insurance, among others, have begun competing In a recent McKinsey survey of 35,000 active online
with traditional intermediaries, including banks, users in some of the largest digital-asset markets—
brokers, and insurance agents. In some cases, they India, Singapore, the United Kingdom, and the United
offer solutions to challenging features of traditional States—20 percent of respondents age 25 to 44
finance such as counterparty risk, high transaction said they own digital assets. Two-thirds of those had
fees, long settlement times, the large share of value already made payments using digital assets
captured by intermediaries, system opacity, and (presumably for peer-to-peer payments or Web3
a lack of interoperability. If businesses currently commerce) and just over half had used NFTs as
provide services that can be coded into an a form of digital identity or performed play-to-earn
automated smart contract, they would do well to activities with digital assets.
take notice.
Web3 will nonetheless need to overcome continuing
Finally, despite the recent market downturn, the challenges, obstacles, and risks for both consumers
speed of innovation is unlikely to slow. Thousands of and institutional participants before it can fully
new developers are joining the Web3 movement establish itself.
every month.7 Given the open-source nature of the
technology, developers can easily develop new The chief challenge is regulatory scrutiny and
applications by building on established programs outlooks. Regulators in many countries are looking
that have been battle-tested and proved under to issue new guidance for Web3 that balances
severe market conditions. It may be hard for even the risks and the innovative potential, but the picture

5
Solely based on returns from trading fees and not taking into account underlying asset price movements that may lead to further gains or
impermanent loss. Those trading-fee revenues are currently about 45 percent for the five-basis-points pair.
6
“DeFi dashboard,” DeFiLlama, accessed August 26, 2022.
7
Electric capital developer report (2021), GitHub, December 2021.
8
For more, see McKinsey Blog, “Meet the metaverse: Creating real value in a virtual world,” McKinsey, June 15, 2022.

Web3 beyond the hype 7

 Before it can fully establish itself,
Web3 will need to overcome
continuing challenges, obstacles,
and risks for both consumers and
institutional participants.

remains unsettled. For now, there is a lack of clarity— risks of decentralized technology, thus expecting
and jurisdictional consistency—about classifying the same type of protections they are used to
these assets, services, and governance models. For from centralized (and often regulated) entities. For
example, smart contracts are not yet legally example, transactions on the blockchain, by their
enforceable. This in turn limits the potential for very nature, are irreversible, so the concept of
institutional adoption, especially by heavily clawbacks or user fund retrieval does not currently
regulated entities. Governance remains a work in exist (although it is technically possible).
progress, and the integrity of decentralized
autonomous organizations—the collective community The technology itself may not be ready for
mechanisms that are supposed to oversee this mainstream adoption. Data privacy in the current
new decentralized world—varies widely and is often system is arguably lacking. For example, while
not yet rock-solid (as some recent examples in wallets are initially anonymous, existing tools are
DeFi have shown), although it is evolving. getting better at attributing wallet identity based
on transaction history. Once anonymity is lost,
Furthermore, the user experience in this new all transactions can potentially be viewed anywhere
ecosystem is not yet ready for mainstream adoption. in the world. While this public nature can be
Interfaces are often poorly designed, and the beneficial, users will likely need to have access to
underlying technology is still too cumbersome for on-demand privacy for the technology to have
users to have a seamless experience. Security is mainstream appeal.
also a concern: until users have peace of mind, they
will likely not adopt this technology en masse. Fraud Last, transaction cost is also a factor, making some
continues to be a risk, with a variety of “rug pulls,” of the technology protocols too expensive to use
Ponzi schemes, and social-engineering scams dog­ at present. For example, fees paid to complete and
ging the nascent sector, while know-your-customer record a transaction on the Ethereum blockchain
and anti–money laundering procedures are often (so-called gas fees) could be prohibitive for users in
lacking. While Web3 ultimately will put the user value large parts of the world, while cheaper and faster
proposition front and center, the current state of alternatives do not typically have the same level of
consumer protection is clearly insufficient. resilience or operational uptime that is needed
for mainstream adoption. Smart-contract resilience
Indeed, a prominently featured concern is that users
engaged in Web3 may not fully understand the

8 Web3 beyond the hype

 is unproven, with new exploits of weaknesses in players and others who are starting to use the
new code or “logic hacks” happening weekly, and technology are aware of these challenges and are
the accuracy of “oracles”—that is, information feeds actively working to address them, often funded
that are used in decisioning by smart contracts— by extensive venture capital (VC). Indeed, VC
continues to be a work in progress. Web3 infra­ investments in Web3 exceeded $18 billion in the
structure needs to continue to evolve to become first half of 2022,9 remaining on track to top the
more robust—many critical services are often full-year total VC investments of $32.4 billion in
too centralized or too sensitive to failure. Finally, 2021. Despite these early challenges, adoption of
given their environmental footprint, proof-of- Web3 applications has occurred at an exponential
work blockchains could present specific adoption pace,10 driven by the enhanced user value proposition
challenges for users, corporations, and regulators and disintermediated business models.
at a time of growing attention to environmental,
social, and governance issues, although the footprint For all the technical complexity and unanswered
of proof-of-work blockchains is continuously evolving, questions, Web3 remains an important internet trend
and there is ongoing work to reduce it. to watch, and C-suite executives across a range of
sectors may want to keep it on their radar, if only
because of the potential for rapid disruption that it
Imagining the Web3 endgame represents. Executives could develop a deliberate
The above examples highlight both Web3’s disruptive strategy by asking how Web3 native companies
potential and its still-nascent implementation. could disrupt their industry and what challenges and
Regulatory oversight, user experience, and the opportunities this might present.
underlying technology will all need to further mature
for mainstream adoption to occur. Leading Web3

The above examples highlight both

Web3’s disruptive potential and its still-
nascent implementation. Regulatory
oversight, user experience, and the
underlying technology will all need to
further mature for mainstream
adoption to occur.

9
Kevin Kelleher, “What winter? Crypto VCs continue their spending spree,” Fortune, July 27, 2022.
10
Daren Matsuoka et al., “Introducing the 2022 state of crypto report,” a16z crypto, May 17, 2022.

Web3 beyond the hype 9

 If the disruption does take place, it and other Infrastructure. As new assets emerge, core
associated opportunities for incumbents (depending infrastructure will likely continue to evolve and
on their risk appetite) are likely to happen across mature to support them. There is a need for
three levels: assets, infrastructure, and services more infrastructure related to custody and asset
(Exhibit 3). servicing, clearing and settlement, tokenization
and issuance, risk and compliance, and wallets and
Assets. Novel and unexplored assets (including identity, to name just a few areas that are currently
stablecoins, CBDCs, governance tokens, NFTs, and insufficiently addressed by legacy players.
tokenized real estate, among others) could continue Incumbent banks and others have an opportunity
to form, driven by new use cases and expanding to partner with Web3 native companies to innovate
latent retail and corporate demand. Certain assets their own offerings and support the maturation of
could also continue to tokenize, indicating that for the Web3 infrastructure that is needed for
many assets—including bonds and commodities— mainstream adoption.
both their traditional and tokenized versions may
coexist. As such, the opportunity for corporations Services. As the infrastructure to support Web3
would be to facilitate access to new Web3 assets native assets matures and the technology continues
such as NFTs or look to bring existing assets to evolve, new Web3 native equivalents that repli­
into a Web3 ecosystem. This could be done by cate some of the functionality of existing services
using tokenization services to bring real- could emerge. We are already starting to see the
world assets, such as bonds, music, or art, into emergence of Web3 native marketplaces, payment
Web3 environments. networks, and deposit and loan platforms. Many

Exhibit 3

Looking ahead, Web3 could

Looking ahead, affectmany
may affect financial services
industries in in far-reaching
far-reaching ways.
ways.

Assets
New markets may
Traditional assets Novel Web3 assets continue to form, and
Equities Debt Commodities Cash Stable- Crypto NFTs2 Tokenized certain assets could
coin and assets continue to tokenize,
CBDCs1 tapping into latent
customer demand

Services Traditional Web3

Marketplaces Payment Banking and Gaming Social Media Multiple platforms may
and exchanges networks lending coexist to deliver
services, both traditional
Marketplaces Payment Banking and Gaming Social Media and Web3 (centralized
and exchanges networks lending and decentralized)

Infrastructure
Custody and Clearing and Tokenization Wallets and Data, risk, and Web3 infrastructure
servicing settlement and issuance identity compliance could continue to
mature and support
Blockchain infrastructure new assets

1
Central bank digital currencies.
2
Nonfungible tokens.

10 Web3 beyond the hype

 expect the emergence of Web3 gaming, social, Web3 is still a world in the throes of creation. Many
and media platforms—the Web3 metaverse—to be issues, including questions around regulation, will
next. While it may be hard to predict which use need to be resolved before it convincingly scales up
cases will scale fastest, multiple platforms, both to reach mass adoption. Yet the value proposition
traditional and Web3, may coexist to deliver similar for consumers at the heart of it—one that unifies
functionality. Each, however, may have a different data, functionality, and value, and in doing so creates
value proposition: the traditional service may have opportunities for new and more efficient forms
higher consumer protection and better user of applications and asset ownership—is a powerful
experience, while the native Web3 version may have one. If history is any guide, companies large and
better economics for the user or operate around small, as well as the public and social sectors, may
the clock. Incumbents may increasingly partner with want to take note of the inroads Web3 is already
Web3 disruptors that serve as a bridge to deliver making and start thinking about responsible ways
or tap into new services. The winners of this trend to interact with it. Incumbents that fail to do so
may figure out how to bring new and enhanced may suddenly find themselves overtaken by a fast-
value propositions to their existing user base moving set of new technologies, new assets, and
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Anutosh Banerjee is a partner in McKinsey’s Singapore office; Robert Byrne is a senior partner in the San Francisco office,
where Ian De Bode is a partner; and Matt Higginson is a partner in the Boston office.

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Web3 beyond the hype 11