This article relates to Shearman & Sterling's upcoming inaugural Digital Finance Summit on November 15-16. Learn more about the Summit.
Entrepreneurs, technologists and regulators stand at the threshold of the transition to the next generation of the internet, known as Web3 or Web 3.0. Web 3.0 is best explained by comparing it to earlier generations of the internet. The first generation of the internet, Web 1.0 was largely static and about reading content or finding information. Web 2.0, the second generation of the internet, became more dynamic and was about creating and uploading content and social networks. Although still evolving, Web 3.0 is generally thought of as a “decentralized” internet. Unlike previous iterations of the web, Web 3.0 allows users to own and control their personal information and provides innovative mechanisms to distribute governance of any given network. In Web 3.0, there is a much higher emphasis on ownership of content, data and the network itself (in the form of digital assets called tokens) by the builders, creators, organizations, communities and users of the content and data. This new and innovative approach is unlocking a new wave of business models and entrepreneurship.
Enormous resources and investment have been put into Web 3.0 companies over the past few years, with over $30 billion invested in these companies in 2021 and $17.7 billion invested through Q3 2022. Venture capital funds have raised billions more in funds for future investment in Web 3.0 companies, representing a significant amount of capital available for future entrepreneurs building Web 3.0 companies.
New Ownership and Governance Paradigm
Although Web 2.0 allowed for an explosion of creative content on the internet, power has become centralized with a very small group of technology companies controlling the gateways to user-created content and, most importantly, retaining ownership of all that content. Under a Web 2.0 paradigm, centralized platform providers (and their owners) were the primary beneficiaries of the creativity of their users. Platforms like Facebook and Google, for example, have become massive companies by monetizing the personal information of their users, who provide the content to the platform that attracts and retains users, which further benefits the owners of the platform.
Web 3.0 represents a marked shift from such centralized ownership and control. Builders of decentralized networks entice creators, organizations, communities and users of content and data to their system with incentives, such as digital assets, that incentivize them to become a part of the network and to participate by contributing to the network in some way.
One example of this model is a network called Helium. The Helium Network is a decentralized wireless network, owned and operated by people around the world. Helium set out to create a worldwide wireless network for “internet of things” devices. To incentivize participation in the network, participants who share their internet bandwidth by installing, powering and maintaining Helium hotspots will be issued Helium Network Tokens according to a transparent algorithm. Instead of Helium owning all of the nodes, each participant owns a part of the network and receives consideration in the form of Helium Network Tokens accordingly. This is a prototypical Web 3.0 model with decentralized ownership and a transparent rewards system.
Helium recently started its 5G rollout with the goal of building a worldwide 5G cellular network using the same model - participants who install, power and maintain Helium 5G hotspots will be issued Helium Network Tokens according to a transparent algorithm.
Helium’s structure is a familiar one in the Web 3.0 world. The Helium Network is governed and maintained by the Helium Foundation, which is a community-run, non-profit organization. A private venture capital-backed company is the original founding team behind the Helium Network and continues to be a core contributor to the Helium Network, supporting the core development of the blockchain and driving usage of the Helium Network.
Many Web 3.0 companies have similar structures, but a structure called a distributed autonomous organization, or a DAO, is gaining significant traction. Most Web 3.0 companies that utilize blockchain networks or smart contract-based protocols are organized as, or intend to organize as, DAOs. DAOs are organizational structures without a centralized authority controlled by participants operating on a set of governance rules agreed to by all participants. The structure of DAOs is still evolving, but essentially, a DAO typically involves a founding developer corporation, a series of smart contracts that own the base protocol, governance smart contracts and an associated non-profit foundation. Although a DAO would typically start off as a centralized entity, it is typically designed to eventually distribute control of the underlying protocol among all DAO participants.
While blockchain networks utilize a variety of different consensus mechanisms, the governance smart contracts have specified control rights with respect to the smart contracts that make up base protocol and establish the rules relating to governance of the base protocol and the issuance of governance tokens. The governance smart contracts essentially automate the decision-making and administrative functions normally performed by traditional centralized management structures. Decentralization of a protocol is achieved when the governance smart contracts are activated and control of the protocol’s base smart contracts is passed from the founding developer corporation to the participants in a DAO.
New Regulatory Questions
These new structures and the issuance of the digital assets to the participants raise a number of regulatory questions and have increasingly caught the attention of regulators. The regulatory environment surrounding digital assets in the United States is ambiguous and evolving continually, presenting a compliance challenge for Web 3.0 companies. Without comprehensive legislation creating a regulatory framework for digital assets and the unique challenges of this developing technology, regulatory agencies have adopted a multitude of approaches, including regulation through enforcement and ad hoc approaches to applying existing regulations to particular fact patterns and technologies. Existing regulations were created long before these new technologies existed and often do not work as a regulatory model if strictly applied to these new technologies.
Although the Biden administration has produced various reports and proposals regarding regulation of digital assets, comprehensive legislation still appears to be far off. Without a comprehensive regulatory regime, the developers and users of blockchain technology must continue to navigate a patchwork of regulations that are insufficient to address even simple issues relating to digital assets. Moreover, developers, users and participants in DAOs risk being caught in the middle of turf wars between regulators attempting to assert authority over regulation of digital assets.
Conclusion
The emergence of Web 3.0 business models presents developers, users and regulators with a complicated web of opportunities for disruption and perplexing governance and regulatory questions. As DAOs and other new business structures continue to evolve, developers, creators, entrepreneurs and users will continue to challenge traditional concepts of ownership, governance and value creation through decentralized ownership and community-based rulemaking. Similarly, regulators will need to consider whether existing regulations are sufficient to provide an appropriate framework for digital assets and these new business structures or whether a whole new regulatory regime is required.
