Unlocking the Crypto Financial Key to Web3

As the financial backbone of Web3, cryptocurrency plays a central role in bringing to life the ideals of the next evolution of the Internet. In the decentralized finance (DeFi) domain, cryptocurrency transforms into reality the financial liberalization ideals of Web3 through its disintermediation function which enables direct peer-to-peer (P2P) transactions. In the digital identity domain, cryptocurrency realizes the data protection ideals of Web3 through the use of cryptographic security to protect personal data tied to digital assets. As for the content ownership ideals of Web3, cryptocurrency supports the attainment of these ideals through the tokenization of user-generated content (UGC) in the form of non-fungible tokens (NFTs) that can be utilized on and traded using decentralized applications (dapps).

Given the central role played by cryptocurrency as the financial backbone of Web3, let’s evaluate the readiness of cryptocurrency to fulfill its role as the financial key to unlocking Web3 by assessing the distribution patterns, liquidity levels, and market composition of the crypto market.

(1) Distribution: Patterns

If cryptocurrency is to be the financial backbone of Web3, the crypto market needs to be stable enough to support the financial needs of Web3. A key factor in determining the stability of the crypto market is the distribution patterns of top cryptocurrencies such as Bitcoin (BTC), Ethereum (ETH), and USD Coin (USDC). As a general rule of thumb, a wide distribution pattern means lower exposure levels to the risks of price volatility, liquidity crunch, and market manipulation. Conversely, high levels of concentration of a significant percentage of the circulating supply of a cryptocurrency in the hands of a select few aka crypto whales could result in systemic instabilities, especially in times of market distress.

Number of Wallets Holding Top Cryptocurrencies (Source: Chainalysis)

According to Chainalysis’ data covering the period from July 2020 to July 2023, BTC has the widest distribution pattern as 50% of its circulating supply is owned by the most number of wallets (4.5k), followed by USDC (196) and ETH (131), In contrast, 50% of the circulation supply of FTX token (FTT) was held by 1 wallet which is a red flag for stability as it indicates a high risk of market manipulation.

(2) Liquidity Levels

If cryptocurrency is to properly function as the financial backbone of Web3, the crypto market needs to have sufficient liquidity to support the financial needs of Web3. A high level of liquidity in the crypto market ensures that Web3 users can easily buy, sell, and trade cryptocurrencies without significant price fluctuations due to processing delays. Liquidity also supports the payment functions of dapps and the trading functions of  DeFi platforms. As a general rule of thumb, a high level of crypto market liquidity would enable faster settlement of Web3 financial transactions. Conversely, a low level of crypto market liquidity would mean that the settlement of Web3 financial transactions would take longer.

Total Active Wallets of Top Cryptocurrencies (Source: Chainalysis)

According to Chainalysis’ data covering the period from July 2020 to July 2023, ETH has the highest liquidity as it has the most number of active wallets (4.8M), followed by BTC (1.9M) and USDC (269k). In contrast, FTT only has 2.2k active wallets which is a red flag for the liquidity of the token as it indicates a low tolerance threshold for market fluctuations.

(3) Market Composition

If cryptocurrency is to properly function as the financial backbone of Web3, the supply of cryptocurrencies in the market needs to be controlled by wallets from a wide cross-section of the service providers’ spectrum to meet the financial needs of Web3 users. Having a diversified composition of service wallet control means that the crypto market would be able to cater to a wide range of Web3 platforms including decentralized autonomous organizations (DAOs), DeFi, NFTs trading, and smart contracts-based platforms. Whilst a diversified crypto market composition is important to support the financial aspects of Web3 operations, the uses of cryptocurrency in this regard should be for legitimate and innovative purposes whereby the risks of illicit and illegal transactions need to be addressed through policy frameworks and regulatory intervention.

Monthly Control Supply Share of Service Wallets of Top Cryptocurrencies (Source: Chainalysis)

According to Chainalysis’ data covering the period from July 2020 to July 2023, BTC has the most diverse market composition though it is the least decentralized as compared to ETH and USDC. Nonetheless, there are indications that ETH and USDC are becoming more decentralized as there was a significant increase in the proportion of the share of supply of ETH and USDC that is controlled by wallets on decentralized exchanges during the relevant period. As for FTT, there was a huge outflow of the token from centralized exchanges to decentralized exchanges in November 2022  in the aftermath of the collapse of its issuer, FTX.

In summary, the distribution patterns, liquidity levels, and supply control composition of the crypto market are key indicators of the readiness of cryptocurrency to be the financial backbone of Web3. Only time will tell as to if and when the crypto financial key can unlock Web3 as the readiness of cryptocurrency to be the financial backbone of Web3 would be changing moving forward in line with changes in market dynamics, regulatory developments, and technological advancements.