The Future of Web3 Wallets: Innovation, Challenges, and Key Issues

Introduction

This article aims to explore the current innovations, challenges, and key issues in the field of Web3 wallets, rather than simply narrating its development history. We will first examine the current state of Web3 wallets (Wallet 1.0), as well as the progress of account abstraction (AA), particularly how ERC 4337 is driving the development of the next generation of wallets (Wallet 2.0). Additionally, we will discuss the potential risks and limitations of Wallet 2.0.

Considering the rapid development of the Web3 wallet space, this article proposes a framework to help builders and investors determine long-term value. The framework revolves around five core questions:

1. Is this a great business?

2. Can Wallet 2.0 create a problem-solving method that is 10 times better than existing solutions?

3. How can enterprises establish sustainable competitive advantages, especially in cases where they heavily rely on first-mover advantages?

4. Can enterprises find a distribution channel to add smart contract functionality to existing products?

5. What assumptions must we believe in for it to be more successful than existing Wallet solutions?

Let's first review the current state of the Web3 wallet field to provide background for the subsequent discussion.

"Not your keys, not your coins"

The emergence of cryptocurrency has fundamentally changed our perception of money and assets. However, the widespread distrust of traditional financial institutions has made it necessary to develop reliable and secure storage solutions. The recent failures of financial intermediaries such as FTX, BlockFi, and SVB highlight the fact that the safety of customer assets depends on the provider's solvency. As a result, users are increasingly turning to crypto instead of intermediaries for greater security. The emergence of Web3 wallet addresses this issue, allowing users to securely store and manage their crypto assets while maintaining full control over their private keys. As the saying goes: "Not your keys, not your coins."

If you cannot control the private keys of your crypto assets, you cannot truly own those assets. The emergence of Web3 wallets solves this problem, allowing users to safely store and manage their crypto assets while maintaining full control over their private keys.

Key Features of Web3 Wallets

Web3 wallet is a digital wallet designed to seamlessly collaborate with decentralized applications using blockchain technology ( dApps ). Unlike traditional wallets, Web3 wallets allow users to have full control over their assets without the need for banks or other third-party intermediaries. Some key features of Web3 wallets include:

Decentralization: Web3 wallet operates on a peer-to-peer network, relying on no centralized servers, thus being more secure and able to withstand threats such as hacking.

Interoperability: Web3 wallet can be compatible with various blockchain protocols and cryptocurrencies, allowing users to manage multiple assets in one place.

Security: Web3 wallet uses advanced encryption technology to protect sensitive information such as private keys, preventing theft and fraud.

User-friendly: The Web3 wallet is designed to be simple and intuitive, making it easy for ordinary users to use.

The Current Status of Wallet 1.0

Currently, digital wallets can be roughly divided into two categories: custodial wallets and non-custodial wallets.

Custodial wallets are held and managed by third-party companies (, such as centralized exchanges ), which essentially hold users' cryptocurrency assets.

Non-custodial wallets allow users to have complete control over their private keys, ensuring that the user is the sole custodian of their encrypted assets. Non-custodial wallets can be further divided into three categories: externally owned accounts (EOA) wallets, smart contract wallets, and multi-party computation (MPC) wallets.

1. EOA Wallet is the most common cryptocurrency storage and management wallet. Users need to hold private keys, usually provided by centralized exchanges or wallet providers. For example, Metamask, Backpack, Phantom, Rabby, and Rainbow.

2. Smart contract wallets manage assets using smart contracts. They are more secure and flexible than EOA wallets, supporting advanced features such as social recovery and multi-signature. Examples include Argent, Safe, and Sequence.

3. MPC Wallet uses threshold encryption technology to enhance security. The private keys required for authorizing transactions are split and distributed to different parties, ensuring that no single party can independently access the keys. This greatly reduces the risk of single points of failure or attacks. For example, Fireblocks, ZenGo, Coinbase MPC, and Particle Network.

In addition, there are some teams developing infrastructure to simplify the process for other developers to create and customize wallets for end users.

Challenges Facing Current Wallet 1.0

Although cryptocurrency wallets have made significant progress in recent years, there are still several challenges that need to be addressed to make them more user-friendly and widespread. The main challenges include:

Difficult for ordinary users to use: Encryption wallets are difficult for ordinary users to understand, hindering the widespread application of blockchain technology.

Login complexity: Setting up an encrypted wallet involves multiple steps, which can be a barrier for new users, especially non-technical users.

Risk of mnemonic phrase loss or theft: Cryptocurrency wallets rely on mnemonic phrases for recovery, but if the mnemonic phrase is lost or stolen, it may result in the loss of all funds in the wallet.

Fragmentation of chains: Different chains require different wallets, increasing complexity and making it difficult for users to manage assets across chains.

Even experienced crypto users can lose funds due to vulnerabilities, as demonstrated by a recent wallet depletion incident revealed by @tayvano_.

To address these challenges, wallet developers are exploring new methods and technologies to create more user-friendly and secure digital wallets, making it easier for mainstream users to adopt.

Innovation of Account Abstraction ( "Why Now?" )

The emergence of account abstraction (AA) in the Ethereum network marks a significant advancement for Web3 wallets. AA introduces on-chain programmability through smart contracts, adding flexibility to Web3 wallets.

The key differences between EOA and smart contract accounts

Traditionally, only EOAs can control funds on the Ethereum network. This means that smart contracts must rely on EOAs to execute transactions, limiting the functional scope of smart contracts.

With AA, smart contracts can now directly control funds, becoming more powerful and versatile.

Why is ERC 4337 important today?

ERC 4337 is an important advancement that implements protocol-level AA without changing the consensus layer. ERC 4337 introduces several key features that enhance the usability and accessibility of Wallet 2.0:

Social Recovery: Wallet 2.0 can have multiple owners, allowing the use of social recovery to recover lost private keys.

Atomic Multi-Operations: Smart contracts can execute multiple transactions as a single atomic operation, simplifying complex transactions and ensuring integrity.

Use ERC20 tokens to pay transaction fees: Smart contracts can now use ERC20 tokens to pay transaction fees, providing more flexible payment options.

Paymaster: Wallet 2.0 allows third-party Paymasters to pay transaction fees on behalf of users, optimizing gas usage and improving efficiency.

These features make Wallet 2.0 easier to use and access, which is crucial for the popularization of Web3 wallets.

The Future of Wallet 2.0

The development of Web3 wallets is still in its early stages, and a lot of work is needed to become mainstream. Wallet 2.0 is the next phase of Web3 wallets, which requires the joint efforts of developers, entrepreneurs, and investors to achieve.

The development of ERC-4337 has led to the emergence of a new type of Wallet, which is expected to fundamentally change the way we store and manage digital assets.

Although Wallet 1.0 provided a good start, it still has limitations in terms of usability and login complexity. The future of Wallet 2.0 lies in addressing these limitations while introducing new features to improve functionality and security.

Some developers have started building Wallet 2.0. These wallets focus on usability, security, and interoperability, leveraging smart contracts to offer features like social recovery, atomic multi-operations, and gas fee sponsorship.

Some emerging Wallet 2.0s focusing on ERC-4337 include Castle, Soul Wallet, Candide, Unipass, Biconomy, Banana Wallet SDK, Stackup, and Etherspot.

5 Key Questions to Ask When Evaluating Wallet 2.0

As with any emerging technology, it is important to assess the potential risks and returns of Wallet 2.0. Here are five key questions to consider when evaluating Wallet 2.0 solutions:

1. Is this a great business?

A successful Wallet 2.0 solution must not only be useful to users but also have a sustainable business model. Developers must consider factors such as revenue sources, customer acquisition costs, and profitability. Additionally, they should assess the potential market size and competitive landscape to determine whether the business can expand and thrive in the long term.

The competition in the Wallet 2.0 space is fierce, and new solutions must offer compelling value propositions to succeed. Business models must be sustainable and have a clear path to profitability.

2. Can Wallet 2.0 create a problem-solving approach that is 10 times better than existing solutions?

Wallet 2.0 is expected to solve many issues of traditional wallets. For example, social recovery and atomic multi-operations can significantly improve existing solutions.

Social recovery offers a more secure and user-friendly way to recover private keys, while atomic multi-operations allow multiple transactions to be executed as a single transaction, saving users time and fees. These features provide advantages that traditional wallets cannot offer.

However, considering Peter Thiel's principle - a successful product must be at least ten times better than its competitors - is important. When assessing the potential of ERC-4337, businesses should evaluate whether the technology brings substantial improvements in productivity, creativity, or quality. The economic feasibility of implementing smart contract functionality should also be assessed to ensure that the benefits outweigh the associated costs.

3. How can enterprises establish sustainable competitive advantages, especially in the case of heavy reliance on first-mover advantages?

Social recovery and atomic multi-operations are likely key differentiators of Wallet 2.0, providing a first-mover advantage. However, the competition in the Wallet 2.0 space is fierce, and developers must establish a sustainable competitive advantage to succeed in the long term. This advantage can be based on technology, network effects, or branding.

Wallet developers must find a unique value proposition to differentiate themselves from competitors. There are two aspects that may form defensive barriers:

1. Unique and proprietary distribution channels: Having unique proprietary distribution channels can help startups stand out. It provides a unique way to reach a hard-to-replicate customer base, thus creating a unique advantage. This uniqueness can attract customers, making the startup distinguishable from similar products in the market.

2. Embedding viral spread into products: Embedding viral spread into products is not a matter of luck, but a result of careful design. Many top companies have a growth loop - a flywheel that accelerates over time. Amazon has a famous growth loop. What is yours?

4. Can enterprises find distribution channels and add smart contract features to existing products?

It is important for enterprises to leverage existing partnerships and relationships with current businesses to distribute Wallet 2.0 to a broader audience. This is especially crucial considering the current challenges in guiding users to Wallet 2.0.

A potential distribution channel for Wallet 2.0 is to collaborate with centralized exchanges, which currently hold a majority of user assets in the crypto ecosystem. By integrating Wallet 2.0 features into their platforms, exchanges can offer users enhanced security and self-custody options while maintaining control over their funds. This also helps exchanges stand out in the competition, attracting users who value self-custody and security. The key question is how to persuade exchanges to collaborate with you instead of building it themselves.

Another potential distribution channel is to collaborate with DeFi protocols to integrate Wallet 2.0 into the platform, providing users with greater control over their funds and transparency. This also helps