If you’ve spent anytime in the cryptocurrency sphere you have probably come across a notion called network effect. Most commonly this is attributed to Bitcoin — in particular, it is given as a reason for its continued success as the cryptocurrency standing taller over all others.
In this article I will articulate exactly what a network effect is, why it is important and how most projects have failed because of it, or more precisely, because of not having it.
Network affect is a phenomena that assumes the basic notion whereby a product or service gains additional value as more people use it. More accurately, if we take a network with number of nodes N, then each node on that network can engage with every other node on that network making N-1 connections. If, then, N nodes can make N-1 connections, then the net number of connections in the network would be equal to N(N-1). Thus the network’s value grows with the number of possible connections, in the order of N squared. This insight is the basis of Metcalfe’s law that states that the value of a network is proportional to the square of the number of members within the network.
This insight is extremely powerful when our objective is to build robust and functional networks just like many crypto projects are trying to achieve. Metcalfe’s law realises the abstracted value of having a large user base in which value V doesn’t map proportionally to N; linear growth of N results in an exponential growth of V in V=N².
So how does this apply to crypto?
I will explain how this applies to crypto by first giving 7 distinct examples of Bitcoin’s network effects to further demonstrate its importance and then explain how the absence of said effect leaves smaller capitalised coins at a considerable disadvantage and thus more vulnerable to failure.
Bitcoin, being the largest cryptocurrency with 45% dominance as of writing, has the biggest network effect. The 7 effects are interlaced and therefore entrenched within one another in a self-reinforcing, compounded effect. These effects can be characterised as follows:
- Speculation around bitcoin causes infrastructure to be developed to meet the speculators demands. Items like hardware wallets and exchanges as well as user friendly wallet software and educational material will all reduce ingress and egress friction points and further accelerate the mean rate of adoption over time. (Interestingly, adoption is often a non-linear function with respect to time and follows an ‘S-curve’ of adoption’.)
- Merchants are a second order network effect in which they accept Bitcoin because of the increasing speculator demand. Bitpay is one solution that has integrated large scale retailers like Microsoft and Shopify, directly increasing the number of application and therefore utility of Bitcoin.
- Consumers are the third order network effect. Consumers begin using bitcoin because merchants accept it. One example of this is purse.io, they allows consumers to save 15% on their amazon orders simply for purchasing with Bitcoin.
- Miners contribute an unfathomable amount of computational power to secure the bitcoin blockchain. By this measure it is hard to see another blockchain being as secure as Bitcoin’s for this exact reason.
- Software developers are incentivised to develop on top of Bitcoin because it is the most secure and has the biggest user base. This in turn brings more applications and utility into the Bitcoin ecosystem.
- Financialisation of Bitcoin happens as more regulated financial instruments are created such as the recent CME and CBOE Bitcoin futures.
- World reserve currency is the last layer on Bitcoin’s stack of network effects and is therefore can only be theoretical in nature and yet to be realised. The more bitcoin is socially accepted as a world reserve currency i.e. the less people have to ‘cash out’ or ‘settle’ into Dollars, Euro etc when moving value, the greater the need and confidence in Bitcoin becomes.
Now take a new, bootstrapped, cryptocurrency project that is trying to compete with Bitcoin, more accurately, Bitcoin’s network effect. They have to incentivise speculators, merchants, consumers, miners, developers and financiers to use their new cryptocurrency by offering them greater utility. It is not enough to even offer equal or marginally greater utility because stakeholders will still prefer to avoid the time and cost it would take to transfer over to the new cryptocurrency than benefit form the marginally better quality service it provides.
This is not to say that no other cryptocurrency has a chance of competing with Bitcoin because they evidently can; one only needs to look at coinmarketcap to realise this. There are 2 ways this has been demonstrated to be possible: vertical innovation and horizontal innovation.
Let’s first take a look at vertical innovation. In traditional business management theory, it states a company can achieve its objectives (i.e. higher sales revenue, increased market dominance, greater brand awareness etc.) by improving the quality of its product. If we ignore the politics around Bitcoin’s future for a second and take the simplified presupposition that Bitcoin’s value proposition is as a peer-to-peer, decentralised and global digital currency network, then a cryptocurrency that wants to compete with this will have to undergo vertical innovation. This is where the currency has the same intended use case but goes about achieving it in a more efficient/favourable way. By nature of being ‘open-source’ anyone can and have already attempted this. Dash, Litecoin and Bitcoin Cash are three notable examples of this; their communities believe they will prevail as the cryptocurrency for global payments, but ultimately only the open market can decide this over time. So far the market has valued all 3 of their currencies combined 1/5th that of Bitcoin.
We have seen horizontal innovation to be far more common in crypto for many reasons, notably, it just makes more logical sense! It turns out that competing with the most secure, most global and most heavily resourced (both intellectually and financially) digital currency network in the world is difficult. It is much easier to compete where bitcoin is not and monopolise a niche by offering a different value proposition. Ethereum offered a virtual machine and bespoke programming language, Solidity, to build decentralised and ‘secure’ applications, IOTA offers free and instant transactions for the futures IOT connected devices to facilitate micro-transactions, Monero enables privacy and fungibility by adding an extra layer of cryptography like ring signatures to obfuscate its ledger. All these projects have been successful in their attempts so far but will all need continued development to further increase scalability and adoption beyond current speculation as we move into the future. How many of these coins will need to coexist is still yet to be determined, and how many will have flown to close to Bitcoin’s sun and get their wing’s burnt by Bitcoin’s innovation (i.e. think Schnorr sig’s and Lightning network improving fungibility and micro-payments) is also an unknown.
What does this all mean?
It means that there are 4,500 cryptocurrencies currently in existence, only 1,500 of these are tradable on exchanges, and the rest are only trapping value. It means that in an open source, highly competitive and merit based market like cryptocurrencies the majority of projects will turn to the graveyard because the ‘innovative minority’ will always steal users form their smaller counterparts. It means that projects like CoinJanitor will be necessary to restore trapped value from dead or failed coins back into the cryptoeconomy to promote further growth, innovation and ultimately…network effect. CoinJanitor will actually gain its own network effect as it absorbs and amalgamates dead coins from the community as well. By absorbing the networks of smaller, under-utilised cryptocurrencies, CoinJanitor’s potency will compound enabling even larger scale value release back into the cryptocurrency communities. This is a very exciting concept for us!
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