Blockchain: Token Network Effect, a concept worth exploring

Thanks to all the researchers who has given us gift of internet, which was created as open platforms that anyone — users, developers, organizations — could access equally. In this era of open network, open platform & decentralized cryptocurrencies (interchangeably used for Token), it is essential to understand how network effect could shape up the industry. Also, knowing how network growth is tied with token’s value appreciation helps stakeholders identify potential network, grow network ecosystem, helps investors strategies allocation of their funds, and hence accelerates overall network effects.

Let’s quickly go through each of these key terms viz Token and Network effect, and then will explore how Token Network Effect has potential to build the entire ecosystem within short span of time resulting in rewards for all stakeholders.

What is a Token?

Key token icons

For the purpose of this article, let’s understand cryptocurrency / token at relatively high level. Blockchain technology enables (digital) token, more commonly called as cryptocurrency, that exist conceptually as entries on a distributed ledger. Here, tokens are indicating inclusive for all types — tokens native to a blockchain platform and tokens used to access underlying application or platform. Some quick examples around these scenarios include Bitcoin, Ethereum, FileCoin and many more.

A new way to design open networks has arose from the cryptocurrency movement that began with the introduction of Bitcoin in 2008. Tokens are given to “miners” (which are the computers on the decentralized network) usually as part of an incentive scheme to encourage miners to help validate transactions and make sure network is up and running. Token revolution accelerated with the introduction of Ethereum in 2014.

What is Network effect?

As per Wikipedia, a network effect (also called network externality or demand-side economies of scale) is the positive effect described in economics and business that an additional user of a good or service has on the value of that product to others. When a network effect is present, the value of a product or service increases according to the number of others using it.

In other words, it’s a concept or phenomenon whereby a product or service gains additional value as more people use it, increasing the prospects of user retention.

Figure: Network effect example for Mobile

There are many real-life examples to explain network effects in non-technical term. Take mobile phone for example. When a user decides to buys a phone, their decision is based on few points such as: How many people within their network uses mobile, number and type of apps that can be used through the mobile, ease of operating the mobile, etc. A greater number of users increases the value to each participant. Also, network effect would improve when product increases in value. Online social networks work similarly, with sites like Twitter and Facebook increasing in value to each member as more users join. Many other examples could also be co-related to this concept such as ebay, online gaming, Microsoft office software, etc

Network effects become significant after a certain subscription percentage has been achieved, called critical mass. As the value of the good is determined by the user base, this implies that after a certain number of people have subscribed to the service or purchased the good, additional people will subscribe to the service or purchase the good due to the value exceeding the price.

However, a key business concern is how to attract users prior to reaching critical mass. One way is to rely on extrinsic motivation, such as a payment, a fee waiver, or a request for friends to sign up. A more natural strategy is to build a system that has enough value without network effects, at least to early adopters. Then, as the number of users increases, the system becomes even more valuable and is able to attract a wider user base.

Beyond critical mass, the increasing number of subscribers generally cannot continue indefinitely. After a certain point, most networks become either congested or saturated, stopping future uptake. Congestion occurs due to overuse. The analogy could be applied to a Bitcoin network as well.

Now let’s apply our Network Effort understanding to Tokens.

Token Network Effects

“Token networks align network participants to work together toward a common goal — the growth of the network and the appreciation of the token.” — Chris Dixon

These cryptographic tokens enable distributed internet hubs to emerge. It innovates a new way to develop open networks, disrupt classic top-down governance structures with decentralized autonomous organizations (DAOs). A well-designed token network carefully manages the distribution of tokens across all participants in the network to maximize the growth of the network.

Token Network Effect Cycle

In a decentralized cryptocurrency based platform, peers in the network directly exchange the coin / tokens. The users and participants in the platform therefore control funds. The token increases in value as the success and utility of the project increases. As long as everyone in the environment believes there is value in token, it’ll be difficult for the token to drop to zero. This relationship increases the value of the token as demand for the token exceeds the limited supply and drives up the price of the token. I am sure many of us could co-relate this to Bitcoin growth story, where global instantaneous P2P payment system was enabled and hence attracted critical mass to gain network effect.

Adding on from investor point of view — for a flourishing project, it becomes an attractive investment for investors. Current investors also hold onto their tokens anticipating future price increases. New investors drive up the demand for the token, which drives up the price of the token. This way Token Network Effect makes the network stronger and rewarding for all stakeholders.

However, we should also understand the chicken and egg problem for network effect — “How to build a base of customers/believers in spite of having no product but just an innovative world changing idea?” This could require initial funding to bring certain number of users and build a platform with some maturity. For traditional network, Angels / VCs used to be common source of “bootstrap funding” that would be required to build team, product development and marketing. Thankfully, blockchain offered a ground-breaking way to initially fund for its own innovation and build network through Token Generation (or commonly called as Initial Coin Offering). Using platform like Ethereum, NEO and others, a new wave of token networks were inspired. Through DAO, tokens now allow projects to work with millions of dealers, thousands of developers, and hundreds of entrepreneurs and build strong network. Something that was previously only saved for big companies with billions of dollars can now be decentralized.

Figure: Tokens help overcome the bootstrap problem by adding financial utility when application utility is low. Credit: Chris Dixon Medium

Let’s us summarize Token Network Effect concept from another dimension with the example of Dash, where project took an innovative approach to build its network. As mentioned in the one of the article from “Michael Karnjanaprakorn” — In the early days of Dash, the ecosystem still needed infrastructure: mobile wallets, exchange adoption, etc to spur adoption. Dash decided to redirect a portion of the mining rewards to a fund. Users could then propose projects to the fund and then token holders in the masternode network would vote on them. Dash created a VC fund out of thin air and called it a decentralized governance by blockchain. It’s now starting to be adopted by other projects and protocols. Today, that fund is now over $750K per month supporting projects that build out the Dash ecosystem. Similar approach of VC fund creation is now taken up by many leading blockchain platforms to develop their networks, example includes EOS, Wanchain and many others.

However, Network Effect not necessarily solve the Token Adoption Problem always. If the product / platform is not sticky or it is not solving real problem, the network effort will not be able to sustain for long and its stakeholders will be eroded overtime from the network.

Benefits of Token Network:

1. Token network remove this friction by aligning network participants to work together toward a common goal — the growth of the network and the appreciation of the token. This alignment is one of the main reasons Bitcoin continues to defy skeptics and flourish

2. Well-designed token networks include an efficient mechanism to incentivize network participants to overcome the bootstrap problem that bedevils traditional network development

3. Token network could be configured for token distribution across all types of network participants such as its end-users, core developers (in-house or community), investors or contributor and partners to maximize the growth of the network

4. Token development could provide combined benefits:

a. Societal benefits of open protocols

b. Financial and architectural benefits of proprietary networks

Crypto tokens are currently niche and controversial. If present network effect trends continue, they will soon be seen as a breakthrough in the design and development of open networks.

Disclaimer: Views expressed in this article are in my individual capacity and do not represent the opinions of any entity whatsoever with which I have been affiliated.

References:

https://hbr.org/2018/06/why-network-effects-matter-less-than-they-used-to

https://medium.freecodecamp.org/token-network-effects-a-new-business-model-for-a-decentralized-web-6cde8b4e862

https://medium.com/@cdixon/crypto-tokens-a-breakthrough-in-open-network-design-e600975be2ef

https://medium.com/coinmonks/blockchain-token-adoption-problem-why-the-network-effect-is-not-enough-4aacc0f32973

https://medium.com/coinmonks/on-network-effects-in-blockchain-based-systems-164aee24de2a