Exploring Network Effects in Cryptoassets

Network effects are often referred to as one of the main factors that facilitated Big Tech to become so, well… big. For example, you might have heard how Google’s search algorithm gets better after every user query, or that the value of social media networks like Instagram grows the more users that it brings on. Both of these perfectly encompass the idea of network effects, whereby the value of a network increases the more users it has.

Recently, the topic of network effects has been brought to the attention of many in the crypto-space with Mike Novogratz, the CEO of cryptocurrency investment firm Galaxy Digital, stated:

“One of the powerful things for the Ethereum narrative is valuing the Ethereum network kind of like we do Facebook the more network effects you get… and so you look at DeFi (decentralized finance) and stablecoins just that alone bringing more prominence and network effects to Ethereum”.

While it is undeniable that network effects have enabled tech companies to become some of the most valuable ever seen, does it make sense to apply them to cryptoassets in the same way?

So far, there have been few studies analyzing the relationship between the value of cryptoassets and the number of users it has. By looking at Metcalfe’s Law, which states that the value of a network is proportional to the square of the number of its active users, we can compare the network effects seen in Bitcoin versus other traditional networks. Metcalfe’s Law was originally created in the context of Ethernet connections invented by Bob Metcalfe, but has been validated in more modern networks like Tencent, the parent company of WeChat.

In a paper from the Swiss Finance Institute, Metcalfe’s Law is attempted to be applied for the Bitcoin blockchain but found that rather than obtaining Metcalfe’s original exponent of two, Bitcoin’s value appeared to be proportional to an exponent of 1.69 of the number of its users (Wheatly et al, 2018). In other words, while Metcalfe’s Law traditionally refers to the value of a network being proportional to the squared number of users, Bitcoin’s value appears to be proportional to its number of users to the power of 1.69. One key difference is that the original law assumes full connectivity between all users, which according to authors of the paper, is not realistic for a more sparsely connected network like Bitcoin’s and thus the lower exponent.

Another major distinction between network effects in traditional technology companies and blockchains lies on the definition of a user. Whereas Facebook can easily identify their number of users, it is much harder (if not impossible) to do so for blockchains due to their pseudonymous nature. By relying on digital keys instead of identities we are unable to properly identify users.

So what else can we use instead? Well in order to use cryptocurrency you need an address. The caveat, though, is that users can have more than one address, and if they store their crypto on a centralized exchange, the tokens are likely to be held in an address shared with multiple other users. While the first limitation could lead to overstating the number of users, the second implies that the user count may be understated. Despite these limitations, the number of addresses is at this moment the best approximation to user counts for cryptonetworks. Leveraging IntoTheBlock’s blockchain data we can better understand the relationship between addresses and the market capitalization of top cryptoassets.

Bitcoin’s Network Effects

Let’s have a look at the growth of total addresses in Bitcoin over time. The total number of addresses created has grown constantly over time, approaching 700 million. However, the vast majority of these addresses have a balance of zero Bitcoin as can be seen in the graph below:

Being used mainly as a store of value or medium of exchange, the Bitcoin network clearly does not derive nearly as much (if any) value from addresses without a positive balance. Those who see Bitcoin as a store of value are presumed to hold Bitcoin expecting it to retain its worth relative to fiat currencies, while those who use it as a medium of exchange derive value from transacting in Bitcoin to purchase, sell or trade goods and services. In both cases value is accrued by the network by its participants holding Bitcoin. Therefore, total addresses with a balance can offer a better approximation to the network effects of Bitcoin.

With over 30 million addresses with a balance, Bitcoin currently has more addresses holding a positive amount than at the peak of the 2017 bubble. By simply overseeing the trend of total addresses with a balance we can see the resemblance with Bitcoin’s price movement. Remember, however, that Metcalfe’s Law considers the value of a network relative to its active users. So how many of these addresses are actually using the Bitcoin network actively?

Roughly a million daily active addresses have been using the Bitcoin network on average for the last week. As can be seen from the graph above, the number of daily active addresses exhibits a correlation with the price of Bitcoin, reaching local highs in December 2017 and June 2019 in tandem with Bitcoin’s price action. Furthermore, based on the generalization of Metcalfe’s Law to Bitcoin, one can attempt to determine when Bitcoin’s price is overvalued or undervalued relative to its amount of daily active addresses.

Put in another perspective, the ratio of active addresses relative to total addresses with a balance can also help plot the relationship between Bitcoin’s valuation and its active participants. While there is a general downtrend in the active address ratio (due to high increase in total addresses with a balance), there tends to be spikes in relative activity as price approaches a high.

Now let’s have a look at the relationship between the users of the Ethereum network and its value.

Ethereum’s Network Effects

In contrast to Bitcoin, total addresses with a balance did not drop following the 2017 bubble burst. Instead, Ethereum addresses with a balance have managed to continue increasing, surpassing even the amount for Bitcoin as seen in the image below:

While total addresses with a balance for Ethereum surpassed that of Bitcoin, less addresses are active on a daily basis, around 380,000 per day for the last week on average compared to a million for Bitcoin. It is important to note, though, that the number of active Bitcoin addresses is currently at a year-to-date high likely because of the anticipated halving event occurring a few days ago. This did not have a noticeable effect on the number of daily active addresses of Ethereum. Overall though, similar patterns arise in Ethereum’s daily active addresses to those seen in Bitcoin.

The number of daily active addresses of the Ethereum network tends to be closely related to Ether’s price. This makes sense as users of Ether can derive more value out of Ethereum if there are more users or applications using it. As a smart contract platform, Ethereum’s role as the infrastructure for a decentralized ecosystem has the potential to further amplify these network effects as more developers working on improving Ethereum’s base layer leads to more projects or decentralized applications building on top of it, attracting more end users and in turn bringing more protocol developers; thus creating a network effects cycle similar to those seen in Big Tech.

While it is still early for cryptonetworks, there is an emerging relationship between active users and network value despite the rampant amount of speculation in the industry. I expect there to be an even stronger relationship between their users and valuations as more organic demand can stem out of the network effects in place for successful cryptonetworks. Perhaps then it wouldn’t be so far-fetched to start valuing them in the same way as Facebook.