A network effect is an attribute of a company or other system such that as more people use the network, the network becomes exponentially more.
Table of contents
- Metcalfe’s Law, Network Effects and Numbers - the Economic Network Called Bitcoin
- The Importance of Network Effects
- Analyzing Bitcoin’s Network Effect
As an economic network, Bitcoin exhibits network effects, both positive and negative. Network effects are observable in many other networks, such as telephones, fax machines, social media, PC operating systems and airlines. In this blog I explore these network effects in Bitcoin from an economic perspective. Many are positive, and extremely powerful, but there is also one negative network effect that is a big challenge.
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The numbers of merchants and consumers using Bitcoin may be small at the moment, but the more merchants there are accepting Bitcoin, the more consumers are likely to pay with Bitcoin; and the more consumers use Bitcoin, the more likely merchants are to accept it. This is called a cross-side network effect and it is a positive one.
There are also same-sided network effects, for example the more investors there are, the more likely the price of bitcoins to go up, and the more it goes up, the more investors are drawn in. The effect can be both positive and negative, as price drops can cause investors to leave. There is a similar same-sided network effect for speculators.
The enabler participants are dependent on the user participants for positive cross-side network effects. The more the Bitcoin network is used, the more incentives there are for exchanges to set up to enable buying and selling bitcoins , for developers to build apps and platforms such as wallets or micropayment mechanisms, and for miners to compete for block rewards and transaction fees. The miners are worthy of closer examination, as they underpin the whole Bitcoin network and make it work. Specifically, they compete with each other to create the blocks where bitcoin transactions are stored and they validate transactions through a proof-of-work consensus mechanism.
This immutability makes Bitcoin what it is: transactions cannot be duplicated, there can be no double-spend of bitcoins, the network can be trusted, and because it can be trusted, it is used more and more. Miners make this happen because they get rewarded in bitcoins for their efforts, and bitcoins have value, so miners generate revenue. The more the network is used, the more valuable bitcoins become, so the more money miners make, the more they compete, and the more they compete, the stronger the immutability and trust of the network becomes.
Metcalfe’s Law, Network Effects and Numbers - the Economic Network Called Bitcoin
As you can see, there are various sets of self-reinforcing dynamics in the Bitcoin network that interact and make it stronger and more valuable the more it used. In the following section, I look at the mathematics of these dynamics and specifically at the economics of:.
In the Bitcoin network there are millions of wallets that people have downloaded to transact in bitcoin, but in this analysis, I have chosen to use the daily number of unique Bitcoin addresses. Currently there are about , unique addresses used each day, a figure that has approximately doubled over the past year. Taking the daily figures for the past year June — May , a scatter diagram of the Bitcoin market capitalisation number of bitcoins x market price versus the square of the unique addresses, does show a rough correlation between the two — applying a rather heroic least-squares fit to these points gives a formula:.
The Importance of Network Effects
Please do not use this formula or rely on it to make any buying, selling or other decisions, it is empirical, based on only 12 months of daily data, unproven and will be different, perhaps very different, for the next 12 months of data to come. I only highlight it here to make three observations:. This illustrates the power of positive network effects when more people join and use the network. However, the number of unique addresses then was only , Miners get paid block rewards and transaction fees. A new block is created roughly every 10 minutes, and the miner winning the race to create a block gets 25 bitcoins at the moment.
The reward halves every four years, with the next halving date being in July this year. After this date, miners will receive only Additionally, miners receive transaction fees — these are set by the sender of a transaction, and can range from 0, in which case miners may ignore the transaction and never confirm it in a block to bitcoins in a recent case in April where it is assumed the sender made a spectacular error, perhaps transposing the fee with the principal.
However, the transaction fee over the past 12 months has averaged 0. Obviously, as the block rewards halve every four years, miners over time need to become less reliant on block rewards and more reliant on transaction fees. This means it is in their interest for the network to grow in use — the more transactions, the more fees and the more valuable the network which helps compensate for the fewer block rewards.
This again shows the positive network effects and incentives in the Bitcoin network. I expect that the economics of mining will change significantly as the source of revenue shifts from block rewards to transaction fees, and will be very different in the future — in particular, if Bitcoin transactions do rise to the billions per year, I would expect transaction fees to be a lot lower than 7 US cents per transaction. This limit is already close to being reached — the miners may need the capacity to process 7bn transactions per year, or TPS, but even if they have it, they are constrained by the 7 TPS of the current Bitcoin network.
There is a massive gap between required and actual network capacity, and congestion is already occurring. Congestion is an example of a negative network effect and can significantly impact the economics and use of a network anyone taking a taxi in central London nowadays during the day can get first-hand experience of this network effect — slow, frustrating, expensive, regrettable.
Increasing the fee for a bitcoin transaction is not really an answer. Wallets are starting to calculate fees dynamically based on transaction size — this is probably improving confirmation and block efficiency, but it does not solve the congestion problem. Given that crypto protocols might maximize for different functionalities, different networks effects will most likely arise. While the current market cap of Ethereum seems to indicate that it has similar strong networks effects than bitcoin, some trends are suggesting a different dynamic for utility protocols.
In the case of smart contract platforms, for example, the trend towards frictionless interchain interoperability might minimize the network effects of such platforms. While proponents of Ethereum often argue that developers and users are locked into the network as it enables the development of smart contracts, distributed apps Dapps , or decentralized autonomous organizations DAOs , interoperability between chains will most likely substantially lower switching costs to other networks or blockchains.
In other words, users will most likely not interact with the blockchain itself, but with front end tools that enable transactions and operations on multiple chains. Ultimately, protocol-native tokens might no longer be relevant as they can be transferred across different chains via smart contracts, or interoperable networks.
The frictionless and interoperable nature of multiple protocols, in turn, might substantially lower the value of the network. In contrast, the network effects of a store of value protocol are driven by a different dynamic. Whereas applications built on utility networks will most likely be indifferent about the underlying protocol, and users will be able to switch frictionless between chains, a non-sovereign store of value protocol will exhibit strong network effects.
If we compare bitcoin to gold, then it is evident that the total addressable market for store of value protocols is orders of magnitude larger and more valuable than the one for smart contract platforms, or other utility protocols. Comparing the market of a dominant non-sovereign store of value protocol to the total value of gold bullion and foreign reserves suggests a potential valuation in the range of 4. The concept of reflexivity, which is used in finance, captures the self-reinforcing feedback loop between investor expectations and price. In other words, the more bitcoin is used, the more liquid it becomes.
Analyzing Bitcoin’s Network Effect
As the comparison with gold shows, there will most likely only one store of value protocol. Furthermore, a store of value protocol will also exhibit strong path dependency.
However, it is often argued that bitcoin can be overtaken by a more a technically advanced altcoin that exhibits increased functionality. This view is based on the analogy of bitcoin and tech companies, which often get disrupted from late movers. This analogy, however, misrepresents the nature of bitcoin. Instead, bitcoin has to be compared to the Internet.