Blockchain network effects — you’ve probably never heard of them, and yet they’re super important for mooning or nuking your coins.
While the bull run was alive and kicking, a few hard questions were asked. VCs were happy to spray and pray investments across blockchains. But in the bear market, hard questions will be asked of the Bitcoin and Ethereum networks:
The utility comes from solving user problems. The more user problems a blockchain can solve, the more new users will flock to it. That is why we are looking at network effects today:
- What is a network effect and why does it matter?
- How do network effects apply to crypto?
- A case study of Bitcoin network effects.
- A case study of Ethereum network effects.
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What Are Network Effects and Why Are They Important?
Our trusted knowledge encyclopedia, Wikipedia, defines network effects as follows:
“The phenomenon by which the value or utility a user derives from a good or service depends on the number of users of compatible products.”
In plain English, this means: the more people use something, the (exponentially) more useful it becomes.
For instance, one person owning a phone is useless (they can't call anyone). Two people are better because they can call each other. Three people already yield two potential persons to call and three connections in total. And so on.
Network effects determine the success of new technology. The more people use a phone (or a social network or crypto), the more useful it becomes. A subset of network effects is Metcalfe's law which quantifies the network effect of communication technologies like the internet or social media.
We can distinguish between one-sided and two-sided networks and between direct and indirect network effects.
A one-sided network would be the telephone. Each user uses the technology with the same goal: to communicate with someone. The exponential growth of connections in a one-sided network can be seen below:
Source: https://www.lynalden.com/bitcoins-network-effect/
A two-sided network would be a marketplace like Amazon, Uber, etc. It connects supply (vendors or drivers) with demand (buyers). It also grows exponentially:
Direct network effects directly result from network growth, i.e., more phone owners resulting in more people being easy to reach. Indirect network effects happen when at least one group benefits from the growth of another group. For instance, the more credit card operators there are, the more competitive the market and the lower credit card fees are. Credit card users benefit from both frictionless payments and low (or zero) costs.
Finally, to determine the strength of a network effect, we have to look at the problem the technology solves and the market it addresses. For example:
- Telephones
- Problem solved: direct and fast communication
- Market addressed: everyone between the age of 3 and 100.
- Credit cards
- Problem solved: instant payments
- Market addressed: everyone between the age of 18 and 100.
- Social networks
- Problem solved: online socialization (debatable, of course)
- Market addressed: initially people between 14 and 34, now nearly everyone.
New technology usually starts in a niche market and propagates to other markets if it is accepted. For example, social networks like Facebook initially appealed to a tiny niche (campus students at Harvard) and eventually propagated to virtually anyone.
A Case Study of Bitcoin Network Effects
Let's assume that we could hypothetically give each person a Bitcoin address. Would that mean that we have reached the maximum network effect for Bitcoin and thus hyperbitcoinization?
Not necessarily. The answer to "Is Bitcoin money?" is a yes, but Bitcoin still lacks enforced demand like fiat currencies have through taxes. However, if everyone had a Bitcoin address, network effects would obviously grow.
If we look at current trends for the network, we can observe some interesting trends. The number of Bitcoin addresses with smaller balances is growing. Here are the Bitcoin addresses with at least 0.01 BTC and at least 0.1 BTC:
However, the number of Bitcoin addresses with big balances is shrinking. Here are the Bitcoin addresses with at least 10 BTC and at least 100 BTC:
Bitcoin is becoming more common among smaller wallets but less popular for storing value. That is at least true for non-custodial storage, since these bigger balances may hold coins at exchanges or in derivatives.
If we look at the number of transactions, we can see that growth is stalling:
The number of transactions and the total size of transactions have gone mostly sideways since the 2017 bull run. Thus, Bitcoin's network effects as a payment network and store of value are currently stalling.
This could be due to several factors. For instance, Bitcoin's volatility may lead investors to the conclusion that it is not such a good store of value after all. Alternatively, they may be holding custodial coins or Bitcoin-related products like Grayscale BTC. On the payments side, the network can only process 120 million transactions per year. Large-scale network effects will only be possible with scaling solutions like the Lightning Network.
However, to determine the strength of Bitcoin's network effect, we need to look at its total addressable market. In other words:
- What is the maximum amount of wealth looking to be stored in BTC?
- How many people want decentralized P2P payments?
The answers to these questions determine how big Bitcoin's market capitalization can become.
Yet, becoming a store of value is an indirect network effect. If enough capital is allocated to Bitcoin and/or enough transactions are processed, its market capitalization will grow.
However, direct network effects would come from increased adoption. Adoption is difficult to quantify since we cannot distinguish how much real economic activity (not speculation-related) happens on the network. For increased network effects, Bitcoin needs more top-down adoption (acceptance as a means of payment) and bottom-up adoption (a desire to pay in Bitcoin).
A true network effect is unlikely to happen before Bitcoin does not separate its base layer use case (store of value) from its L2 use case (P2P payments).
This is because users that want to hoard coins (SoV use case) will not want to transfer their coins (payments use case). At best, they would use the Bitcoin network as a settlement layer to transfer non-BTC-denominated values.
TLDR:
- The number of Bitcoin wallets with a small balance (<1 BTC) is increasing, and the number of wallets with a bigger balance (>10 BTC) is decreasing.
- The more storage of wealth in BTC and the bigger the demand for decentralized P2P payments, the bigger the potential network effect.
- Bitcoin will need to separate its base layer use case (SoV) from its P2P payments use case (L2).
A Case Study of Ethereum Network Effects
Ethereum operates more as a two-sided network and is thus more comparable to an operating system like iOS or Windows. Its main value pitch is "a decentralized world computer."
However, Ethereum suffers from a problem.
Since decentralization is a key part of its value pitch, the number of nodes is essential to the network (since more nodes mean a more decentralized network). But the marginal value of each additional node decreases since the 10,000th node is not as important as the 10th. In other words, it doesn't matter all that much whether there are 10 nodes or 10,000.
However, being a node is lucrative and has become even more lucrative after the Merge, now that ETH can easily be staked for yield. But the more ETH is staked, the less ETH there is for network usage. This could result in more expensive ETH (see: the ETH Merge Trade) and higher gas fees. But higher gas fees make the network less attractive to use.
In other words, Ethereum paradoxically suffers from negative network effects because more demand for blockspace results in higher gas fees and slows down the network.
However, there are also positive network effects. For example, successful scaling of Ethereum itself and via L2s like Arbitrum, Optimism, zkSync and Starkware would make the ecosystem more appealing to use. This would be a positive direct network effect, although it would have a negative indirect effect of reducing gas fees on the mainnet and thus burning less ETH.
Furthermore, increased composability would be another direct positive network effect. The more decentralized applications exist for Ethereum, and the more interconnected they are, the more appealing the ecosystem is to use.
Unfortunately, Ethereum suffers from two additional problems. First, although it has a couple of experimental use cases like DeFi and decentralized gaming, it still lacks clearly defined non-speculative utility. Arguably, the point of most DeFi apps is "make more money from money" rather than providing a real alternative to existing financial services. Similarly, many play-to-earn games like Axie, in fact, suffer from negative network effects since too many players drive up the price of in-game assets and slow down the blockchain.
Ethereum's core "product" is decentralized blockspace, and its main strength is a talented and innovative developer community. Thus, there are many potential use cases of Ethereum, but most of them are experimental and still very limited by technology.
The size of the total addressable market for Ethereum's value pitch remains unclear. A classic operating system, like Windows, addresses every computer user, setting a high benchmark for Ethereum. Still, it is uncertain how many users want to put up with technologically inferior products for the sake of decentralization.
TLDR:
- Ethereum is liable to negative network effects: more blockspace demand clogs the network and increases gas fees.
- Scaling can increase Ethereum’s direct network effects.
- Ethereum’s real-world utility so far is experimental and limited by technological bottlenecks.
- A more tangible value pitch would allow us to define Ethereum’s total addressable market and its potential network effect more precisely.
Conclusion
Network effects will be a key factor in a potential future bull run. Switching costs for users are low - it's easy to use other L1s instead of Ethereum, But how well-built a network is in terms of composability and scaling will directly influence the number of users a blockchain has.
The bear market is the perfect time for blockchains to zero in on the actual problems they are trying to solve.
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