DeFi Technologies | Your Gateway to Decentralized Finance ...

Network Effects and Cryptocurrencies - Explained

January 07, 2022

Network Effects and Cryptocurrencies - Explained

Ever wondered why Facebook is still relevant today, but many other social media platforms have fizzled out? Or perhaps, why is Apple making waves with each new iPhone release yet some phone companies struggle with sales despite being market leaders? The answer is not far-fetched, as everything could be explained with the concept of “Network Effect.” 

Network effect refers to a situation where a product becomes more valuable with each added person using it. It leverages human capital to provide more utility. Let's take the internet as an example. In its early days, it was only relevant for the military and a few early birds. As more people started to use the services provided by the internet, it became more important in our everyday lives. Nowadays, it has gotten to the point that almost everything in our lives can be improved with the internet. 

The network effect is seen in all spheres of life, cryptocurrencies included. Ever since their inception in 2009, cryptocurrencies are paving the way towards decentralized finance. This article will attempt to show the influence of the network effect on the cryptocurrency space. 

Network Effects and Cryptocurrency

The success or failure of any given cryptocurrency hinges on the network effect it creates. The growth and sustainability of a project depend on its ability to retain existing users while getting a consistent flow of new ones irrespective of other projects coming up and promising better value propositions. 

What was the worth of one bitcoin when the first BTC transfer was made? Quite a bit lower than its current price, that’s for sure. As more people began to accept Bitcoin as a valid means of payment or used it as a store of value, the price began to increase. We have seen over 10,000 new cryptocurrencies released so far, but Bitcoin remains at the top. One of the main reasons for that is none other than the network effect it has created over the years. 

However, network effects can also have their demerits. For instance, we’ve recently seen Ethereum fees skyrocketing due to an increased demand for the token. While the increase in demand is certainly a positive thing, the underlying network effect surely contributed to exposing the limits of this technology. We probably won't see a cryptocurrency that is not reliant on network effects. 

Types of Network Effects

Network effects can be categorized broadly into two groups. 

  • Direct Network Effects

  • Indirect Network Effects 

A direct network effect is a measurable, quantifiable result of a network. An increase in users would mean additional value to the project. For instance, as more users accept a crypto token, its value increases. 

The indirect network effect refers to the spiral, extending the effect of having a network effect. A good example of this is the Internet. The internet would never have been possible without devices that supported its usage. In this case, the network effect of these devices also becomes the network effect of the internet itself.

Pros & Cons of Network Effects in Cryptocurrencies

Pros

  • The more people join a network, the more autonomous it becomes. Popular cryptocurrencies can act as means of payment, or can easily be exchanged for fiat currency. Several years ago, this was an arduous task as numerous intermediaries had to intervene in this process. 

  • Another important benefit of the network effect is that creators of intellectual properties can pursue other projects and gain leverage with trust acquired from users of the existing service. Imagine if Vitalik Buterin, founder of Ethereum, came up with a new cryptocurrency project. Do you think he would have to go through the building and acceptance phase of Ethereum all over again? We certainly doubt it. 

  • Though many believe the DeFi space is largely crude, network effects still play a crucial role in it. A smart contract with a high TVL (total value locked) and users would be difficult to topple down by other projects. This makes the sunk cost for projects worthwhile. 

Cons

  • Cryptocurrencies of today still haven’t found a way to increase their throughput without making sacrifices elsewhere (decentralization and security). Most networks cannot handle excessive demand for their tokens. A recent example of this is the SOLANA project that crashed after it experienced a surge for validation of over 4,000 transactions per second. It took hours before normalcy was restored. 

Ethereum would be another good example - with its throughput of only 13 transactions per second, the second-largest cryptocurrency by market cap has faced its share of transaction bottlenecking. 

  • The very disappointing truth about numerous crypto projects is that most of them plateau rather too early. When a company rapidly gains a large market share, they often get overwhelmed and forget to keep innovating. Even if that is not the case, they still have to pay attention to current users, especially in the cryptocurrency sector. 

One great example of this is the implementation of Ethereum 2.0. In this case, the team behind Ethereum has to be very careful, as one small bug can cause major losses for its current customer base. This is, therefore, drastically slowing down the innovation process.

Conclusion

Unknowingly, we are a part of many network effects. None of the services like the internet, social media platforms, and blockchain technology would have existed if not for this concept. It would certainly do new cryptocurrency projects more good than harm to strategize on including network effects into launching, distribution, and self-sustainability. What are your thoughts on network effects? Let us know!

DeFi Technologies | Your Gateway to Decentralized Finance ...
© 2021 DeFi Technologies, Inc. All Rights Reserved
LinkedINTElegramoutubeTwitter