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Bitcoin and the Network Effect

Bitcoin and the Network Effect

Explainers Cryptocurrencies

10 Apr 2021

When thinking about the value of Bitcoin, or any other cryptocurrency for that matter, it is important to take the network effect into account. A network effect is when a product or service becomes more valuable as more people use it.

Since blockchains and money essentially organise people and gain utility as more people use it, looking at Bitcoin through the lens of the network effect can be helpful, especially when dealing with negative commentary that paints Bitcoin as lacking any underlying value.

What is a network effect?

A network effect is an economic effect that describes a product or service where additional users add value to the network. When a network effect is present, each new user adds value to the product by entering the network. This, in turn, incentivizes new users to join the network, adding more value to it, and so on.

When describing the power of networks, many point to Metcalfe's Law, which states that the value of a network is equal to the square of its user base. As a result, adding new members to a network causes it to enjoy disproportionate gains in value.

An example of a network effect that is often used is the telephone. In the early days, only few people owned telephones. As the technology matured, more and more people could afford a telephone, which in turn increased the value of the entire telephone network. Increased usage led to exponential growth.

The Internet is another example of the network effect. Initially, there were almost no users on the Internet since it was of little value to anyone outside of the military and some research scientists. However, as more users gained access to the Internet, they produced more content, information, and services. The development and improvement of websites attracted more users to connect and do business with each other. As the Internet experienced increases in traffic, it offered more value, leading to a network effect.

Now it is nearly impossible to run a successful business without plugging into the Internet.

Bitcoin and the Network Effect

Some investors who are new to crypto might hold that there are now blockchain protocols out there that are superior to Bitcoin. The assumption might be that markets generally gravitate towards the best solutions in the long run, but while this may be true, this is not just a matter of protocol.

Bitcoin might be inferior in some regards, and superior in others, but in terms of network effect, its risk-reward ratio is unrivalled. As Bitcoin grows exponentially, with giants such as Paypal, Square and other payment providers offering support for the currency, trust, confidence and other qualitative factors also play into Bitcoin’s long term appeal.

With more people buying, holding and using Bitcoin, we can expect continued price appreciation which in turn adds to the asset’s magnetic effect. Satoshi Nakamoto, the founder of Bitcoin, spoke of this dynamic when they wrote:

“As the number of users grows, the value per coin increases. It has the potential for a positive feedback loop; as users increase, the value goes up, which could attract more users to take advantage of the increasing value.”

In a recent article, we pointed to Willy Woo’s observation that Bitcoin is today where the Internet was in 1997 in terms of user adoption, but that Bitcoin usage is increasing at a faster rate and is likely to hit 1bn users in the next four years (on par with the Internet in 2005).

Source: @woonomic

The network effect doesn’t just impact the investment community, but miners as well.

Miners support network security and have great liquidity to sustain their operations. But if, say, another network is launched that aims to serve a similar use case as Bitcoin, miners could potentially be persuaded to leave the Bitcoin network and mine another coin instead.

However, while they might get higher rewards on the new protocol, they won’t have the same liquidity to exit their positions. Even if the alternative would be technologically superior, or bring in more rewards, it wouldn’t necessarily make sense to switch.

Learn more about Bitcoin mining:

The Price Of Bitcoin

When we look at Bitcoin through the lens of the US dollar, we might think the asset is overvalued. However, when seen from the perspective of the network effect, it’s clear that we are still early.

Bitcoin doesn’t just offer a sound form of money, due to its perfect scarcity. It also offers the benefit of a growing network of users in the form of investors, traders, custodians, exchanges, miners, corporations, hedge funds, sovereign wealth funds and eventually, perhaps, central banks, that will each have an interest in its success and prolonged adoption.

MIchael Saylor, MicroStrategy’s CEO, said it best, when he stated that instead of looking at the price, we should be looking at Bitcoin’s market capitalization, and if we see Bitcoin as a giant bank in cyberspace, then Bitcoin’s market cap simply tells us, how much money is in the bank.

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