While some investors chose to invest in cryptocurrencies based upon an understanding of the underlying technology and potential of their blockchain, others invest in crypto because they are following a trend and may not understand what drives the valuation of cryptocurrencies. While there are multiple factors at work in the market prices of cryptocurrencies, one important and often overlooked aspect of the valuation is the influence of network effects.
What Is a “Network Effect”?
Network effects occur when the value of an asset running on a network increases with the number of users on the network. Simply put, the more users a network has, the more valuable the network becomes. As a result, some cryptocurrency valuations are driven by the size and strength of their user base and the potential for the number of users to increase. That potential can be assessed by looking at the historic growth in the network’s user base and other factors that could propel further growth.
For example, in what is currently a sea of negative publicity surrounding crypto assets, the International Basel Committee on Banking Supervision (BCBS), which is the primary global organization for establishing prudential bank regulation, took an interesting position regarding crypto assets as it finalized its new global crypto banking rules, which are intended to be implemented by January 1, 2025. Among the standards outlined in the new policy, banks are permitted to hold certain crypto assets in their Tier 1 and Tier 2 capital, subject to limitations. Tier 1 and Tier 2 assets are the core capital held in a bank’s reserves and a significant indicator of a bank’s health and safety. The announcement of the BCBS standard signals the further evolving integration of crypto assets into the world’s mainstream commerce as well as the banking system. Moreover, this development comes from a conservative and highly sophisticated regulatory body. As crypto assets become more mainstream, their user base should grow. That growth in users triggers positive network effects.
Metcalfe’s law — or the principle guiding the network effect—holds that the value of a network is proportional to the square of the number of nodes on the network. Nodes can be computers, servers, or even users. Each cryptocurrency is like a network. Cryptocurrency is, therefore, often valued using the concepts underlying Metcalfe’s law.
More Users Means More Usefulness
Why does the maxim “more users; more usefulness” apply to cryptocurrencies and blockchain-based start-ups in particular? It might help to look back in history to the invention of the telephone. While the telephone was a groundbreaking innovation, its usefulness was extremely limited when it was invented by Alexander Graham Bell. There was simply no one else to call.
The telephone’s real value could not be realized until it was widely adopted by the public. Bell went on to found a small tech startup called the American Telephone and Telegraph Company (AT&T). However, until there were multiple nodes (i.e. telephone users) on the network, neither the telephone nor AT&T had much value.
You Are Only as Good as Your Network
Metcalfe’s law, or the network effect, applies to cryptocurrency in the same way it applied to the telephone. As more people adopt cryptocurrencies, the additional users add more value to, and derive more utility from, the network. When there was no one to call, the telephone did not look so important. But as the network expanded it became essential and the network value itself drove demand for the telephone.
Some follow-on positive network effects that can impact the value of a network and its related crypto assets include:
- Security effect. Widely adopted systems used by a large number of decentralized users make it harder for third parties and wrongdoers to hack into cryptocurrencies.
- Size stability effect. Currencies with larger market capitalization tend to be more stable, and the longer it is established, the more the network effect takes hold.
- Market depth effect. Currencies with a larger base have higher market depth on exchanges. This means that users can efficiently and more dependably convert larger quantities of funds in and out of that currency.
- Single-currency preference effect. Users often prefer to use the same currency as others to avoid interchanging currencies due to complication and friction, and to avoid incurring fees. This tendency may decrease the value of obscure network/currencies and stoke the value of well-established cryptocurrencies with a broad base of users and investors.
In business generally, network effects are not merely about obtaining as many users as possible as quickly as possible. Rather, for the health of a crypto-based business, understanding how to grow wisely and build strong systems and “sticky” users may be the best way to benefit from network effects.
Beware of Negative Network Effects
Not all network effects are positive. Often, in a decentralized finance protocol, cryptocurrencies have to be mined for the network to run but have no central authority to keep the network running itself. Node operators need to have some kind of incentive to continue to mine crypto and operate the node. As a network expands, the weight of maintaining the network at greater scale also expands.
Taking Ethereum as an example, the incentive for miners to maintain the system is called “gas.” When users want to execute cryptocurrency transfers, they pay a “gas” fee to miners at the market gas price. However, the number of miners is limited, as well as the maximum transaction throughput. Therefore, if there is more traffic, gas may be more expensive. If transactions become too expensive, users may migrate away. If this trend continues unabated, the active user count may decrease. If the active user count decreases, so will the value and significance of Ethereum. This cycle is known as a “negative network effect.”
As noted above, the value of a network generally increases as its number of users increases. However, this feedback loop can run the other way, and a once-popular network may see its value drop as the number of its users declines. For crypto assets that rely on a “proof of work” mechanism (such as Bitcoin), the user base could erode for a number of reasons. For example, proof of work mining requires a significant amount of electricity (a physical world limitation on a virtual asset).
As energy prices rise, unless there are corresponding increases in the price of Bitcoin, Bitcoin mining becomes less profitable. This trend could cause some miners to stop operating. Similarly, the political environment around crypto assets and energy-intensive mining generally may negatively affect the perceived value of Bitcoin. If enough users conclude that Bitcoin is not a stable investment (e.g., due to an unfavorable regulatory regime or financial scandals), its value will be negatively affected. This subject may be addressed in a follow-up article.
Whenever we look to value an asset, we talk about the “fundamentals” underlying the valuation. Traditional businesses are often valued based on their earnings, hard assets, and potential for earnings growth. Cryptocurrency valuations are based on a different set of “fundamentals.” One of them is network effects. As we see certain crypto assets make their way into more mainstream business (Bitcoin is the best example) and expansion in the applications that are based upon the asset (Ethereum is the best example), we see network effects taking hold over time.