Cryptocurrencies are often valued in terms of network effects. Network effects are emergent properties that occur when the value of a network increases with the number of its nodes. Thus, some bitcoin valuations have been based on the bitcoin network and its users. Metcalfe’s law — which holds that the value of a network is proportional to the square of the number of nodes — has increasingly been used to model Bitcoin’s value.* Some advocates of bitcoin — so-called bitcoin maximalists — even claim that bitcoin’s strong network effects will ultimately lead to hyperbitcoinization — a bitcoin-induced demonetization of fiat currencies. Now, setting aside whether bitcoin will win, or an altcoin will takeover, it is essential to recognize that different protocols will generate different network effects.
To understand the nature of crypto network effects, we need to distinguish between crypto protocols and the different functions their native cryptocurrencies perform. Crypto protocols can broadly be categorized as utility and store of value protocols. Whereas smart contract platforms, such as Ethereum, can be grouped into utility protocols, Bitcoin can be characterized as a store of value protocol. Each group of crypto protocols maximizes for different dimensions. A smart contract platform optimizes for different functionalities — such as Turing completeness or rich statefulness — than a store of value protocol, which needs to maximize censor- and judgment-resistance, decentralization, and safety. 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 case of utility protocols, users would not need to “hodl” coins, which would translate into a higher velocity and lower values of these utility cryptoassets. Instead, users would only “hodl” the dominant store of value cryptocurrency, which can, in turn, create “digital cash” network effects.
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. Some analysts, which have taken the gold market as a proxy to model Bitcoin’s value, have arrived at estimates of bitcoin’s price that range from 260’000 USD to 800’000 USD per bitcoin. 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 4.7 to 14.6 trillion USD.
The concept of reflexivity, which is used in finance, captures the self-reinforcing feedback loop between investor expectations and price. The more market participants “hodl” bitcoin, the more valuable it becomes, which increases demand, hash rate, and network security, and, in turn, attracts more “hodlers” and developers. In other words, the more bitcoin is used, the more liquid it becomes. This liquidity feedback loop, which bootstrapped bitcoin into existence, reinforces bitcoin’s network effect and promotes the success of one single dominant cryptocurrency over all other competing cryptocurrencies. As the comparison with gold shows, there will most likely only one store of value protocol. Having multiple store of value protocols — which would have smaller market caps and be less liquid — would not provide more utility. Furthermore, a store of value protocol will also exhibit strong path dependency. Consequently, the fact that bitcoin is by far the largest protocol — and has operated almost nine years now with practically no failure — further reinforces the strong network effects it already has. In addition to its reflexive and path-dependent nature, bitcoin also exhibits a strong “Lindy effect,” which implies that the future life expectancy of a technological system is proportional to its current age, so that every additional period of survival implies a longer remaining life expectancy.
Bitcoin has all the features, such as censorship-resistance, scarcity, security, and a hard-coded immutable monetary policy, that make it a far more advanced store of value — it also does not have the physical constraints of gold (such as extraction, transportation, and storage costs). 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. Whereas the Internet is a protocol for information, bitcoin can be described as the protocol for value. We do not have multiple competing Internet protocols, but one protocol on which the infrastructure and applications of the Internet have been built out. Similarly, given its strong network effects and long track record of safety, the bitcoin protocol will likely become the dominant non-sovereign store of value protocol, which will provide the basis for second-layer applications that might make bitcoin also relevant for smart contracts, or payment rails. Whether or not Bitcoin will win as the ultimate store of value protocol — and given that bitcoin is the leading cryptocurrency it seems likely that bitcoin will emerge as the dominant non-sovereign store of value protocol — it appears that, unlike the fragmented market for utility protocols, the store of value use case appears to be a winner-takes-most if not a winner-takes-all market.
*In a recently published research paper, we developed a generalized Metcalfe’s law that can be used to derive a fundamental valuation for bitcoin: https://arxiv.org/abs/1803.05663
Thanks to Pierre Rochard