What Is A Network Effect And Why Does it Matter?

There are many different ways for products and services to gain traction in the financial sector. The most obvious way is by building something people want to use regularly. When such a project gains traction, a network effect is created. It is a compelling concept that all developers should aim to achieve, even though not everyone will be successful in that regard. 

When more people start using a product or service, the general perception is how that solution gains more value. Therefore, services and products must gain traction and keep attracting new users over time. For most applications, gaining that initial traction is the easy part. Retaining users, on the other hand, is a very different matter. 

In the cryptocurrency and blockchain industry, the network effect is even more crucial. As financial solutions help organize people, it is essential to fuel network growth. More users mean more utility and value as a service, paving the way for broader mainstream adoption.

A Brief Introduction

In the cryptocurrency industry, Bitcoin is the dominant asset without question. Not just in price but also mining power, user growth, and overall usability. However, it is essential to understand why this project became the industry standard. It is not just a matter of being the “best” project on the market either, as Bitcoin has a fair few flaws that need to be resolved sooner rather than later.

One can argue Bitcoin’s main selling point is how it launched at a most opportune time. The 2008 financial crisis took the world by storm and forced people to explore alternatives. Bitcoin is such an alternative with innovative technology, and it arrived at a reasonable time. In addition, the introduction of blockchain technology has been beneficial to building an alternative financial system outside the control of governments and banks. 

The Network Effect Concept

As mentioned earlier, a network effect is an economic effect determining the value of a product, service, or ecosystem. In most cases, more users will automatically result in more value being added to the ecosystem. However, to achieve the network effect, every additional user needs to add value by entering the network, incentivizing others to do the same. Creating this snowball effect is no easy feat. 

For those who want a relatable example of a network effect, look no further than the telephone. It was initially shunned and deemed unnecessary. As a result, very few people had a phone at home. The biggest hurdle to adoption was the physical connection required to other telephone owners to use the device in question. Not an ideal situation, but things improved gradually.

Over time, owning a telephone becomes more affordable, putting the device in more homes. Thus, every new user that owns a phone contributes value to the network. But, more importantly, more users equals more utility, which is beneficial to everyone involved. Thanks to this positive feedback loop, people kept joining, and the telephone became commonplace in the long run. 

Different Network Effect Types

Contrary to what one may be inclined to think, a network effect does not have to be “direct” by definition. However, the telephone example is a direct network effect, as the increasing use of this technology brings more value to all other ecosystem participants. 

However, there are indirect effects that can prove beneficial. Although their impact is different – complementary, rather than revolutionary – it can still add value to an ecosystem. For example, if a project triggers a network effect, it can unlock additional benefits to help snowball that effect. 

Moreover, a project gaining recognition is likely to attract developers who will audit the code and offer enhancements. It is a different form of added network value, yet one that will benefit the broader ecosystem in the long run. Such an effect can compound and elevate particular projects or ventures above others with ease. Through this form of “network effect’ market and industry leaders can carve out their dominant position. 

Modern Network Effect Examples

Several modern-era concepts and ideas have created network effects over the past decade. One prominent example is ridesharing; a vision people never gave a second thought about twenty years ago. Today, taking an Uber is as normal as hailing a cab. Other industry players, such as Lyft, have benefited from the industry growth as well. After starting with a small user base, these services are now used by millions of people globally. 

Another modern-day concept is social media. While these platforms remain double-edged blades for most people, one cannot ignore these ideas started as a minor project that couldn’t gain critical mass. However, market leaders, such as Facebook, Twitter, and others, are now commonplace terms and platforms in every household. Unfortunately, that also makes it nearly impossible for alternative media to compete with these leaders, although nothing is impossible. 

What About Cryptocurrencies?

As one of the more impressive financial products in existence today, cryptocurrencies remain a very interesting concept. Moreover, they need a network effect to become relevant and keep their momentum going over time. Achieving those goals is far more difficult than people will give it credit for, though. 

Looking at Bitcoin as an example, one can safely say it has had a successful network effect. Thanks to its appealing properties, speculative value, and potential to be a store-of-value asset, the overall interest in this ecosystem continues to grow. As a result, more users begin exploring Bitcoin, either as traders, investors, miners, node operators, or service providers. This demand and interest have made the ecosystem more secure, attractive, versatile, and powerful. 

If a rival network comes to market-  which happens nearly every day – there may be an incentive for miners and node operators to switch allegiances. However, joining a new network can pose liquidity concerns. If miners cannot convert their earnings to standard money to cover expenses, there is no incentive to do so. Some may tough it out and hope for things to improve. Others will prefer the safer option and continue to mine Bitcoin. Those who return to Bitcoin are drawn in by its network effect and will enhance it even further.

What makes Bitcoin stand out from most new projects launching today is its fair launch. There were no pre-mine, pre-sales, token allocations, treasuries, or anything else. Instead, the network became accessible to everyone from day one and still maintains that status after over eleven years. 

The same idea applies to decentralized finance. New ideas may come and go, yet a few industry leaders will always remain relevant. As DeFi is still in the very early stages of development and experimentation, everything remains subject to change in this industry. However, it has proven difficult for newcomers to disrupt established entities, even if they offer technological improvements and other changes.

Negative Network Effects Exist

Whereas all of the above paints off network effects as beneficial, that isn’t always the case. Negative network effects are something to keep an eye on. For example, if a network grows too big, new users can detract value rather than contribute it. That concept applies to blockchains, too, as new users need to bring value to the ecosystem. Unfortunately, blockchains and scaling don’t always go together, creating network congestion and inflating transaction fees.

Ethereum’s gas structure – in its current form – can create a negative network effect. As users “bid” on fees to pay Ethereum miners, gas fees will grow higher as more users join the network. As this creates an unsustainable situation, the developers can raise the gas limit per block. Additionally, some users will delay using the network until things return to normal. which isn’t ideal for anyone. The developers will address most of these concerns through the upcoming London hard fork and the switch to ETH 2.0.

Closing Thoughts

Network effects are a fascinating concept that can have significant ramifications. However, achieving a positive effect is far more complex than people may think, let alone sustain such an effect over years and decades. New users can all add value to the network they decide to enter, continually fueling growth in this industry.

However, a blockchain or cryptocurrency ecosystem is only as appealing as its underpinning mechanisms. If those mechanisms cannot generate any network effect – neither positive nor negative – chances are sim the concept will ever gain real traction. Many lessons are to be learned from ventures in recent years, as most of them were not too successful (for long). 

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