Bitcoin and Network Effects

A network effect is the value created when a large number of people regularly use a product. For example, an online multiplayer game such as World of Warcraft still appeals to new players because they know that they will have an easy time finding other players to play with. Many competitors to WoW were praised for their innovative features, but they never managed to attract and sustain a sufficient player base to establish network effects to keep them in business as long as WoW. Successful games these days need millions of players all over the world, and these games usually offer some sort of incentive to players so they log in every day to collect their rewards; the number of accounts and daily logins are critical metrics investors analyze to determine whether a game deserves more funding. If players can’t find other players to play with, then they stop logging in, making it harder for other players to find other players, leading eventually to a failed game.

The most successful game isn’t necessarily the best game; it is often the game with the most dedicated players.

When asked why the price of Bitcoin remains so much higher than other, newer cryptocurrencies that have features, technologies, and use-cases that Bitcoin lacks, many people point to Bitcoin’s network effects as an answer. However, Bitcoin’s network effects may be overstated. The top 100 richest Bitcoin addresses all have tens of thousands of BTC, hundreds of millions of dollars worth of Bitcoin. 90% of all Bitcoins are held in less than 200,000 addresses. 60% of all Bitcoins are held in less than 20,000 addresses. And remember that one person can have multiple addresses. The millions of addresses that supposedly constitute Bitcoin’s network effects hold less than 1% of Bitcoin’s value.

So, there really aren’t that many people who have and use Bitcoin. And after 8 years there are still hardly any non-internet vendors that accept it as a form of payment. So what keeps the price of Bitcoin so high, if it really isn’t that popular and it doesn’t have many uses? Ironically, what keeps the price of Bitcoin high is demand for other cryptocurrencies and decentralized application tokens – what many Bitcoin devotees derisively call “alt-coins” or even “shit-coins”.

Due to various regulations, technological hurdles, and the international character of cryptocurrencies, it is a bit of a challenge for new investors to acquire “alt-coins”. New investors generally don’t have any coins at all; all they have is fiat currency, and most alt-coins can only be acquired by trading other cryptocurrencies on cryptocurrency exchanges, most of which don’t allow trading with fiat because doing so would expose them to regulation by agencies such as the SEC.

The common path most new investors take is to buy Bitcoin (or Ether or Litecoin) through a service such as Coinbase that accepts fiat, and then transfer that Bitcoin to an exchange such as Bitfinex to trade for alt-coins. Incidentally, Bitfinex holds over a half billion dollars worth of Bitcoins.

As such, Bitcoin’s market cap of $80 billion is about half of the total $160 billion market cap of all cryptocurrencies. I’d expect the ratio of this relationship to remain fairly constant in the near-term. As other tokens increase in price and demand, Bitcoin will increase as well. In reality, Bitcoin’s network effects extend through the entire market of almost all cryptocurrencies.

However, this state of affairs is unlikely to continue into the long-term. This year has seen an explosion in the number of people who mine different cryptocurrencies, meaning they will acquire more coins without needing to buy them with fiat/Bitcoin. Furthermore, as alt-coins become more popular and governments become more accepting, it will be easier to buy alt-coins directly with fiat. Finally, decentralized protocols for currency exchange, such as 0x, Kyber, Bancor, and others, will soon come online and gain a lot of the market share currently dominated by centralized, Bitcoin-powered exchanges. When this switch occurs, Bitcoin will lose a lot of the network effect value it gained by being something like the “reserve currency” for other cryptocurrencies, and it will have to live and die on its own.

Luckily, implementations of solutions such as larger blocks, SegWit, and Lightning Network will make Bitcoin more functional and increase its possible use-cases. However, infighting between different forks of Bitcoin will dilute and damage the perception of the Bitcoin brand with the mass market. Although competition can often increase a market’s appeal to consumers, who love to pick sides in a fight, the current situation with Bitcoin forks just increases uncertainty and discourages new adopters. Xbox One vs Playstation 4 excites consumers, but Playstation 4 vs Playstation 4 Pro confuses them.

Even if Bitcoin successfully implements updates that keep it competitive with other currencies, and the brand stays popular with the general public (hopefully avoiding the perception that Bitcoin is “only for rich people”) , Bitcoin will still have the problem of the concentration of the majority of coins in a tiny minority of addresses. New adopters who want to own Bitcoin to actually use it will have to pay a premium to the Bitcoin elite to play their game. If consumers can get the same functionality from another coin without paying such a high premium, then demand for Bitcoin will drop even further.

Consider: if Kim Jong-Un accumulated almost all the Bitcoin in existence and charged a very high price to buy it from him, then most people interested in cryptocurrency would just choose a different product instead of enabling a tyrant by enriching him further. And if Kim Jong-Un couldn’t find any buyers for hit Bitcoins because no one wants to play his game (or he was sanctioned by the UN), then the price of BTC would drop to $0.

The game only has value if there are many other people you can and want to play it with, and right now Bitcoin really only has the illusion of network effects. To get millions more actual individuals across the world using BTC daily, the price would probably need to balloon another 10-30x from purchases to redistribute the coin away from its current concentration. As this price rises, however, the majority of potential users will be increasingly priced out of acquisition. At nearly $5k per Bitcoin, the price is already so high that most people don’t even give it any thought, just as they don’t think about mansions or private jets or other luxuries that are on the market but they’ll never have any need or interest in buying.

Ethereum, however, is quite different. Coins like OmiseGo and Bancor are built on and utilize the Ethereum computing network for their transactions. Therefore, the price of Ether will always benefit from network effects of other alt-coins it is tied to, even if consumers buy these alt-coins directly, bypassing Ether purchases, Ether will still be in demand to power everything built on the Ethereum network. So long as Ethereum-based companies stay in business, Ether will have a solid price-floor even if consumers lose interest in Ether itself as a currency.

The price of Bitcoin, however, depends on brand salience that is increasingly diluted, network effects that are overstated and tenuous, and…well…plain old hype. There’s still plenty of money to be made with Bitcoin over the next year or two, particularly because it will take time for people to transfer their holdings out of legacy Bitcoin-powered exchanges they’ve become comfortable with to new decentralized solutions. But in my analysis, Bitcoin carries far more risk than Ether over the long-term.

Beginners’ Guides to Buying Crypto: Money, Markets, and Governance

Reddit user peacheswithpeaches has created a few URLs with step-by-step instructions on how to buy some of the more popular decentralized app tokens.

Eth: Golem: Siacoin:

Aragon: Augur: Status:

Each of these tokens falls under my general pioneer principle for new-world-investing: markets, money, and governance. Startups that dominate these three categories in new industries will be the backbone that profits from the success of virtually any other company in that space. Any venture whatsoever requires a location in which to operate, a medium to facilitate exchange, and a program to normalize behavior and resolve disputes.

This is akin to buying securities in Amazon, the Federal Reserve, and the U.S. Treasury. Even if a company that sells products on Amazon loses money, Amazon still profits from their business activity, and the US Government still collects their tax payments. Investments in these categories tend to be less risky while offering slow but steady growth over the long term. Sometimes, they end up being “too big to fail”, and only collapse when the entire space collapses. Once a large number of smaller ventures adopt these systems as industry standards, it becomes very difficult for competitors to enter the field, because startup costs are enormous to compete at such a large scale, and they’d have to offer existing users a tremendous incentive and benefit to offset the costs of transitioning. Many smaller ventures even become so intertwined with these systems that it actually becomes impossible to disentangle themselves.

Success is in no way guaranteed, however, especially at such an early stage in the development of the industry. However, with the talent-pool so small and brands and partnerships already established, it seems increasingly likely that this network of services will play a fundamental role in new economy of Web 3.0.

Fear, Uncertainty, Doubt

Markets love good news. Markets can handle bad news. What markets absolutely despise is fear, uncertainty, and doubt. Buyers and sellers, investors and producers, need to have an idea of what the future will look like so they can make decisions. Think of it like this: if you can only take either a pair of sunglasses or an umbrella with you, but you don’t know whether the weather will be sunny or rainy, then you might just decide to stay at home. Since the middle of June, the market for Cryptocurrencies has been dominated by uncertainty. But on August 1, that all changed.

Bitcoiners didn’t know for certain whether the coin would undergo a hard fork or a soft fork or an upgrade or nothing at all. The uncertainty leads many people to imagine the possibility of the worst possible outcome – a failure of the coin and panic. The same principle leads to runs on banks: depositors doubt that they will be able to withdraw their money tomorrow, so they all rush to withdraw it today, and the bank runs out of funds and collapses. Rather than deal with the uncertainty, Bitcoiners simply sold their BTC and stored their wealth in fiat. The price fell nearly $1,000 in a month.

Then Segwit was approved, and, unexpectedly, a hard fork was announced as well at nearly the last minute. Now, the weekend after the August 1 event has passed, Bitcoin just reached a new all-time high. The fork didn’t collapse Bitcoin, the market supported Bitcoin Cash, and fear of missing out drove investors back into cryptocurrencies in a feeding-frenzy. Even Ethereum is climbing again after losing 50% of its all-time high of $400. The rising tide lifts all boats.

If the outcome of an event at a known date is uncertain and news relating to that event continually coincides with decreases in the price of the related asset, then you should consider buying low, unless you expect the outcome to be severely negative. People almost always overreact to uncertainty, they always fear the dark more than they should, it is basic nature and psychology. We try to avoid loss as much as we can, and we’ll forego gain and success if we have to risk a little to get a lot. “Be greedy when others are fearful.”

This was predictable and predicted. The only real downside risk was a true black swan, wherein the Bitcoin mining community splintered into a thousand factions. But there was simply too much money at stake for irrationality to triumph over the profit incentive. Bitcoin’s future looks bright today, so grab those sunglasses, but there still might be storm clouds far off in the distance.

Investing in networks, not companies

When deciding where to invest their money, many people research a few companies, determine which one has the best product and profit margins, then dump their funds in that company; but that is a narrow, unsophisticated strategy. Great companies have great products, marketing, profit margins, and leadership; but the best companies are part of a wide network of great companies. Investing in networks over companies reduces risk and increases gains.

Some companies start out isolated and later in their development join larger networks; but companies who stay isolated their entire lifespan often die early deaths, or do not grow to their full potential. When investing, don’t analyze a company as an atomistic entity, look closely at how it relates to and interacts with other companies across the whole market. Look at the other firms with which it has partnerships and contracts. Check the names on the board of directors and see what other investments and professional duties they have and how that ties in to the company under analysis. For example, if a former top executive from Apple is on the board of a new tech company, then you know that startup has mentorship, direction, and access that its competitors may lack.

In your research, you may discover that a company has everything it needs to succeed, yet other companies networked to it will see even more success. Even if that company has an incredible product, they might not be the organization in their supply/value-chain that profits the most from the product’s success. Consider a killer-app for a gaming console: you may expect the software developer to sell millions of copies at a profit of $10 per unit, but if those millions of consumers have to buy the new console to run the software, and the hardware company earns a profit of $100 per unit, then the hardware company is the better investment choice for the short-term. Companies such as Aragon, which make products and services that enable thousands of other companies to succeed, will benefit massively from the growth and success of  blockchain-based Web 3.0.

If a well-networked company stumbles, then it can receive support,  guidance, or bailouts from its partners. An isolated company will have to fend for itself in shark-infested waters. A company that has strong, dependable friends that succeed when it succeeds carries less risk than others. However, since their fates and fortunes are so closely linked, there lies the possibility that one major scandal or failure could bring the whole network down simultaneously. Therefore, when investing in a network, it is critical to also identify firms that will benefit if your favored network collapses; make small investments in these firms as a hedge to further mitigate risk to your portfolio.