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.