Bitcoin and Network Effects – Bitcoin Magazine: Bitcoin News, Articles, Charts, and Guides

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Bitcoin’s price and ecosystem benefit from network effects.

As more users join, demand pressure increases the price of bitcoin, which in turn attracts more buyers in a self-reinforcing cycle. Likewise, user growth creates a larger market with more liquidity, incentivizing companies to provide more services, integrations, and security, which then encourages new users to join the more robust ecosystem.

Understanding this network effect is important when considering Bitcoin’s place in the wider financial world.

Legacy financial systems also benefit from network effects to some extent, as increased user growth enables the expansion of financial services, thereby promoting user growth. As more customers adopt Visa credit cards due to their widespread use as payment options, more merchants are incentivized to integrate with Visa to access customers, enabling greater card adoption. Visa.

Network effects are a powerful engine of growth.

However, not all network effects are the same. Each network has its own value proposition, potential growth rate, structural limitations, and barriers to entry and exit. Metcalfe’s law postulates that the value of a telecommunications network is proportional to the square of its nodes. As more and more users (nodes) join such a network, the number of possible connections increases exponentially, prompting more and more new users to adopt this network.

Although Metcalfe’s Law has limits beyond communication networks, it still helps illustrate the exponential power of network effects in our increasingly interconnected world.

A less discussed phenomenon of network effects is their potential for decline. Just as increasing the number of nodes can add value to a network exponentially, decreasing the number of nodes can also reduce the value of the network exponentially.

Social giant Facebook has leveraged network effects in its growth, as each additional Facebook user has added exponentially more social connection opportunities, thereby enticing more users to join. However, with every user who deletes their Facebook account, the potential number of social connections decreases at an exponential rate, a phenomenon I’ve written about before. As Facebook users’ newsfeeds become stale, posting the same posts by the same few people, users may abandon the social network due to its diminishing usefulness, which would make newsfeeds existing users all the more obsolete in a cycle of self-reinforcement. .

Network effects go both ways.

Artwork by Matthew Pettigrew on The Bitcoin Letter.

This potential for declining network effects was described by Game B co-founder Jordan Hall in his article The Rise and Fall of Networks. In this article, Hall describes how companies that have benefited from network effects such as Facebook, YouTube and Twitter are potentially more fragile than they appear.

These companies have reached a level of market dominance, by which they attract an overwhelming share of new users, further strengthening their market dominance. This is a powerful network attractor, which may seem overwhelming to new market entrants. However, in the face of these powerful forces of network attraction, Hall articulates a different concept:

“Any for-profit entity based on the value of network effects must extract as much as possible of this value up to the limit of the network attractor. This produces an “extractive repulsion” force. Approaching the limit, the network becomes fragile. »

This demeaning “extractive repulsive” force on social media manifests itself especially in intrusive advertisements and the sale of user data. As Hall points out, these forces are countervalued by users and cause them to leave the network. Users do not join a social media site to see advertisements and have their behaviors tracked or manipulated, on the contrary, these things are tolerated up to a point.

Less obvious examples of this extractive push force can be seen in onerous restrictions on network use, reduced customer service, intrusions on user welfare or even social consequences, all of which put pressure on the decline in network growth.

If too much extractive repulsive force is applied, the network’s growth rate will stop and begin to decline, diminishing its value to its users.

This is the Metcalfe-Hall equilibrium. For-profit networks have an incentive to extract value to the limit of repelling network effects, but no further, otherwise the network risks causing a potentially exponential decline in network value.

Hall also points out how the decline of a network can be faster than its rise, since the fall of a network is now also encumbered by the extractive repulsive force.

As users delete their Facebook accounts due to declining social connections, having their News Feeds interspersed with intrusive ads will only serve to hasten abandonment, a point I’ve written about before. The precariousness of such a Metcalfe-Hall equilibrium means that for-profit networks that rely on network effects could suddenly initiate a self-sustaining, exponential drop in the number of network users.

Little by little, then all of a sudden.

In the context of financial networks, one should consider the extent to which network effects pull users in and value extraction pushes users away.

As for-profit entities, traditional financial systems impose extractive push forces in the form of fees, overdraft penalties, and onerous exchange rates. In addition to these forces, there are minimum balance requirements, limited opening hours, withdrawal limits, and wait times that hinder the user looking to store and trade value. These things are devalued by users, but tolerated up to the limit where they stay with the network.

Until recently, the Metcalfe-Hall equilibrium within traditional financial systems was at least partially supported by a lack of alternatives. While a person could delete their Facebook account and take their social life elsewhere, deleting their bank account or credit card to take their financial life elsewhere was more difficult.

With the growth of the Bitcoin ecosystem for buying, selling, borrowing, lending, and digitally securing value, a new financial network is emerging. This new network offers a completely different approach to fees, waiting times, opening hours, exchange rates, minimum balances and withdrawal limits. The fringe user looking to manage their finances can now do so in an alternative network.

In the payments space, people are turning to the big credit card providers for their convenience, despite fees ranging from 1.3% to 3.5% per transaction (or more in some markets), and companies credit card companies have a habit of abusing the dominance of their payment network. However, with the advent of Bitcoin, the Lightning Network, and Lightning-based services such as Strike or recently the Cash app, this balance is about to be upset.

The video of Strike CEO Jack Mallers scattering dollars over the Lightning Network is a demonstration of a fundamentally different payment network. While Lightning Network-based payments can offer lower-cost final settlement, the fringe merchant can offer preferential rates to pay through Lightning, or simply restrict or deny credit cards altogether. If more people switch to a Lightning-based payment network, credit card companies may have to compensate for lower revenue by charging higher fees to their users, which could accelerate a popular switch to Lightning. It is the downward slope of a network effect.

Another notable example is the remittance industry, which allows workers to send money overseas through its networks of offices, agents, ATMs and websites while extracting value via fees and exchange rates. As more and more people send funds through the Bitcoin network, in search of more attractive fees, latency and exchange rates, the traditional remittance industry will face a crisis. Falling revenues may force higher fees, lower customer service, or worse exchange rates, which will serve to both depress the attractive force of the network and amplify the extractive repulsive force.

Mitigating the loss of customers by improving the robustness of the network is no small feat in the face of a deteriorating financial situation.

The fixed overheads of for-profit financial networks can be seen as structural extractive push forces, integral to their business models. While historically people have gravitated toward the largest networks with the greatest economies of scale, those same networks now bear the greatest financial burdens on the downward slope of a network effect.

For financial networks, the deleterious impact of a declining network may be less abrupt and noticeable initially. Many customers and merchants adopting Bitcoin-based networks will not immediately diminish the value that legacy financial networks bring to their existing user base. Credit cards will still be swiped, money will still be transferred, and account balances will still be accessible. However, over time, as the pull forces of the network increasingly drive marginal users away from traditional networks, fees, wait times, accessibility, and exchange rates will worsen, and not improve.

This deterioration in user experience can be self-reinforcing at an exponential rate and is the downward slope of a network effect.

As Bitcoin and the Lightning Network offer alternatives for storing and exchanging value with little or no barriers to entry, legacy financial networks will be challenged. Any business that relies on the power of network effects must recognize the precariousness of a Metcalfe-Hall balance and that the declines can be steeper than the slopes.

Little by little, then all of a sudden.

This is a guest post by Matthew Pettigrew. The opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.

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