Digital currency is a 'network effects' business and, more specifically, it is a two-sided market.
In other words, it means that it is a type of market that requires two distinct types of participants to be useful (most often merchants and consumers). A classified ads market is a two sided market - you need sellers providing listings and buyers who want to purchase from the sellers. A social network, on the other hand, is not a two-sided market as users are all of the same type. Social networks have great network effects but they are still not as strong as those of 2-sided markets.
Two sided markets are notoriously difficult to kick-start and then notoriously difficult to displace once they become established. What we have seen in the last fifteen years with the internet confirms this. The first 2-sided internet marketplaces to achieve scale (eBay, Craigslist) have proved remarkably resilient to new competitors even when, in the case of Craigslist, their feature set seems mired in 1999. Whereas 1-sided markets (like social networks), while having serious network effect stickiness, are displaceable (MySpace, Friendster, etc).
Digital currency is a classic 2-sided market. If no merchants accept, say, bitcoins, it is not particularly useful for consumers to have a bitcoin wallet. If no consumers have bitcoin wallets, then it is not particularly enticing for merchants to accept bitcoins. So something has to happen to get the first group on board in order to get the second group on board.
Given this, what are the conclusions that one could draw about bitcoin and digital currencies in general:
(1) Bitcoin has probably achieved escape velocity relative to its clones, in terms of usage, money supply and public awareness of its brand. It has a good chance of becoming the generic word for digital currency.
By the end of 2014, there will be millions, if not tens of millions, of consumer wallets and hundreds of thousands of merchants who directly or indirectly accept bitcoin.
That is probably enough to end the 'competition' for which cryptocurrency will be broadly adopted.
(2) Given this, it is going to be extraordinarily difficult for any 'alt-coin' (alternative digital currency) to displace bitcoin. Even if a certain alt-coin has certain feature X that is superior to bitcoin (and I am not convinced that any alt-coins do have any meaningful advantages at this point), that will not be sufficient to dislodge bitcoin. Getting consumers and merchants to use/accept bitcoins is already a huge adoption/branding challenge that requires a few hundred million dollars, if not a few billion dollars, of free / editorial publicity to solve. Minor technical improvements (if they are not co-opted by bitcoin itself) are not going to cause a rush of users to a second, third or fourth digital currency.
(3) With this lens in place, the speculative excitement around the 'asset value' of bitcoin isn't a bad thing. It is probably in fact a necessary condition to generate interest, generate publicity and induce the first million consumers to open a bitcoin wallet. Bitcoin is truly in the stage where all publicity is good publicity. The fact that some people now hold bitcoins, for speculation or just curiosity, is what is now drawing in the merchants.
The biggest risk to a new digital currency is not that it is volatile in the beginning (something that will calm down over time), but that nobody knows or cares that it exists. By accident or by extremely savvy design, bitcoin has solved the awareness problem in spades.
(1) By 'winner-take-all', I mean 80%+ market share.
(2) What could keep bitcoin from achieving that level of market share in digital currencies? Only two things I can imagine
(a) Regulatory decrees in specific countries: E.g. if Brazil banned bitcoin exchanges but allowed "brazilcoin" exchanges, that would probably move the market share needle in Brazil (though that would inevitably create a brazilcoin-bitcoin black market).
(b) Government-backed coins: An officially backed digital currency would take market share. Though hardly imminent, this is something we will discuss in a later post.