This is a brief post about network effects. They exist in various forms and at various depths in different fields and today we will look at Bitcoin through this prism. I must, at this point, thank Chris Dixon for introducing the '4-sided market' to my vocabulary. Today, I will posit that Bitcoin is actually a 6 sided market.
(1) The basic example of a powerful 1-sided network effect is a social network. The more people on it, the more valuable it is for others to be on it. It can, however, be broken by a competitor that provides a more valuable service to one group, the users, who might then migrate en-masse (see Facebook v. MySpace).
(2) Successful 2-sided markets like eBay or Craigslist are significantly more difficult to disrupt. Customers want to be there because vendors are there; vendors want to be there because customers are there. To break them apart, you have to simultaneously have a better value proposition for both parties, otherwise nobody moves. That is why Craigslist, with limited innovation, is still a dominant website, leveraging its early 2-sided lead.
My hypothesis is that the leading cryptocurrency (which, as of today, is clearly Bitcoin, but in theory any other cryptocurrency that gains a big lead) has actually a six sided market working in its favor, with six-sided network effects that will be very difficult to disrupt:
Side 1: Merchants will adopt Bitcoin because more customers hold Bitcoins
Side 2: Customers will adopt Bitcoin because more merchants accept Bitcoins
Side 3: Developers will adopt Bitcoin because more customers and merchants use Bitcoins. Note that in a complex regulated financial product like Bitcoin, this does not only relate to the applications existing, but reaching scale, going through trial-by-fire, proving their trustworthiness, gaining regulatory approval and so on. This is similar to the dynamics of an OS platform.
Side 4: All the parties in 1-3 adopting Bitcoin creates demand for the currency, causing its price to rise, making mining rewards more valuable, drawing miners and their computational power to the currency and therefore making the blockchain more secure against a fatal 51% attack. This makes it more appealing to developers and investors at a minimum.
Side 5: Adoption by the ecosystem plus the security of a strong blockchain, draws pure financial investors to the currency, who push the price up, drawing more miners.
Side 6: More adoption plus better financial institutions ("Side 3") means more liquidity running through the exchanges that exchange Bitcoins back and forth to sovereign currency, which reduces the spreads to exchange into/out of the currency and making it more cost-effective for customers, merchants, developers and investors to use it. (Spreads to sovereign currencies are the main transaction costs in any cryptocurrency, far outweighing the currencies internal transaction fees).
And the cycle repeats.
Each one of the six sides reinforces at least one or more of the other sides. In aggregate, it is a superb setup of market incentives for the first currency to hit escape velocity. It is as if, by buying stock in eBay the company, you magically gave eBay a direct cost and security advantage in executing transactions that other auction sites could not match, that drew more customers to it, that raised its stock price and so on.
I can't guarantee of course that Bitcoin will maintain its lead and there might be a technical flaw that has been uncovered to date. I will state with some confidence however that Bitcoin's 'lead' over other alt-coins will not be easily disrupted by other non-state backed coins and certainly not by small feature tweaks.
The network effects are very strong in this one.
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