Why Investors in Crypto Assets Should Care About Network Effects

Written by Michael Ippolito

There has been a lot of discussion in recent months about network effects in the blockchain community. Specifically, interest has been geared towards how these effects will impact the adoption of blockchain protocols. In the age of internet giants like Facebook and Amazon, you would be hard pressed to find someone who hasn't at least heard the term 'network effect.' But you might be just as hard pressed to find someone who could define exactly what that phrase actually means. As it turns out, there are different types of network effects, each with their own distinct definition and set of implications. Understanding network effects and how they have driven adoption for the winners of the Web 2.0 movement will be instrumental for investors looking to pick the winners of Web 3.0. Some of the industry's most successful participants (including Andreessen Horowitz, USV, and Multicoin Capital) are examining how network effects will drive adoption of some blockchains over others. Let's begin by defining what network effects are and why they matter for blockchain.

First things first - why do we care about network effects?

Blockchains are all built in an open source environment. All of the code for even the most widely used blockchains, such as bitcoin, are available for anyone to view and copy. Outside of the world of blockchain, some of today's internet giants like Wikipedia, Facebook, and even Google are completely open source as well.

That means that if I wanted to, I could start my own Google or Wikipedia competitor this afternoon. It would be the exact same, down to the very last line of code. So why don't companies do this? How is open source sustainable as a business model? The answer is what you probably said to yourself in my little example above - just because I (as Mike Ippolito) could copy Facebook today, doesn't mean that anyone else would want to use it. And now we've arrived at network effects.

What are network effects?

Good question. Let's start by defining some of the most common types of network effects and how they have historically driven adoption in communication networks. Simply put, network effects are an emergent property that occur when a product or service becomes more valuable to its existing users as more people use it. Telephones are a great and easy to understand example of network effects. Just think, how valuable would a telephone be if you could only call three people?

Network Effect Image 1

Network effects represent a new concept of defensibility. They act as defensive moats for open source entities like blockchain protocols against competitors who could copy their functionality down to the most minute feature. In the past, companies have had proprietary advantages in the form of products, intellectual property, or operational setup. Let's use Chris Dixon's (General Partner, Andreessen Horowitz) explanation of the network effects of Wikipedia to understand how this paradigm has shifted for at least some of the internet giants.

According to Dixon, much of the value from Wikipedia comes from its community of active users. Think of the website as a venue or a restaurant - you visit Wikipedia because of the website's other participants, who contribute meaningful content to the platform. You could easily go out and create an exact replica of Wikipedia tomorrow, but that doesn't mean that the community of users who contribute to Wikipedia will move with you.

The value does not lie in the lines of code, but rather in the community that code has built around it in the physical world. In reality, Wikipedia is a framework for how to organize a community to effectively deliver value. In the case of blockchains, the most valuable protocols will be the frameworks able to best coordinate their respective groups of developers and users to do the same.

Different Types of Network Effects

There are several categories of network effects, each of which have their own distinct set of characteristics. In order to understand how these will impact the adoption of blockchain protocols going forward, it will be helpful to understand how they have affected the growth of today’s internet winners. (Note: the following is borrowed largely from Kyle Samami’s much more in depth article “On the Network Effects of Stores of Value.”)

Direct Network Effects – increases in usage lead to direct increases in value. This is the type of network value derived from the phone example above – i.e, the value of a telephone is directly proportional to the number of people who have telephones. This type of networking primarily applies to closed-loop communication (or advertising) networks. Direct network effects are behind the rise of companies like Facebook and WhatsApp.

Indirect Network Effects – increases in product use result in increased value of complementary goods, which in turn increases the value of the original product. The canonical example of indirect network effects is in Operating Systems (OS). Think for a minute about the relationship between Mac’s wildly successful iOS and the app store. App developers are incentivized to build on a platform that consumers will use. Consumers, in turn, will look to the platform that gives them convenient access to the best apps.

Indirect Network Effects

Two Sided Network Effects – similar to indirect network effects, two sided network effects occur when one subset of users increases the value of a complementary product to a different subset of users, and vice-versa. This typically is represented by the existence of distinct groups of buyers and suppliers in online market places, such as Amazon, AirBnB, or eBay. I.e, consumers benefit from more choice and competition, and suppliers benefit from increased access to consumers.

How should network effects inform my investment strategy?

Defensive moats look different for internet companies than they have in traditional consumer facing or b2b businesses. When Warren Buffet famously coined the term, he defined economic moats as “a business’ ability to maintain competitive advantage over its competitors in order to protect its long-term profits and market share from competing firms.” Only half of that statement applies to crypto assets, which do not produce cash flows. They are an asset class that accrues value in a fundamentally different way from companies.

Understanding network effects is even more crucial for investing in crypto assets than internet companies or apps because that is really their only competitive advantage. Companies like Google indirectly rely on them, but at the end of the day they are still a company with established operations and cash flows. Crypto assets will appreciate directly (although not necessarily linearly) as a result of the size and utility of their user bases.

So how can you tell if a blockchain is likely to benefit from network effects?

1. Governance - hard to overstate the impact of this one. Joel Monegro of Placeholder Ventures has spoken pretty extensively on the importance of governance in blockchain adoption. The idea here is that the blockchains with the best relative governance systems will attract the most developers, which will in turn lead improved function and features. This would be an example of indirect network effects similar to the OS example above. Governance is a good candidate for best indicator of which blockchains will gain traction and ultimately 'win'. For a more complete explanation on the integral role governance plays in blockchains you can read more here.

Blockchain Governance

2. Tokenomics - if governance is the system for how to change the rules in a blockchain, then the rules themselves are tokenomics. Tokenomics is a broad subject, and in general terms refers to the system that governs how value is accrued in tokens. There's really no short cut here - if you want to invest in crypto assets, you MUST have a basic understanding of how this works. The economics behind value accrual in tokens will also be one of the most important aspects of how blockchain networks will grow.

3. Barriers to Exit - look for blockchain protocols with low barriers of exit for developers. One of the best ways to conceptualize the value of blockchain is as a new type of design space (again, borrowing from Multicoin) that will allow designers to collaborate in new and interesting ways. Developers want choice in which protocol they want to use, and (most importantly) they don't want to be locked in to designing on only one. It's the same principle as companies looking to avoid vendor lock-in with SaaS providers like AWS. Everyone wants to have a choice almost as much as everyone hates paying expensive switching costs one year down the road. Blockchains that specifically design low barriers to exit for coders looking to switch will likely see an inflow of developers and therefore court indirect network effects.

There you have it. Network effects will be massive for crypto assets because they are really the only significant economic moat that blockchains can have. Investors looking to place their bets should look for blockchains that have emphasized the role of good governance, clearly laid out and defined tokenomics, and low exit costs for developers.

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