To reach your destination, you first have to begin. This is especially true for business. Instead of directly
launching a business, people might need to create a network.
One of the significant innovations of the Bitcoin system is that it is a new way to develop open networks. This
began with the introduction of Bitcoin in 2008 and accelerated with the introduction of Ethereum in
2014. The blockchain and cryptocurrency space has experienced tremendous growth since then. The
structure of token networks reveals the underlying trust between different actors involved in the network. Analyzing
the network makes it possible to identify the most influential actors in the network and the relationships between
them. Such analysis can help to identify potential abuse of power or fraudulent activities. Furthermore, token
networks can provide an understanding of the underlying economic incentives of the network, which can be used to
guide decisions about the design of new protocols and incentives. Finally, token networks can be used to identify
usage patterns, allowing for better forecasting of future trends in the industry. JOEL MONEGRO'S fat
protocols explain how tokens incentivize protocol adoption.
Earlier in 2016, crypto experts called out that the token adoption will solve the chicken
and egg problem for startups, that is, how to build a base of
customers/believers despite having no product but just an innovative world-changing idea.
In this article, I intend to discuss how the token network effect can help to solve the chicken and egg
problem.
What are network effects, and what thing is each effect attached to?
To properly understand what network effects are at play in the crypto economic context, one should have clarity on
this question. I have listed a few of the major ones (see here for primary sources):
1. Security effect
More widely adopted derive their consensus from larger consensus groups, making them more difficult to attack.
2. Payment system network effect
Payment systems that more merchants accept are more attractive to consumers, and payment systems used by more
consumers are more attractive to merchants.
3. Developer network effect
There are more people interested in writing tools that work with widely adopted platforms, and the greater
number of these tools will make the platform easier to use.
4. Integration network effect
Third-party platforms will be more willing to integrate with a widely adopted platform, and the greater number of
these tools will make the platform easier to use.
5. Size stability effect
Currencies with larger market caps tend to be more stable. More established cryptocurrencies are seen as more likely
(and therefore, by self-fulfilling prophecy, actually are more likely) to remain a nonzero value far into the
future.
6. Unit of account network effect
Currencies that are very prominent and stable are used as a unit of account for pricing goods and services, and it is
cognitively easier to keep track of one's funds in the same unit that prices are measured in.
7. Market depth effect
More significant currencies have higher market depth on exchanges, allowing users to convert larger quantities of
funds in and out of that currency without taking a hit on the market price.
8. Market spread effect
Larger currencies have higher liquidity (i.e.lower spread) on exchanges, allowing users to convert back and forth
more efficiently.
Users that already use a currency for one purpose prefer to use it for other purposes due to lower cognitive costs
and because they can maintain a lower total liquid balance among all cryptocurrencies without paying interchange
fees.
Users prefer to use the same currency that others use to avoid interchange fees when making ordinary transactions.
11. Marketing network effect
Things that more people use are more prominent and thus more likely to be seen by new users. Additionally,
users have more knowledge about more prominent systems. Therefore they are less concerned that they might be
exploited by unscrupulous parties selling them something harmful that they do not understand.
12. Regulatory legitimacy network effect
Regulators are less likely to attack something if it is prominent because they will get more people angry.
The first thing that we see is that these network effects are actually rather neatly split up into several
categories: blockchain-specific network effects (1), platform-specific network effects (2-4),
currency-specific network effects (5-10), and general network effects (11-12), which are to a
large extent public goods across the entire cryptocurrency industry.
A currency is used as a medium of exchange or store of value; for example, dollars,
BTC , and DOGE.
A platform is a set of interoperating tools and infrastructure that can be used to
perform certain tasks; for currencies, the basic kind of platform is the collection of a payment network and the
tools needed to send and receive transactions in that network, but other kinds of platforms may also emerge.
A blockchain is a consensus-driven distributed database that modifies itself based on
the content of valid transactions according to a set of specified rules; for example, the Bitcoin blockchain,
the Litecoin blockchain, etc.
Network effects are traditionally linked to high market concentration, early-mover advantages, and entry barriers,
and in the market, they have also been used as a valuation tool.
How does the network effect occur?
Network effects occur where the value of the network V grows supra-proportionately to the number of users n
participating in the network. Reverse network effects occur where the value V drops supra-proportionately to the
number of users n that leave the network. Unless there is a reason to distinguish between positive and reverse
network effects, we collectively refer to them as network effects. Therefore, we define network effects to occur in
cryptocurrencies when a positive value change ∆V > 0 is larger than a positive user base change ∆u > 0 or when
a negative value change ∆V < 0 is smaller than a negative user base change ∆u < 0. Notice that we do not
consider that network effects apply when value and user base move in different directions, e.g., when the value
increases while the user base decreases, regardless of which increases or decreases more.
In simple terms, a network effect could occur if the value of a cryptocurrency increases as more users join the
network or if the value drops as users leave the network. For such an effect to be considered a network effect, the
increase or decrease in the value must be larger than the increase or decrease in the user base. Network effects can
also be caused by other factors, such as the number of transactions on the network, the number of applications built
on the network, or even the amount of media coverage the cryptocurrency receives.
Do you wonder if this network effect is a new concept in Web3?
The answer is a Big NO.
The network effect can be correlated in everyday real-world applications such as Amazon, Twitter, and Uber in
Multi-Sided platforms (MSP).
Ok, then, what is the origin of the network effect?
The theory originally emerged from Metcalfe's Law, one of the foundational principles of network economics. It
suggests that as the network grows, its value grows much faster than its user base. i.e., the value of a network is
proportional to the square of its users. ( V ∝ u^2). Many analyses were conducted to confirm whether crypto assets
comply with network effects, particularly if it follows Meltcafe’s law.
Having understood the concept of the network effect, let’s see how it affects a platform economy.
The size of a platform determines the value of MSP, as the platform's utility of the platform depends on the number
of other participants on the platform. Once the platform reaches a critical mass of users, these network effects
take effect and accelerate platform growth, paving the way for companies' growth.
In the initial stages, the platform users need more incentive to join the platform because of low platform utility.
This is more prominent in the case of two-sided markets, where buyers have little incentive to join the platform
when there is less number of sellers, and vice versa also holds good. Incentivizing the early adopters is the need
of the hour in order to overcome this issue.
Before the launch of the platform, Blockchain-based entities issue tokens at a certain price and use it as a
bootstrap to start an ecosystem. It limits the supply of tokens which, in turn, will increase the value. This acts
as a financial incentive and investment vehicle for early adopters as the token value presumably increases.
Potential users follow the incentive to become an early part of the platform and benefit from platform growth. This
potential investment gain is associated with a positive effect on platform growth, the so-called token network
effects. Every participant of the platform has the incentive to increase platform growth and gain from the increase
in the value of token. This leads to faster platform growth and even bigger platforms. These positive feedback loops
can lead to rapid scaling once the flywheel begins to turn.
Digital platforms led to multiple settings of platform governance, and there is no single owner of the core anymore.
Web2 companies spend a lot of money for marketing and advertising to develop their platform, whereas, in Blockchain
there is no need to spend money on marketing as users are genuine owners, love what they do, and love telling other
people about it.
MSP providers like Amazon mediate product interactions between different participants in the platform. If there are
several platforms competing for the same product, users can participate in multiple platforms and obtain the maximum
network benefit. For instance, a customer can hold both Master and VISA credit cards; the merchant will obviously
accept either one of these.
Let’s dive into knowing the role of the network effect for a Web3 Project.
Web3 projects introduce rewards programs to entice and retain customers. The key is through the initial distribution
of tokens through an airdrop campaign, waiver of transaction fee in the initial stages, monetary rewards for good
behavior in the community and reward for continued participation.
Combining these ways of tokens, privileges, and rewards allow an application to offer enough value to early users to
overcome the chicken-and-egg problem and reach the point where positive network effects kick in and drive future
growth. When the network grows, the token adds value to the platform and accelerates the network effect. Financial
utility target users who are not among a product's early adopter cohort. They churn faster when the incentive is
reduced.
Take the example of Uber:In a new city, the wait time was long, and drivers were idle for long periods
in the initial days. But as the rider network eventually increased, driver's earnings improved, and drivers came on
board, the wait times went down.
I must at this time thank the authors of the research paper “The token’s secret: the two-faced financial incentive of
the token economy” Benedict J. Drasch & Gilbert Fridgen & Tobias Manner-Romberg & Fenja M. Nolting
& Sven Radszuwill that discuss Blockchain-enabled utility tokens to overcome the “chicken and egg problem”.
What is a Token Network effect?
In the essay “Crypto Tokens: A Breakthrough In Open Network Design,” Chris Dixon described how tokenization could
actually increase the speed with which network effects take hold:
“Token networks…align network participants to work together toward a common goal — the growth of the
network and the appreciation of the token…Moreover, well-designed token networks include an efficient
mechanism to incentivize network participants to overcome the bootstrap problem that bedevils
traditional network development.”
"Token networks align network participants to work together toward a common goal the growth of the
network and the appreciation of the token.” —
Tokens incentivize early participants to join the network before the unit economics make sense. Bitcoin was
initially worthless. When Bitcoin got a price on May 22,2010 it motivated developers, miners, investors,
entrepreneurs, criminals, exchanges, hardware manufacturers, and many others to contribute to Bitcoin’s success.
Through DAO, tokens now allow projects to work with millions of dealers, thousands of developers, and hundreds of
entrepreneurs to build a strong network. Something that was previously only saved for big companies with billions of
dollars can now be decentralized.
How does a financial utility happen in the first phase to enable application utility to kick off?
The initial distribution of on-chain tokens can take place in several ways, as below.
The issuing entity can spread the tokens for free to owners of specific cryptocurrencies as part of its
marketing strategy in a process called “airdrop."
Developers of a blockchain project can earn tokens as a giveaway.
The issuing entity can distribute tokens in Initial Coin Offerings (ICOs) in exchange for fiat currency or cryptocurrency payment. Usually, the sale process serves to finance an underlying blockchain project. ICOs
became a popular alternative to traditional financing methods for organizations.
Early platform adopters can participate in the financial success of a platform. Blockchain technology may enable
entrepreneurs to raise funds directly, democratize access to financial capital, give investors the opportunity to
invest in early-stage projects, restructure fundraising and investing, and facilitate user and developer
communities.
Before the platform is accessible to users, the platform-building entity issues token with the aid of smart
contracts (e.g., during an ICO). These tokens are sold in exchange for fiat currency. The proceeds are used to
finance the further development of the platform. In the case of deflationary token supply, the number of tokens
issued will not change at any point. These tokens can be traded on the secondary market. No
transactional cost is associated, and no interest rate.
Demand and supply drive the value of the token. If potential users have confidence in the platform and token, they
buy the token to be part of the platform and earn a financial profit with the appreciation in the token's value. The token subscription at the initial date of ICO by investors also drives the value as it is one
of the critical factors of assessment for the potential buyers. When the platform is yet to be launched in the initial stage, it may not be accessible to buyers. In the development phase, no trade takes place on the platform. If the
potential buyer believes that the value platform is useful in the future, then he may buy the token in expectation of
price appreciation. After the platform launch, use the token to transfer money, sell or hold the
token.
Why are tokens critical for a Web3 product?
Tokens are a breakthrough in open network design that enables:
The creation of open, decentralized networks that combine the best architectural properties of open and
proprietary networks, and
New ways to incentivize open network participants, including users, developers, investors, and service
providers.
For instance, people buy video game consoles only if there are games they can play. And game designers make
games for a console only if enough people own it. The proverbial chicken and egg problem. How does
one solve this impasse?
Today, Airbnb is a huge company with a $35B valuation and 11k employees all around the globe. But in 2008, they were
just starting with an idea of air beds and breakfasts for strangers. And like all marketplaces, they faced the
chicken and egg problem:
Landlords are not interested in adding their apartments to the service without visitors.
Tenants have nothing to rent on the platform.
At a high level, the only way to address this problem is to link token incentives to network
utility, i.e., ensure that users can only receive token incentives if they add value
to the network. In other words, rewards need to be restricted to specific, desirable actions, not just
adoption.
The concept of a network effect is pretty simple: the network becomes more valuable as more people use it. The more
people participate in a system, the higher its value.
Example of token network effect from one of the existing project
In the early days of Dash, the ecosystem still needed infrastructure: mobile wallets, exchange adoption, etc., to
spur adoption. Dash decided to redirect a portion of the mining rewards to a fund. Users could then propose projects
to the fund, and then token holders in the master node network would vote on them. Dash created a VC fund out of
thin air and called it decentralized governance by blockchain. It’s now starting to be adopted by other
projects and protocols. Today, that fund is over $750K monthly supporting projects that build out the Dash
ecosystem.
Chart showing an increase in application utility as the network grows and a decrease in financial utility, i.e.,
reward distribution, as below:
Key Takeaway
“Financial utility” refers to the incentives which get emitted. It is the supply that gets declined over a period of
time. Incentives facilitate the growth of the application.“Application utility” is the activity in the
network. In the initial phase, the utility will be lesser when the network is in the bootstrap stage.
If there are more consumers on the network, the more valuable the network is to the producers. When the utility
increases, then the token value also increases. Current investors and future investors drive the value of a token.
Current investors will hold it considering the viability of the product, which leads to demand for the token in the
market, and future investors will want to buy the token, which will drive the price. This wayToken
Network Effect makes the network stronger and more rewarding for all stakeholders and will solve
the chicken-and-egg problem.
Research paper on The token’s secret: the two-faced financial incentive of the token economy. Benedict J. Drasch1,4
& Gilbert Fridgen2 & Tobias Manner-Romberg3 & Fenja M. Nolting3 & Sven Radszuwill1,4
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Priya M
Priya is the CFO of BlockSurvey. A year ago she made a career change and left the traditional finance world as a Chartered Accountant to work full time at BlockSurvey. She is specializing in “Tokenomics” in Web 3 space.