The Nature of Bitcoin, Part 3: Network Effects and Altcoins

| Originally published on on January 19, 2014 |

The last two posts have been about how Bitcoin works, how this gives rise to value, how it compares to offline alternatives and how we can think about its long term potential. But to get a complete picture of the fundamentals there is one more topic to cover: the network effects that drive Bitcoin and what this means for its future and for other cryptocurrencies (“altcoins”).

There are several types of network effects in action and although they are similar in nature, it is worth making certain distinctions to further our understanding.

1) Direct network effect – more users on the network result in each one of them deriving more value. Think of the phone network or a social network, where each additional user represents one more peer you can interact with.

This network effect is taking hold today and is driving much of the adoption of Bitcoin worldwide. This benefits the Bitcoin currency in several ways, with more users:

  • leading to more liquidity
  • encouraging more services to be built on and around Bitcoin
  • representing more potential peer to peer transactions

2) Two-sided network effect – more users of one type make the network more attractive for users of a different, but complementary, type (and vice versa). Think of a credit card that needs both merchants and consumers or an operating system that needs both software developers and users. This network effect is more difficult to bootstrap, as you have to get two different populations on board, but the corollary is that a two-sided network is stronger and harder to disrupt.

As a payment network, Bitcoin is starting to gain traction as a two-sided network but there is still a long way to go. While there are probably tens of thousands of small merchants that already accept Bitcoin, there are few high profile ones. However, the recent announcement is a very welcome step in this direction and it may just be a matter of time until more and larger merchants see a real market/business opportunity and start accepting Bitcoin. In a subsequent post I’ll talk about the value to a merchant of accepting Bitcoin and what the main issues are there.

In addition, it is worth noting that Bitcoin’s nature as a protocol for decentralized financial transactions has the potential to enable a myriad of two-sided networks and marketplaces that leverage its functionality. This development, if and when it happens, will also result in the reinforcement of the value of the underlying Bitcoin network. Call this a “second order network effect”. (For a minute I thought I might have just coined this term, but after Googling it I see that Fred Wilson beat me to it by 6 years.)

3) “Variant” two-sided network effect – this is the same general concept as above, but along a different axis: Bitcoin users and miners. I believe this relationship results in most of the strengths of a more traditional two-sided network, but I’ve separated it out because there are two interesting, and potentially important, differences:

  • miners and users are not transacting with each other
  • the attraction between them is asymmetrical  

The first point is straightforward: as a Bitcoin user I do not directly transact with miners, yet I still depend on them to validate and confirm my transactions. This is an interesting distinction, but is more of a technicality.

The second point is more nuanced and far more interesting. Miners are attracted to the network because there are transactions to process and therefore money to be made (both from newly issued Bitcoins and from transaction fees). The more users and transactions, the better it is for existing and prospective miners. As a network user, however, I don’t really care how many miners there are as long as transactions are processed securely. In fact, information on the number of miners and their effectiveness is not easy to find and interpret for the average Bitcoin user today. But here is the kicker – there are dynamics here that could have perverse consequences for the whole network. Since mining requires significant, and increasing, computing power, miners have an incentive to join “mining pools” that coordinate resources and distribute the Bitcoins earned when a block is generated. This can become a problem because a relatively large enough pool is theoretically capable of a “51% attack” which could compromise the integrity of the blockchain and the whole network. (Explaining this type of attack is outside the scope of this post, so I’ll leave it to the reader to look into how such an attack could work.)

What does this mean? I think it means that most of the benefits of a two-sided network effect are in place between users and miners, but some technical and social measures will have to be taken to prevent excessive miner concentration.

So where does this analysis of the different network effects leave us? It can give us some guidance on Bitcoin’s likelihood of success and that of altcoins. My current opinions are as follows:

  1. The network effects of Bitcoin are strong and, barring any unforeseen technical problems or regulatory interventions, they should strengthen the network exponentially over time.
  2. First to take off will be peer to peer payments and other services that leverage the protocol to enable financial transactions between individuals.
  3. B2C and B2B commerce (especially offline) will take longer to gain traction. But if and when it does, the whole ecosystem will grow even more quickly.
  4. I see a limited future for alternative cryptocurrencies as the network effects for users, businesses and miners around Bitcoin will be too strong. There are two possible exceptions:
  • Specialized scenarios that require a separate blockchain for some reason. But attracting miners to give it enough processing power and security will be a challenge.
  • If the current “proof of work” processing becomes too vulnerable to a 51% attack, an altcoin with a different processing scheme could take Bitcoin’s place.