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Why Bitcoin Benefits From The Network Effect

Bitcoin benefits from the network effect in several ways. This digital currency is the world's largest by market capitalisation (market cap) at the time of this writing (July 2018). It benefits not only from a market perspective (greater price), but also from a development perspective, as more people step in to make contributions to its code.

Metcalfe's Law

When describing the power of networks, many point to Metcalfe's Law, which states that the value of a network is equal to the square of its user base.[1] As a result, adding new members to a network causes it to enjoy disproportionate gains in value.

This phenomenon is clearly relevant to digital currencies. At this point, there are more than 1,000 digital currencies listed on CoinMarketCap,[2] and none of them will remain relevant without a user base.

Bitcoin Markets

One major impact of an increase in the digital currency's user base is a rise in price. Tom Lee, co-founder of independent research firm FundStrat Global Advisors, stated in November 2017 that Bitcoin's price is largely a function of its network.

"If you build a very simple model valuing Bitcoin as the square function number of users times the average transaction value, 94% of the Bitcoin movement over the past four years is explained by that equation," he told Business Insider.[3]

He likened the digital currency to a social network and said that "the more engagement there is, the greater the value rises."[3]

Aside from the analysis performed by FundStrat, there is other evidence to support Lee's point of view. One solid indicator of societal interest in Bitcoin is Google Trends data, which measures how much a specific word or phrase is coming up in online searches.

Search interest in Bitcoin reached an all-time peak during the week spanning 17-23 December 2017.[4] At that point, search interest in the digital currency had a measure of 100, compared to as little as 6 between 2-8 July 2017.

Bitcoin peaked on 17 December 2017 at more than US$20,000 on CoinMarketCap,[5] right at the start of the aforementioned pinnacle of search interest.

As of 28 June 2018, Bitcoin was trading at roughly US$6,100. The digital currency was trading at this level as Google Trends provided a rating of 10 for the term "Bitcoin."[4]

Speculation

When it comes to market behaviour, Bitcoin functions largely as a speculative investment, which it resembles more than a fiat currency.[6] As a result, its price movements are driven largely by factors like sentiment and media hype.

However, investors should keep in mind that eventually speculative investments must have some kind of substance to remain valuable. In other words, Bitcoin requires users to stay relevant.

Evaluating Bitcoin's Prospects

Going forward, it is difficult to tell how the digital currency landscape will evolve. More specifically, while there are north of 1,000 of these currencies on CoinMarketCap, no one knows how many of these will still be around 10 years from now.

Max Gulker, a senior research fellow at the American Institute for Economic Research, looked back at historical competition between varying technologies and noted that in some cases, the technology with the greatest network effect emerged as the only winner. And in other cases, he found that the competitors boasting the strongest networks simply had an advantage over others.[7]

He said that it is entirely possible that we will end up with a situation where Bitcoin has the greatest network of users, but other digital currencies are still in existence.[7]

Summary

Network effects are important to Bitcoin, the world's largest digital currency by market cap. The cryptocurrency's price has a notable relationship to the user base, and with more users comes more engagement, which impacts the value.

Traders should keep in mind that the digital currency market is relatively new. The first units of Bitcoin came into existence in January 2009, for example.

While there is a significant number of cryptocurrencies in existence, the number could decline significantly going forward. As a result, investors interested in Bitcoin, or other digital currencies, can benefit from conducting thorough due diligence before getting involved with these assets.

Russell Shor

Russell Shor

Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…

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