The Network Effect and the Social Layer of Bitcoin
Guest article by BitcoinSampo
See also: El efecto de red y el aspecto social de Bitcoin
The network effect theory argues that the value of a network can be derived from the number of its users, either directly or indirectly. It’s still relatively unknown, especially among traditional economists. It has been used to explain, e.g., the dominance of big tech companies.
This article suggests that Bitcoin is the most eloquent manifestation of Reed’s law. If true, this could be beneficial in the fundamental analysis of the ever-growing value and complexity of Bitcoin. Bitcoin is not only a new digital open monetary standard, but also a network of networks, or in Reed’s terms a group-forming network (GFN), that benefits from both direct and indirect network effects.
Metcalfe’s Law and Expanding upon It
Metcalfe’s law can be used to e.g., measure the value of a social media network based on the number of its users squared (n2). The model has been validated with user data from companies such as Facebook and Tencent, and it has even been used for Bitcoin.
While Peterson’s paper validates Bitcoin’s price movement in 2011–2018, it over-simplifies the uniquely complex network effect of Bitcoin, viewing it as supply = the number of available coins and demand = the number of wallets. While this might have sufficed four years ago, technology moves fast and a lot has happened since.
Bitcoin has become legal tender in El Salvador, and investment instruments such as Bitcoin ETFs are being launched at the time of writing. Bitcoin is currently in the process of critical mass adoption where the indirect network effects contributing to the total value of the network are becoming impossible to ignore.
As Peterson proved, the direct effect can be calculated based on the number of wallets, but even the base layer of Bitcoin benefits not only from the users, but also from other network participants; node operators, miners, and developers.
Since Bitcoin is an open monetary standard, it is a uniquely additive network where all participants, even companies building on the standard, benefit from the collaborative effort of all users, and contribute, at least via indirect network effect, to the total value of Bitcoin. Thus, Metcalfe’s law only suffices in estimating the value of the base layer of Bitcoin, but it ignores all other development. Luckily, another model exists for a more comprehensive evaluation.
Reed’s Law and Why It Applies to Bitcoin
Expanding on Metcalfe’s law, Reed’s law, developed by American computer scientist David P. Reed, and published in the article The Law of the Pack in 2001, defines a group-forming network. Reed suggests that large networks can expand exponentially according to 2N — N — 1, where N is the number of participants.
Since even two network participants can form a group, such as a direct peer-to-peer link between their nodes, Reed’s law seems like the perfect model to evaluate the network effect of Bitcoin. In other words, the network effect of Bitcoin, which is unique in its properties of combining business, finance, social networking, technology, and altruism (just to name a few) in a complementary manner, is the most eloquent manifestation of Reed’s law.
The Bitcoin network is the most extensive collaborative effort in the digital sphere, perhaps even in human history. Node operators, miners, developers, and users all contribute to the security, immutability, and ultimately the value of the network, and should therefore be included in this GFN. However, things get tricky when one considers that a single user might be a wallet owner, even own multiple wallets, run a node and a mining operation, and even participate in Bitcoin’s development. Thus, each participant might operate on multiple levels, and form multiple groups that bring their own value to the network, either directly or indirectly.
Indirect Network Effect of Bitcoin
Layer 2 solutions such as companies building their business on Bitcoin should be considered as separate subgroups that indirectly contribute to the network effect of Bitcoin since “the utility of at least one group grows as the other group(s) grow”1 . This is due to the interoperability of the Bitcoin standard, but also increasingly the direct interoperability of services such as Cash App and Square.
This indirect network effect is also increased by services such as Fold, which further increase the network effect by “rely[ing] on extrinsic motivation, such as a payment, a fee waiver, or a request for friends to sign up”.2
It is also common for exchanges, such as LocalBitcoins, who utilize an affiliate program where users earn commission on others’ trades. Since all users who own any amount of bitcoin are directly invested in the network, this creates a uniquely devoted network of people. However, there is much more to this promotion than just self-interest.
The Quest for Knowledge and the Social Layer of Bitcoin
Humans outwitted their surroundings thanks to their superior intellectual capacity, which can be seen as an evolutionary trait. When it comes to Bitcoin, this thirst for knowledge is truly never-ending since the amount of information available already exceeds the limits of any single individual, with more content being produced every day.
Expanding on Reed’s analogy, the subgroups of groups include Bitcoin discussions on all social networks; those speculating on the price, discussing the technical aspects, engaging with the memes of the season, meet-ups, conferences, and even spontaneous Twitter Spaces. The amount of Bitcoin podcasts, articles, news, discussions, and casual content is truly mind-boggling.
This humbling feeling of not knowing enough, combined with each individual’s self-interest, and the tendency of people to form groups based on their interests, creates the unique network of social networks, or ‘The Social Layer of Bitcoin’. Its value might be rather impossible to measure numerically, but in the end it might be one of the decisive factors in explaining Bitcoin’s continuing success.
Reed’s theory has been criticized by Andrew Odlyzko, who states that the maximum value of said groups is limited by the so-called Dunbar’s number (the maximum number of relationships a person can maintain). In fact, Odlyzko’s criticism rings true for the social groups of Bitcoin, and this has even been validated with, for example, data from Twitter discussions. However, this is not true for all the groups on the group-forming network since many of them are formed based on technical, not social aspects.
Personal Tipping Point
These social subgroups increase each individual’s commitment to the network, and ultimately serve as the catalyst for market tipping where “one system [… pulls] away from its rivals [once they realize] it has gained an initial edge”.3 It is still too far-fetched to claim that this tipping point has been reached throughout society, since the value of Bitcoin is ultimately still counted in fiat terms.
However, it is beneficial to define a so-called personal tipping point since increasingly Bitcoin network participants have already adopted the value system of the new standard; they count value either in bitcoin or in satoshis.
Thus, on a personal level they feel that the three conditions needed for market flipping have been met; “1. The utility derived by users from network effects must exceed the utility they derive from differentiation, 2. Users must have high costs of multihoming (i.e. adopting more than one competing networks) 3. Users must have high switching costs”. 4
It is common to digress into competing assets and fall for their alluring marketing lingo. However, the most important realization is that those who have adopted Bitcoin don’t need an exit strategy since they firmly believe that Bitcoin will ultimately consume all other value.
Hyperbitcoinization as the Market Tipping Point
At the ultimate market tipping point, hyperbitcoinization, the exchange rate for fiat currencies becomes irrelevant since value transfer will primarily occur on one of the layers of the new digital monetary standard, and all other value will either be derived from it as commodities or tokens.
Fiat value will perhaps remain a curiosity and an exchange rate for traders, speculators, and freshly minted coins. Cryptocurrencies will become tokens of interest, speculation, and leverage. Ultimately they serve as so-called social satellite groups that inevitably lead to Bitcoin.
This market tipping point might be 5–20 years away, or might never occur. However, the combined network effect of the aforementioned parts of Bitcoin’s GFN, combined with the absolute scarcity of Bitcoin, tip the scale in favor of Bitcoin. Increasingly, this realization dawns on even the most conservative mind and buying bitcoin becomes a game of musical chairs, where many people will be left struggling for a seat. Reserve your spot as a beneficiary of this new monetary standard by buying bitcoin.
