Bitcoin and the issue of network effects
Bitcoin supporters vary in the extent to which they expect the new cryptocurrency to circulate in the future. Some see the potential of Bitcoin in replacing the dollar. Others believe that the Cue Ball can serve as the main currency for cross-border trade, while fairly well-managed national currencies, such as the dollar, continue to circulate within the country.
Still others expect that the use of Bitcoin will be largely limited to countries such as Venezuela, Zimbabwe and Argentina, where national currencies were used incorrectly in the past. But most of them are referring to the widespread use of Bitcoin.
The market capitalization of Bitcoin suggests that there is some probability that it will become widespread in the future. Experts say that the market capitalization of the BTC reflects the degree to which Bitcoin is useful for making transactions today or is expected to be useful in the future.
As events suggest that Bitcoin is more likely to replace the bolivar (the currency of Venezuela), or capture market share in global money transfers from Western Union, or otherwise be more widely used in the future, people are willing to pay more for Bitcoin today. As a result, the market capitalization increases.
On the other hand, when events suggest that Bitcoin is less likely to be widely used in the future, people pay less for the asset, and the market capitalization decreases.
Currently, the market capitalization of Bitcoin is comparable to the capitalization of many national currencies. According to Coinmarketrate.com Today, there are about 18.8 million Bitcoins in circulation, worth about $45,000 each, with a total market capitalization of approximately $0.85 trillion.
For comparison, the market capitalization of the US dollar is about $5.25 trillion. The market capitalization of the Chinese yuan is $1.4 trillion, and the Canadian dollar is only $0.352 trillion.
Since Bitcoin is not widely used today, its market capitalization suggests that those who invest their money in it think that it will be more widely used in the future.
Are they right? Perhaps.
But those who expect widespread adoption should recognize that Bitcoin faces at least four obstacles: network effects, government opposition, suboptimal supply constraints, and limited transaction capacity. Let’s talk about the network effects of BTC.
How Network Effects Apply to Bitcoin
Network effects are of great importance for the usefulness of Bitcoin as a currency and a store of value. Like all major currencies, its value depends on who wants to accept it as payment or buy it as an investment. As more and more people accept it, it becomes more valuable for those who want to spend it.
However, any other currency also depends on network effects. This powerful phenomenon favors which product has the largest user base, regardless of the main utility of the product. This means that currencies that have proven themselves well with large user bases have strong blocking effects, encouraging people to continue using them.
Bitcoin is designed to replace fiat currencies by millions of users. Moreover, many people expect it to largely replace gold, the global store of value and one of the oldest currencies still in use.
In order to compete with established currencies, Bitcoin must overcome the blocking effect that they currently benefit from. This is why the adoption of Bitcoin took a long time, despite the fact that it had much better characteristics of money than existing ones
Bitcoin is a savings technology and a payment settlement network. Smart contracts, applications and other things are created on its basis, but currently this is not the main use case.
Its hashrate has consistently reached record heights, while many cryptocurrencies still have a hashrate of the level back in 2018, which is considered a record high for them.
Such a high hash rate makes attempts to attack the Bitcoin network so expensive that it will require as much electricity as in a small country. And that’s not all: you need so much equipment that it exceeds fifty percent of the existing machines in the network.
It is also difficult to measure how many people use BTC or other crypto assets, or what is the concentration of addresses in the network. The address does not always correspond to one person. Sometimes large addresses often have accounts of a huge number of crypto users, and large users often store their Bitcoins at more than one address. But, it is worth noting that the growth of retail investor addresses with a small number of PTS continues. And it’s just great!
It is enough to take, for example, the crypto exchange Coinbase, where there are more than 40 million users. Adding several exchanges together and eliminating possible duplicates leads to more than 120 million users worldwide.
Network effects
It is important to understand that bitcoin is facing long-existing players. Since we are already using money, choosing to use Bitcoin means less use of some of the available money. This is a decision about the distribution of the portfolio. A person wants to keep a certain percentage of his fortune in highly liquid assets for making transactions.
Before switching to Bitcoin, she only had some current money (for example, dollars, euros, rubles, etc.). An increase in the distribution of BTC in the portfolio means a decrease in the distribution of existing money. This is a problem for Bitcoin, because network effects contribute to maintaining the status quo.
The demand for money is very different from the demand for many goods and services. We use money for transactions with other people. If more of your trading partners decide to use certain money, this money will become more useful for you. In other words, the demand for certain money depends on the demand of trading partners for this money, and vice versa. We care not only about the characteristics of money. We also take care of their network of users.
Current money, like the dollar, uses a large network of users. Almost everyone in the United States, and many outside of their borders, will gladly accept dollars today. Upstarts like Bitcoin don’t have such a big network. Only a few accept it.
Let’s say everyone has independently admitted that BTC is superior to existing money. Can the recognition of this fact encourage them to switch to Bitcoin? Not necessarily!
They may want to switch if they are sure that a sufficient number of their trading partners will also switch. But without such guarantees, the safest strategy is to continue using the money that you and your trading partners used. And this inertia can maintain the status quo, even if the available alternative is better.
The coordination problem associated with choosing which money to use is similar to the problem associated with choosing whether to drive on the left or right side of the road. Speaking abstractly, it probably doesn’t really matter if we’re all driving on the left side, or if we’re all driving on the right side. The important thing is that we all go on the same side!
In Russia, we drive on the right side of the road. But suppose that a respected analytical center had to distribute to everyone a very well-thought-out and well-written study, which clearly states that driving on the left side of the road is better than on the right side of the road.
We could all admit that it would be better to drive on the left side. But, even putting aside legal issues, it would be stupid to start driving on the left side of the road before anyone else does. In the absence of coordination (and probably changes in the laws), we would continue to adhere to the status quo.
The same can be said about money. No one wants to use money that no one uses. Few people are ready to switch to the BTC as it is used by few people. Even if everyone recognized that Bitcoin is superior to existing money, they could continue to use ordinary money if they were not convinced that other people would also switch.
Conclusion
The main conclusion is simple. It is not enough that Bitcoin is better than the available alternatives. It should be good enough to guarantee the switching costs, which include the costs of coordinating this switching with others.
The problem of network effects is not an insurmountable obstacle. Entrepreneurs can take steps to reduce the problem of network effects. However, this is an obstacle that Bitcoin must overcome in order to achieve widespread adoption.