Network Effect

A child's one-of-a-kind scribble is scarce but not a store of value due to lack of network effect. A network effect is a phenomenon in which a user gets more value from a product when other users join the network. Airbnb is an example of a technology with a network effect: the more users, the more properties available for use, the more attractive the service becomes. A few other examples include the English language, social media, YouTube, and Uber.

Metcalfe's Law states that a telecommunication network's value is proportional to the square of the number of users. The number of users is squared because it's the number of connections within the network, not the number of users, that gives rise to value. Metcalfe's Law is an effective way to value any technology that exhibits a network effect. As partial evidence for Metcalfe's Law consider the time period from June 1 2017 to June 1 2021. The number of Bitcoin wallets increased five-fold while Bitcoin's market cap increased by a factor of 14. (Bitcoin wallets are software applications that allow users to make transactions. Bitcoin wallets are a proxy for Bitcoin users: users who self-custody could have many wallets, while many users who use institutional custody have no wallets of their own. Data on number of Bitcoin wallets is available here.)

Trace Mayer, host of the Bitcoin Knowledge Podcast, outlines Bitcoin's seven network effects in the following video. First speculators buy Bitcoin, secondly merchants accept Bitcoin, then a payments network follows. The fourth and fifth effects are miners securing the network and software developers building applications. The last two effects are the creation of financial instruments such as futures, and the attainment of world reserve currency status. Each network effect feeds on itself and motivates the adoption of the next effect.

The video below dates back to 2016. This is an opportunity to see how far Bitcoin has come by 2021. The global Bitcoin derivatives market is now well-established and some financial institutions use Bitcoin for fast, secure international settlement. Bitcoin is now legal tender in one country (El Salvador). Some public companies, such as MicroStrategy and Tesla, hold Bitcoin as a treasury asset.

Bitcoin's Seven Network Effects