Network Effect and Blockchain

In this topic, we give an overview of network effects in the field of blockchain.

Cryptocurrencies

Cryptocurrencies (an application on the blockchain layer) feel the impact of network effects too. Cryptocurrencies are only useful if many people accept them. The more people think a particular cryptocurrency is valuable, the more people will accept it, either as a means of value storage or payment.

This attracts more miners/validators making the network more secure. It also generates more attention among coders who develop clients, wallets, dApps, etc. This, in turn, makes it easier and more valuable for other users, which propels the value of this currency further.

Further examples in the blockchain space are layer 2 solutions like payment channels and rollups. In both cases, users need to lock funds away to use a payment channel or rollup. Those funds can only be transferred within the particularly layer 2 services. The more users use a particular solution, the more attractive it becomes because one can send money to more recipients.

But there are also negative network effects. New users mean more transactions, cloaking the blocks and network. As a result, transaction fees rise, the cost of storing the blockchain rise leading to more centralization.

Smart Contracts

Smart contracts are scripts that “run on the blockchain”. They offer different services like lending and borrowing, NFTs, Oracles, etc. Most smart contracts are open source. This means their codebase can be copied easily. Also, the user interface provided by the service operator is easy to imitate. But they feel the effect of network effects too.

This could be because of liquidity or collateral the service holds. The more liquidity a DeFi protocol provides, the better is the user experience. Hence, users tend to flock to the protocol with the highest liquidity. Liquidity is not copyable, which creates a competitive advantage over other newcomer services. But at the same time, more users mean more liquidity and wider acceptance which fosters the position of the service.  

Rollups/Payment Channels

Scaleability solutions like rollups and payment channels underly the network effect too. When sending tokens or coins via such a layer-two-solution, both sender and receiver must be part of the service. The more users a certain layer-two provider has, the more useful the service is. This, in turn, attracts more users, which again makes the layer-two service more useful.