Cardano and the power of the network effect

TLDR

• The success of global firms is mainly due to the network effect. However, there is not a single network effect, but many. Each of them plays a role in the overall value of a given company or project.
• A strong network effect can result in disadvantages for end users. Centrally controlled firms may begin to abuse their position to the detriment of users. Monopolies are emerging that are hard to compete with.
• Decentralization is a very important feature for the internet, as it is proving to be the new backbone of the world and everything important will happen on it. The centers of power are weak points of the Internet and should be eliminated.
• Regarding cryptocurrencies, we can find several network effects. To name a few of them, we can find those that are associated with currency, brand, transmission network, platform, blockchain, and decentralization.
• Experts are exploring the impact of the network effect on the success of products and services and have described many of them. The most powerful network effects are the direct ones, i.e. those that directly connect users to each other. There is also a whole category of social network effects, which includes belief and religion.

The importance of the network effect

Apple, Google, Microsoft, Facebook, and Amazon are some of the most impactful and significant companies in the world. They are called the Big Five. These companies reach new all-time highs nearly every year regarding market capitalization. Each company is very different in a lot of ways but they have something in common in their business models. It is the network effect. The network effect is Alpha and Omega of their success. It is crucial to understand it well to be able to search for parallels with blockchain technologies.

We can observe the network effect when a company’s product or service becomes more valuable as usage increases. The network effect grows with users’ adoption and it has a significant impact on the market capitalization of the company.

The Big Five companies built their businesses purely on the network effect. If you check the statistics you will see that most of the outsized returns of companies since 1994 have succeeded via the network effect. Based on historical data, you can also predict that the next successful company similar to Uber, Airbnb, or Snapchat will most probably appear every two years. You can be pretty sure that the network effect will be the core of the business.

New companies that bet on the network effect tend to grow rapidly. In the last two decades, the network effect has taken part in the value creation for approximately 70% of the technology industry. Supporting the growth of the network effect is the key to success and it is maybe more important than decisions made by CEOs, the number of employees, and sometimes even the quality of services.

As a matter of fact, companies that use the network effect are usually much more valuable than companies without the network effect. The Internet became the center of our lives and these companies succeeded mainly for the reason that they are global. The Internet does not know national borders. The Big Five companies, and many others, adopted the concept and became global as well. They are tremendously powerful and have a significant impact on society, the economy, and even politics.

Why and how to compete with Big Five

With power comes problems. A strong network effect is a great competitive advantage, but it also brings some disadvantages for users. Social networks are accused of influencing elections and de-platforming inconvenient people. The Big Five companies are a major threat to start-ups because they can easily copy new ideas and promote them more quickly through their existing network effect. When Amazon announces its entry into certain business sectors, it almost immediately destroys competitors who have tried to innovate. Amazon can introduce new services quickly and well. You could find many other examples of disadvantages.

Unfortunately, you can’t buy the network effect. It can only be achieved over time and is incredibly hard to compete with the existing ones. Without the ability to compete with the big five, they become monopolies. Monopolies almost always tend to abuse power and dominance. Without relevant competitors, users cannot switch platforms or service providers. This can be a serious problem.

The Big Five companies have such a strong market position that they can easily avoid paying full taxes or even debate with legislators about regulations and try to dictate their terms. Individual governments have control over their citizens, but large global companies have control over all users of their services. We do not think that international organizations have as much power as the Big Five companies. We do not all realize how powerful global companies are right now, and it is hard to predict the future. We can assume that their power will grow.

Technological domination and control over people is not only a problem for users themselves, but is slowly becoming a problem for governments as well. It is easy for global companies to maintain and continuously expand the network effect and gain the trust of users. If the trust in governments, banks, and institutions gradually decreases, then trust in these global hegemonies may increase. This could be dangerous.

It turns out that without the ability of start-ups to quickly harness the network effect, there is little chance of competing with the Big Five companies. Cardano and other public blockchain networks, in general, can also be considered startups. However, they bring the kind of innovation that can have an advantage against the Big Five. It’s the kind of edge that Big Five companies can’t so easily take over.

Decentralization is something completely new. Cardano can provide decentralized services and enable users to create value without a power center. Without conditions of use, resistance to censorship, fairness and equality of users, transparency, and the possibility to audit, there is no chance to abuse power and dominance. Why? There is no one who is dominant and can abuse power. There is no one who can disproportionately benefit from decentralized services in a way that allows abuse of power.

Don’t get us wrong. A successful decentralized service will need to have a large network effect. Teams or owners can partly benefit from the success of the service. The key difference is that truly decentralized services should not have a central authority that is able to change the rules and take the whole profits. Decentralized products and services should be owned by the community, and the community should be responsible for decisions related to change. Ideally, it should not be necessary to change the service at all.

What is the difference between centralized and decentralized services in terms of infrastructure? Both blockchain networks and Big Five companies use the internet as the underlying infrastructure that is capable of transferring data from computer to computer. We can consider the Internet as a kind of decentralized infrastructure.

The Big Five companies have centralized the business from the users’ perspective. This means that global companies own their infrastructures and have full control over them. For example, Amazon has its own servers, R&D, management, marketing, layers, CEO, etc. What is the issue here? De-platforming is always about the decisions of individuals and is a kind of censorship. The misuse of user data is essentially a dubious business model. It is caused by low transparency and is considered an unfair business practice. We could go on with more examples, but let us rather ask the fundamental question. Why is this possible? We have already answered this question. Ownership of infrastructure is to blame. The Big Five companies have access to user data. They can change the terms of use. They change software every day as they need without consulting the change with users.

More importantly, they are trying to be as profitable as possible. They are therefore practically economically motivated to move on the edge of the law or even to exceed it. Making a profit is almost always a stronger motivation than acting in the public interest. To be clear, the services of the Big Five companies are amazing. With a few clicks, you can have lunch on your desk in minutes. You can order a cheaper taxi. You can be in touch with literally the whole world and voice your opinion. It works well until you find out that you could have the same lunch cheaper, taxi drivers have to pay a lot of money to middlemen, your opinions are monetized and social networks benefit from it. If companies don’t like your views, they can de-platform you.

Decentralization is a very important feature for the internet, as it is proving to be the new backbone of the world and everything important will happen on it. This is already true today and will be even more true in the coming decades. The centers of power are weak points of the Internet and should be eliminated. That’s why it’s so important to push for decentralized networks like Cardano. A decentralized network naturally has no center of power. Thus, the network is owned and maintained by the users themselves. Also, some large users may become centers of power over time. It is therefore important to monitor and improve the quality of decentralization. If Cardano remains under the control of the users, the services created on it will also be decentralized. Charges for using the service must go at least partly to the network itself. The infrastructure of Cardano as a platform will thus be continuously improved and offer the possibility of creating competing services. The creators of decentralized services will never have the infrastructure in their control. This is very important, as they will not be able to abuse their position as easily, if at all, as in the case of centralized services.

It is theoretically possible to create a decentralized service with elements of censorship, but this will only be present at the level of the service itself, not at the level of the platform. Users would probably refuse to use such a service, even if it achieved a large network effect. The service could easily be copied because of the open-source nature of the whole decentralized movement and thus the censorship elements can be removed.

Decentralization should be seen as a concept where all people benefit from the existence of the service. Users, or a subset of users, are the ones who are responsible for making decisions about changes. There should not be a CEO and management in the system. If the service is profitable, those who manage the service should be rewarded and it should be easy to get some of the voting rights.

There are several types of network effect

A simplified definition of the network effect states that the value of a product or service increases as the number of users increases. The national language of a country has a very strong network effect because everyone in the country speaks that language. If a few citizens learn to speak another language, they may speak it among themselves, but the network effect will be smaller in that country. Similarly, money has a very strong network effect because literally, everyone in the country uses it. Cryptocurrencies, meanwhile, have a very small network effect, as far fewer people use them as a medium of exchange. A highway has a negative network effect, as the more people want to use it, the faster it gets clogged up and ceases to serve its purpose. We can say that the network effect of a highway has some limits. It may be that the network effect cannot grow due to insurmountable constraints.

If we look at this more closely, we find that there are several types of network effects that behave differently and affect the overall value of the product or service differently. Each network effect brings different values to users and is more or less important in terms of overall value. If we apply this observation to cryptocurrencies, we can conclude that the market capitalization of a project will reflect the sum of all network effects.

It is important to note that each individual network effect evolves at a different rate. Individual network effects may interact with each other. For example, if brand awareness grows, it is likely, not certain, that the number of users will grow. Conversely, if the number of users grows, it is likely that brand awareness will also grow.

If we wanted to define all the network effects of the Cardano project, we could easily count over ten. For simplicity, let’s divide them into two basic categories: currency and platform. This division makes it easy to demonstrate that the two categories are somewhat independent of each other. During the analysis, we find several network effects.

Let us now briefly describe both categories.

The currency category mainly includes ADA coins, which can be used as a store of value, a medium of exchange, to distribute power in the Cardano network, etc. Analogies to the real world could be dollars, stocks, or voting rights.

The useful capabilities of the Cardano network fall into the platform category. These include infrastructure that allows you to send ADA coins between users, create your own tokens, the ability to deploy smart contracts, serve as a payment network, and so on. Notice that the ability to work with blockchain as a distributed database is very important.

If you look at how the traditional world of finance works, you will find that money is completely independent of infrastructure. Central banks are responsible for the money supply in a given country. Card manufacturers produce one kind of card that can be used for dollars, euros, yen, and so on. If you have dollars on your card and you go to Europe, you can pay with your card and not even notice that the transaction is converted into euros. PayPal and other payment networks can easily transfer multiple currencies.

It can be said that the network effect of individual currencies and the network effect of payment networks differ but help each other. We can also observe that payment networks and payment cards increase the utility of currencies. PayPal has even adopted Bitcoin, so it has strengthened its network effect and at the same time increased the network effect of Bitcoin. What network effect will Bitcoin specifically increase? The network effect of the brand and currency will increase. The Bitcoin brand will be visible on PayPal’s web services. If BTC coins are used to pay, the usability of bitcoin as a currency or store of value will also increase.

Note that if bitcoins are transferred via PayPal, it will increase Bitcoin’s brand awareness. Thus, it will increase the particular network effect that is associated with the brand. That’s definitely a positive thing. Conversely, it may reduce the network effect of the first layer of Bitcoin, because the protocol, meaning the transaction network, will be used less. Ultimately, this is a good thing, because the first layer of Bitcoin is like a highway, the more people want to use it, the faster it gets clogged up. The technical limitations of this network effect will be taken over by other networks, whose network effect will in turn be enhanced.

Issuing tokens and deploying smart contracts need interaction with the first Cardano layer. Only then can other networks such as Hydra be used. Thus, the network effect of the first layer is also extremely important as it is the gateway for the use of other networks. It also has a significant impact on financial inclusion and the ability to use the network. Thanks to the Cardano network’s ability to tokenize digital assets, it will also be possible to tokenize Bitcoin. It is thus possible and very likely that the network effect of the Cardano network will grow thanks to bitcoin. This will strengthen the network effect of the Bitcoin and Cardano brand (currency category), but only the network effect of the Cardano transmission network (platform category). Both projects will benefit from this.

It should be mentioned that issuing tokens and deploying smart contracts is a capability or a utility that will also have a network effect. Let’s call it the network effect of the platform.

In the case of protocol decentralization, we can also talk about the network effect. The more pools and stakeholders Cardano has, the greater the network effect. Note that the network effect of decentralization does not correlate with the network effect of people using Cardano as a transactional network. People can send not only ADA coins over the network, but also NFTs, stable coins, and other things. As with Bitcoin, the network consensus of the Cardano network has limits, and the network effect cannot grow indefinitely. So it is necessary to work on technological innovations to help increase the network effect of the first layer.

Now let’s go back to our analogy with fiat currencies and try to think about it in the context of cryptocurrencies. Native coin projects and the transmission network are interconnected. Security and decentralization are dependent on the price of coins and their distribution among users. While ADA coins will go over other networks, such as PayPal, ideally most coins should be transmitted over Cardano protocols. The reason is that the network effect of decentralized protocols will grow and will not reinforce the network effect of competing for centralized solutions. In addition, it is necessary to think about the economic model of public networks that need to collect usage fees. Strengthening the inherent network effect is important for security and decentralization. On the other hand, the network effect of a brand can also lift the market value of a project, so PayPal’s adoption of ADA is not necessarily a bad thing. Sometimes it can be difficult to gauge what’s best for a project.

In conclusion, in the case of Cardano, one can also decouple currency and platform, but it is not desirable. PayPal has an economic model that is independent of the currencies it transfers. The existence of the platform or blockchain network is directly dependent on its own native currency and its utility or ability to transfer value. Once the network effect of the transmission network is reduced, it can directly threaten the network effect of the currency.

As you can see, we have described several network effects, specifically those that fall into the currency category: currency, brand, and those that fall into the platform category: transmission network (number of users), platform, blockchain, and decentralization. As we said, more network effects could be found.

Network effect reloaded

Many experts are exploring the impact of the network effect on the success of projects and services. As a result, many general network effects are well described today. The most powerful network effects are the direct ones, i.e. those that connect users to each other and allow them to interact. There is also a whole category of social network effects, which includes, for example, belief and religion. You can see them in currencies and also cryptocurrencies. There is also a network effect related to technological performance. Let’s dive into the world of network effects and think about how they can be applied to cryptocurrencies.

The utility of cryptocurrency decentralized networks lies mainly in peer-to-peer communication. That is, on the direct connection of users who can interact with each other socially or financially. The value of a network is proportional to the number of connected users squared (N²). This is now known as Metcalfe’s Law. The direct network effect depends on the digital infrastructure, i.e. the pools, nodes, and wallets of the users who can use the network.

Interestingly, in the case of cryptocurrencies, people can send each other volatile coins. Although all users are connected to each other they do not want to send ADA or BTC coins. Paradoxically, as the network effect grows, the value of coins increases, which acts as a brake on usage. Speculation is more important than the actual use of the transaction network. To be precise, the network is used to buy and sell coins, so transfers of value do occur. However, there is not so often direct interaction between users, but rather interactions between users and exchanges.

The author of the text personally knows dozens of cryptocurrency holders, but he regularly exchanges with only two people. In this context, we can conclude that the direct network effect has not yet developed much.

If we are to talk about the growth of this direct network effect, we expect it to grow only due to tokens that are stable or less volatile in value. Such tokens will be sent more frequently between users. We can also expect to see the emergence of local or special interest sub-groups that will use the network for a particular reason. Perhaps they will exchange NFT tokens or shares among themselves, or pay with stable coins. The number of users of NFTs and other types of tokens may only be temporary, or may only be relevant to a certain part of the population, but they have the advantage that there may be more than one type. Their value may or may not be permanent; many tokens will be speculative. What is important, however, is that a direct network effect is building, and as soon as a token becomes established, as the first likely stable coin, the network effect will gather momentum. For a direct network effect to develop, it is extremely important that people interact with each other, and that is not likely to happen anytime soon with volatile coins.

Let us add that once a strong player establishes itself, it is generally difficult to compete with it as it can be costly to build similar infrastructure and get users’ traction. However, this is especially true in the physical world where we would be talking about cables. In the digital world, where protocols are used, this may not theoretically be such a big problem. The competition will be mainly on the technological level, i.e. in the field of scalability and user experience.

In practice, we can see that today it is almost unthinkable to dethrone TCP/IP. This is due to the fact that there are many other protocols running on top of these protocols, including Cardano and Bitcoin. Protocols above the TCP/IP layer change quite frequently. It is relatively easy to create a new protocol above the TCP/IP layer, it is more difficult to attract users.

The success of adoption strategy is often less about technology and more often about marketing, social engineering, and the choice of a market niche. Other network effects, such as faith or religion, or the current economic situation, play an important role in the case of cryptocurrencies. We can observe that Bitcoin has established itself as a store of value despite being expensive and slow to use the protocol compared to competitors. However, it must be added that no cryptocurrency has yet crossed the critical threshold of adoption and become a standard. A given protocol must be able to transmit data at the required volume and quality to become a standard at this level of the network effect. It is possible to build additional protocols that will expand the possibilities under the same brand. Second layers such as Lightning Network or Hydra are examples.

Cryptocurrencies will not fit into established categories and it is more than likely that more standards will be enforced. The protocol that represents the store of value may not necessarily need to transfer a big amount of transactions. Moreover, it does not need to have a lot of other utilities and functionalities. Bitcoin, as a currency or store of value, has a chance to establish itself because of the strong belief network effect, despite the fact that the network effect of the transmission network will be low. But this finding inevitably means one thing. Decentralized value transfer and value creation will have to be provided by other networks that have a chance to attract many users and thus have large network effects.

Can decentralization as a concept be built or fully exploited only on volatile ADA or BTC coins, or can we find some advantages beyond the direct use of these coins? The usability of the Bitcoin network is entirely dependent on BTC coins. The Bitcoin protocol can’t store or transfer anything other than BTC coins or provide any other functionality that leverages the blockchain and network consensus. Thus, if a user holds BTC coins in their wallet for a long period of time, they will essentially not use the transaction network and thus will not reap any benefits of decentralization in their daily interactions with their environment. This opens up a huge opportunity for other networks to target other uses of blockchain technology.

If we find another usefulness of decentralization that will be of interest to a larger number of people, the direct network effect of the project will increase. Here we see great potential for Cardano. As a smart contract platform with the ability to issue tokens, Cardano will not build its utility solely on ADA coins. The services and tokens issued can achieve a large direct network effect, thus helping Cardano’s brand network effect. This will increase Cardano’s overall value. It is important to note that Cardano can succeed in many areas and be of great social, economic, or even political importance. The store of value is only a peripheral thing in the whole spectrum of people’s needs and current world problems. Any of us could list many problems that could be improved at the technological level and through decentralization.

Let’s not forget that the first-generation blockchain can store value in the first place and then only transfer it. The transfer itself is not very user-friendly and here it is possible to innovate. Importantly, blockchain technology can also enable value to be created or become a necessary tool for this purpose. Great social and economic significance and at the same time a strong direct network effect can arise through the possibility of monetizing art, tokenizing digital assets, connecting people via identity, or providing a trust layer for business. Blockchain has the potential to disrupt many industries. DeFi can compete with the banking sector with peer-to-peer lending. It can disrupt the art industry and connect artists to consumers directly so fees don’t go to middlemen. Any tokenized asset such as a stock can have a real value that will be stored in the blockchain and can be transferred. All of this can be seen as creating social and financial value with the potential to grow the network effect.

DeFi may have more users than there are BTC coin holders in another 10 years. DeFi services are more connected to everyday use and the real economy. Almost everyone on the planet needs a loan, savings, or investment, which cannot be said for a store of value. Of course, the traditional world of finance is a lot of competition for DeFi, so it’s hard to predict the future of the sector. However, judging by current user interest, things are on track.

Another large group of services with the potential to achieve a large network effect is related to people’s identity. All Big Five companies belong to this group to some extent. There are a large number of services that use people’s identities, whether real or fictional. Identity is needed in the world of finance, on social media, when buying goods and services, at the doctor’s office, when interacting with government agencies or banks, and many other places. Things like a house, a car, a diploma, a loan, insurance, an investment, a will, stocks, a driver’s license, the ability to enter a particular building or room, a digital asset, the right to use a service you paid for, they are all linked to identity. The requirement for exclusive ownership without an intermediary applies not only to the storage of value or money but also to many other things that may be associated with identity.

If you want to pay in a decentralized way, it will be via stable coins and not volatile ones for the next 10 years or more. If regulators tighten up the use of cryptocurrencies and require KYC/AML, again this may be the identity that allows us to use decentralized services that comply with regulations. Identity can also quite fundamentally improve the user experience when using wallets and rid us of the dangerous copying of blockchain addresses. A decentralized identity (DID) issued on the Cardano network may one day achieve a greater network effect than a store of value. When you consider that almost anything can be tokenized, once the regulators have done their homework, the door opens for many uses. Tokenizing shares will be a piece of cake as the issuer will have its decentralized ID and it will be easy to verify that the shares are authentic. You can then exclusively own the shares without an intermediary. You can also sell them at any time without an intermediary.

The social value of DID can also play an important role, for example, in the relationship between employers and employees, or producer and consumer relationships (marketplaces). A DID has no specific nominal value to anyone other than the owner. However, connecting people through a DID, being able to get a job remotely, or facilitating access to handy services, is of great importance. Let us add here that the more people use the DID, the more the personal network effect and the overall value of the network will grow.

Cardano is a platform that allows for a two-sided network effect. On one side are developers who want to create an application. On the other side are users who consume the developers’ applications. Both groups have different interests. The platform is just an intermediary that connects the two groups and allows to build and consume applications. Think of it as an operating system from, say, Microsoft. Developers can build many applications and anyone who has Windows can upload and use the applications. This creates games, utilities, tools for work and entertainment. Each individual application has a network effect, which can be small or large. However, with a large number of applications, the network effect of the platform grows dramatically. Bitcoin and Cardano are not competing on this front. Bitcoin will never be a platform, as it would technologically fail to serve this purpose in terms of its ability to create applications and, more importantly, its performance (mainly scalability).

Let us add that marketing and the promoters who will sell or promote each app can play an important role here. In a decentralized world, we don’t see much yet of anyone promoting any DeFi service or game. We think it’s only a matter of time and with the growing number of users and competition, we will see it happen.

The last major group we will look at is the social network effect. Here, human interaction, psychology, and to some extent marketing play an important role. Again, the more people use a product or service and talk about it with others, the more the overall value increases. People can interact with each other and thus change the overall perception of confidence. This can encourage other people to use the product or service. The social network effect can be very difficult to create, but if it can be achieved, it can be a great competitive advantage.

This type of social effect can to some extent be considered as brand protection. This is a very typical feature in the world of cryptocurrencies, but it can also be observed in gold. This effect is so strong that we can talk about religion. It is no wonder that Bitcoin proponents often try to weaken gold’s position as a direct competitor. It should be noted that sometimes the belief-based network effect is at odds with reality.

People are social by nature and want to share the same values and believe in the same things. We can talk about group thinking. Belief in money or in the state is very strong because only a small part of the population doubts it. If individuals don’t believe what the majority believes, they may be considered weirdos or dreamers.

It is said that faith is like sand. If only a small number of people believe, the wind blows and the sand is scattered. But if more people start believing, the sand becomes a stone that the wind cannot threaten. It took 5000+ years for gold to be as solid as a rock today. The past gives people confidence that the belief in gold will continue. Belief thus strengthens with time.

Individual cryptocurrency projects must be interested in building strong communities. This is essential for success. However, the belief must be backed by technology.

Summary

The network effect of cryptocurrencies is still relatively small, although it is steadily strengthening. Perhaps the strongest network effect is the social one. Cryptocurrencies in their early days were mainly a symbol of protest against the financial world. This influence is still evident, and over time it has turned into an effort to compete with gold or create non-state money. The first generation of cryptocurrencies, led by Bitcoin, has a very ambitious goal and it will be extremely difficult to combat the social network effect of gold, fiat currencies, and governments. Belief is stronger at the moment than Bitcoin’s technological ability to replace fiat money. We need to acknowledge this and remember that without innovation we will not move forward. Belief cannot overcome and obscure technological shortcomings. Bitcoin is first and foremost a network protocol and if technological shortcomings manifest themselves at the wrong time, belief will crumble like sand.

It’s hard to say if Cardano and other cryptocurrencies will become a store of value, but this is not the mission of the Cardano project. Cardano aims to become a global social and financial operating system. Thus, it is more important for Cardano to reach technological maturity and grow stronger at the level of direct and platform network effects. Belief is also important, of course, but plays a weaker role. It is important to note that the network effect of the Cardano project may be larger than the network effect of Bitcoin, since identity, loans, insurance, savings, and many other things are needed by people for everyday life. This is not about competition in market capitalization, but about the real-world application and improving the living conditions of people, especially from poor and developing countries. We can speculate about the impact on market capitalization, it will certainly not be negligible, but it is not that important at the moment.

At the outset, we described some of the problems associated with centralization that mainly affect Big Five companies. Alongside them, we could also put the world’s big banks, central banks, and often governments. At this point, it is too early to say whether blockchain can in any way disrupt the dominance of these companies. However, if we want to build a new decentralized world, we should not be afraid to think about the possible disruption of these entities. Only time will tell how this will happen and how blockchain technology will take hold. We will discuss this in a future article.

Source: Cardano and the power of the network effect