One of the strongest competitive advantages that a company or a system can have is the network effect, which makes it one of the most valued intangible attributes in any investment.
The network effect is a phenomenon where increasing users or participants improve the value of a good or service, making the network exponentially more valuable to each user. The Internet is an example of the network effect. In its beginnings there were few users since it had no value for anyone other than the military or scientific sector, but later the increase was exponential and the value increased for everyone.
Also, the network effect can be defined as the attribute of a company or a system in which, the more users use a network, it will become exponentially more valuable for each user. It is one of the main competitive advantages that a company or a system can have over its competitors.
One of the earliest examples of a network effect was the telephone. A single telephone was useless, but as more and more telephones came into existence, the telephone network became quadratically more valuable as more people used it, rather than just linearly more valuable. We talk about the value of exponentiality as an intangible competitive advantage.
If there are two phones or “nodes” on the network, there is only one possible connection between them. If there are three phones (A, B, and C), there are three possible connections (A to B, A to C, and B to C). If there are four phones, there are six possible connections. If we jump to ten phones, there are 45 possible connections. With 100 phones, there are 4,950 possible connections.
As “n” becomes extremely large, the equation asymptotically approaches “c = 0.5*n^2”. This equation is known as Metcalfe’s law and was originally introduced for computer networks. Where “c” represents the number of connections and “n” represents the number of nodes.
Robert Metcalfe is a famous electrical engineer from the USA; Ethernet co-inventor and founder of the multinational 3Com. The law that bears his name states that the value of a network is proportional to the square of its size, that is, for a network with “n” members, each one can make “n-1” connections with the other members. If all those connections are equally valuable, the total value of the network is: n*(n-1)2. For example, if a network has 5 members, there are 10 possible connections.
Metcalfe’s law states that the larger the network of users, the greater the value of the network. This tendency for networks to expand drastically leads us to the law of increasing returns, where the feedback loop is positive: each additional member increases the value of the network, which in turn attracts more members, starting a spiral of exponential profits. .
In the case of Bitcoin, this cryptocurrency is growing in the same way that technologies such as the telephone, the internet and social networks grew at the time, both in its user base and in its value, thanks to the enormous security and robustness of Bitcoin. its network, and its proven value reserve functionality as a treasurable investment (no storage and maintenance cost) with an inelastic supply (21 million units and deflationary) and, furthermore, difficult to expropriate or confiscate by governments, as is being demonstrated in the war in Ukraine and also, the enormous complexity that would be to carry out its global regulation. With the arrival of Bitcoin on the market and its Blockchain technology, the so-called digital scarcity arises, thanks to its consensus protocol and the surveillance work carried out by all the nodes and the ability to create bitcoins by the so-called miners. This provides control of private property through cryptographic keys and where such property is truthfully and immutably recorded in the distributed ledger of the blockchain.
Bitcoin is a technology that mainly provides its users with savings and a decentralized payment settlement network (without the need for intermediaries); Although smart contracts, applications and other technologies are being built on top of this cryptocurrency, these developments are still not representative in terms of the value to be provided to its users.
On the other hand, the research carried out by Alabi (2017) with blockchain networks that allowed validating Metcalfe’s law is noteworthy, showing that the growth in the value of the network was related to the number of unique addresses that actively participate in the network. net. The number of unique addresses participating daily he suggested as a relative measure of the number of active users on the networks.
Through the methodology provided by Alabi (2017), possible price bubbles in cryptocurrencies such as bitcoin could be identified, since the growth of user adoption is modeled, correlating the value of the Bitcoin network with the square of the unique addresses that participate. actively in this network. Such bubbles can be detected when the value of the network begins to grow rapidly without accompanying growth in the number of users participating in the network.
In our case, we have carried out our own investigation in this regard. For this we have used the data provided by the source “coinmetrics.io” of both the market capitalization of bitcoin and the daily active addresses of this cryptocurrency, in a period of one year, between March 8, 2021 and on March 8, 2022.
Once the data is obtained and processed, we obtain a Pearson correlation coefficient of 0.54, to later graphically represent the relationship between the magnitudes in a dispersion map.
Let us remember that the correlations established between two magnitudes can be divided into two: positive correlations or negative correlations.
The positive correlations, is that if one magnitude rises, the other will also do so. On the contrary, negative correlations assume that if one quantity goes up, the other should go down.
Pearson’s correlation coefficient is a test that measures the statistical relationship between two continuous variables. The correlation coefficient can take a range of values from +1 to -1. A value of 0 indicates that there is no association between the two variables. A value greater than 0 indicates a positive association, telling us that as the value of one variable increases, so does the value of the other. A value less than 0 indicates a negative association; that is, as the value of one variable increases, the value of the other decreases.
Once the correlation has been analyzed, continuing with our investigation and taking into account the period between March 8, 2021 and March 8, 2022, we will proceed to calculate the value of the Bitcoin network, for this we will use the Daily Active Address magnitude (DAA) or the number of active addresses connected daily to the system and we will square it:
Bitcoin Network Value = (Bitcoin DAA)2
On March 8, 2022, the number of daily active addresses was 962,840; If we square this figure, it gives us a network value of 927,060,865,600 US dollars, which results in a value per bitcoin of 48,838.35 dollars. If we compare it with the price of that day, which was 38,737.27 dollars, we find a discount of 20.68% compared to to the value of the Bitcoin network.
To see more graphically the relationship between the market capitalization and the value of the Bitcoin network, we have represented the respective graph, which runs from March 8, 2021 to March 8, 2022.
In addition, Alabi (2017) proposes a ratio that relates both magnitudes.
Alabi Metric = Capitalization of BTC/ (Bitcoin DAA)2
We have graphically represented this metric suggested by Alabi, based on the values provided by the source “coinmetrics.io” from March 8, 2021 to March 8, 2022.
Specifically, on March 8, 2022, the Alabi metric gave a value of 0.79, the result of dividing the capitalization of bitcoin that day, which was USD 734,927,000,000 by the squared value of its daily active addresses, which amounted to USD 927,060,865,600. During the period considered in our investigation, the maximum value was 2.41, obtained on June 27, 2021, and the minimum value was 0.59 obtained on June 2, 2021.
This metric is analogous to the Price to book ratio applied to publicly traded companies, in that a high ratio value implies that investors expect a given network to generate more value from a given number of users.
In summary, Alabi (2017) demonstrated, as we did with our research and the results presented here, that the growth in the value of networks such as Bitcoin was related to the number of unique addresses, modeling the value of the network based on the price of the cryptocurrency and the number of users, represented by the unique addresses that participate in daily transactions. This fits intuitively with our understanding of how the value of Bitcoin should work: if we are the only holder of bitcoin it is not very valuable because there is no one to exchange it with, however, if many people have bitcoins, the value will go up considerably since there are numerous exchange possibilities.
This has been demonstrated thanks to the arrival of institutional investors to bitcoin in a way that no other digital asset has achieved, such as the companies listed on the North American stock exchange: MicroStrategy (MSTR), Square (SQ) and Tesla (TSLA), which they currently hold bitcoins directly on their corporate balance sheets. As well as great investors such as Geroge Soros, Carl Icahn, Ray Dalio, Paul Tudor Jones, Stanley Druckenmiller and Bill Miller, among others, who have opted for Bitcoin among their investments.
Disclaimer: The information and/or opinions expressed in this article are the sole responsibility of Ismael Santiago and do not necessarily represent the points of view or the editorial line of Cointelegraph. The information set forth herein should not be taken as financial advice or investment recommendation. All investment and commercial movement involve risks and it is the responsibility of each person to do their due research before making an investment decision.
Ismael Santiago is a doctoral professor in Finance and a researcher at the University of Seville. He international consultant on DeFi, ICOs, STOs and IDOs. He is the author of the books: “Introduction to Blockchain and Cryptocurrencies” and “The New Blockchain Economy”. Also, he is CEO of OLIVACHAIN R&D.