Crypto and NFTs: Network Effects in Web3

Web3 has become the defining technology trend of 2021 — and network effects are at the heart of it. First do the background settings of Web3:

  • Web1.0 is the “read-only” stage of the Internet, where users can obtain information online (eg Yahoo, Google);
  • Web 2.0 is a transition to a “read and write” phase where users can not only access information, but also create it (eg Facebook, Wikipedia). Value creation in this era shifts from companies to users—but still in closed networks owned and operated by companies;
  • Web3 refers to the next phase of the Internet, where user-owned and operated decentralized networks create value. This will be enabled by a series of complementary innovations, including cryptographic protocols and NFTs.

The purpose of this post is not to unravel the possibilities of web3 or the complexities of the technology, but to focus on the nature of network effects in this era.

So far, I’ve been exposed to 3 of 4 unique network effect models – marketplace, interaction network, and platform – in various web3 projects. These web3 models share several characteristics:

  • Their network effects are natively layered, i.e. each project incorporates multiple forms of network effects.
  • They also have weaker and less defensive network effects than web 2.0 variants, at least so far.

I will explain these patterns with the help of two case studies – Ethereum and Axie Infinity, one of the most successful web3 projects to date. They are also representative examples because their network effects share many characteristics with the wider web3 field.

Ethereum: The first layer protocol

DAOrayaki | Crypto and NFTs: Network Effects in Web3

Ethereum is often referred to as a layer 1 protocol (capital “L”), i.e. it is the underlying blockchain “computer” on top of which other projects are created. The animation above shows three different types of network effects on Ethereum. Let’s take a deeper look at them.

Network Effect 1: Ethereum Blockchain and Ethereum (Interaction Network)

DAOrayaki | Crypto and NFTs: Network Effects in Web3

The Ethereum blockchain is essentially a network of interconnected computers or nodes. These nodes validate transactions and “mint” new Ether tokens as a reward for their efforts. Adding nodes increases the throughput or capacity of the protocol – to support more token transactions and developer activity. At first glance, this looks like a simple one-sided network effect. But it’s more subtle than it looks – because adding more nodes doesn’t increase the value of the protocol to other nodes. If anything, it reduces the value of other nodes as there is now more competition to validate transactions and mint new tokens. However, adding more nodes increases capacity, which increases the value for ether buyers. More token buyers increase the value of ether tokens, thus making it more valuable for nodes to validate transactions. In other words, these are cross-side network effects on two-sided interacting networks, with side swaps built in (token buyers can also be validators and vice versa).

However, this network structure also presents some challenges: (1) unique forms of negative network effects, and (2) commoditization risks. Let’s dive into negative network effects first. Ethereum and other crypto protocols face the risk of network congestion, where excessive activity can overwhelm the protocol’s capacity, resulting in high transaction fees and processing times. Therefore, beyond a certain point, adding token buyers reduces the value of the network to all other token buyers. This negative network effect does not exist in web 2.0 products. It is specific to encrypted and physical networks like telephony or broadband, where too much traffic can reduce speed or quality of service.

The second challenge here is commoditization risk. This is partly because the blockchain is identity agnostic, i.e. the identity of each node has nothing to do with other nodes or token buyers. Therefore, as the network expands, each new node adds less incremental value to the network. Compare this to the network effects of the original telephone network. Unlike blockchain protocols, phone networks are identity-centric, i.e. if they don’t have a phone connection, you can’t reach a specific person even if others do. This means that the utility of the telephone network continues to grow as adoption increases – as it increases the number of specific individuals you can call. Conversely, the network effect of a blockchain interaction network diminishes as it grows, i.e. it becomes less defensible. Competing blockchain protocols only need to become “large enough” relative to their transaction volume or activity to compete — leading to a sea of ​​competing blockchain protocols and tokens.

Network Effect 2: Ethereum Smart Contracts (Platform)

DAOrayaki | Crypto and NFTs: Network Effects in Web3

The ability to create and execute smart contracts or decentralized applications (DApps or “Layer 2”) is the focus of the Ethereum protocol. DApps are programs created on top of the blockchain that run automatically based on pre-specified conditions. End users need to acquire ether to interact and transact with these DApps. As a result, adding a DApp developer to the Ethereum protocol increases the value of ether to buyers. This has many of the properties of the platform, with a few key differences:

First, it doesn’t have the “match” (or “app store”) component we see in Web 2.0 platforms (e.g. iPhone, Salesforce, Shopify, etc.). This is by design, as web3 emphasizes open architecture. However, this makes it harder for users to find suitable DApps, thus weakening the network effect. Of course, third-party app stores can make up for this over time.

Second, there is no underlying product here other than ether. Platforms typically have underlying products that users engage with the platform. The underlying product ends up capturing most of the value created by the platform. For example, the iPhone is the biggest financial beneficiary of the iOS app store. Developers join the app store (platform) to make the iPhone (the underlying product) more valuable to users. But in the case of Ethereum, the addition of developers only makes the ether more valuable to buyers (see: Fat Protocol). This has a direct impact on defensibility, as ether is liquid and has zero switching costs – users can always sell it and buy another token to access a DApp built on another blockchain (e.g. Solana). Imagine if you could turn your iPhone into an Android phone, Windows phone or Blackberry with just a few taps and access their respective developer ecosystems. If so, the iPhone’s platform network effects would no longer be a meaningful form of defense — even if it would lead developers to innovate more rapidly. This is the gift and curse of layer 1 blockchain protocols.

These two factors have led to a new wave of layer 1 blockchain protocols, surpassing Bitcoin and Ethereum — from Cardano to Solana and more.

Network Effect 3: Composability (Interaction Networks)

DAOrayaki | Crypto and NFTs: Network Effects in Web3

This is not to say that layer 1 protocols are defenseless. They do benefit from switching costs on the developer side. In large part, this is due to the composability of smart contracts, whereby developers are able to create new smart contracts by “remixing” components of existing smart contracts. This has some similarities with TikTok creators remixing other videos to create new ones. Think of it as another network effect (interaction network) layered on top of the platform – the more smart contracts a protocol has, the easier it is for developers to build new contracts. However, cross-chain composability, the composability of smart contracts built across protocols, may weaken its impact on defensibility.

This brings us to actual DApps built on top of Ethereum and other Layer 1 protocols. Many of these leverage Non-fungible Tokens (NFTs) – simply put, you can think of them as unique digital assets (like collectible cards). Some of them — like Loot, Bored Ape Yacht Club, and CryptoPunks — spawn fascinating communities and behaviors. However, it is difficult to categorize their network effects as their value and utility remain unclear. This is not uncommon in the earliest stages of a technology cycle – experimentation and hype always precede practicality. Other types of DApps already have clear network effects – one example is playing games, games where players can earn tokens by playing games. Let’s take a look at the most prominent of them.

Axie Infinity: Play and Earn NFT Games

DAOrayaki | Crypto and NFTs: Network Effects in Web3

Axie Infinity is the largest pay-as-you-go (P2E) game with over 2.2 million monthly players as of November 2021. As you can see in the animation above, Axie Infinity combines four different network effects:

Network Effect 1: P2E Gaming (Interactive Network)

DAOrayaki | Crypto and NFTs: Network Effects in Web3

The game shares some similarities with Pokémon—players aim to breed, fight, and trade creatures called Axies. Each Axie has a unique set of stats and types, which can make it more or less against other types. Players earn SLP tokens as a reward for winning battles and other in-game challenges. These tokens can be traded or sold, creating a revenue stream for players – this is the revenue part of the game.

Obviously, this is a multiplayer game, making it an interactive network similar to Minecraft and Fortnite – more adoption gives you more opportunities to discover, fight, and trade with other players. Therefore, the ability to make money is also related to the adoption rate. However, it also has nothing to do with identity – the identity of each player doesn’t matter. Therefore, increasing player adoption does not increase the utility or monetization potential of the game. This has direct and negative consequences for the defensiveness of this network effect.

In fact, early data suggests that increasing player adoption has created network congestion and reduced monetization potential—a negative network effect. This presents a great opportunity for other P2E games to compete and poach players. So it’s no surprise that alternative P2E projects like Splinterlands are gaining popularity. Upcoming projects such as Illuvium and Blankos Block Party have also received strong interest.

Network Effect 2: Axie Marketplace

DAOrayaki | Crypto and NFTs: Network Effects in Web3

Axie Marketplace is the second layer of the Axie Infinity network effect. The name speaks for itself – it’s a marketplace for players to buy and sell Axies (and other in-game items). This is not much different from a web 2.0 marketplace with side toggles such as Poshmark. The resulting market network effects reinforce the game’s interactive network effects. Players breed more Axies, increasing the variety of in-game items, thus making the game more valuable and engaging.

One factor to keep in mind is that Axies are NFTs. This means that there is nothing stopping players from selling their Axies on another NFT marketplace, like Opensea (which is itself a web 2.0-style marketplace with strong network effects). However, each Axie has unique properties – which makes the Axie’s offering very diverse. And because Axie Marketplace is integrated with games, it’s easier to aggregate the “long tail” of unique Axies and in-game items than third-party marketplaces like Opensea. Therefore, as of November 2021, there are 40% more traders in the Axie market than Opensea.

Due to the differentiated nature of its offering, Axie Infinity’s marketplace component is highly defensive, i.e. Axie Marketplace is likely to remain the preferred destination for purchasing in-game items. However, it is only defensive if the game remains engaged, i.e. it cannot prevent players from transitioning to other P2E games.

Network Effect 3: DAO (Network of Interaction)

DAOrayaki | Crypto and NFTs: Network Effects in Web3

Axie Infinity was originally created by the Sky Mavis team. However, with the help of another token called Axie Infinity Shards (AXS), Sky Mavis aims to move the governance of Axie Infinity to a Decentralized Autonomous Organization (DAO). My compatriot Atomico Angel Sarah Drinkwater describes DAOs as “group chats with a common purpose and money” – an accurate summary. For simplicity, holders of AXS tokens will be part of a group (or DAO) that governs and votes on the future roadmap of the Axie Infinity project — essentially acting as a distributed governance team.

This is another form of interactive web in which identity affects defensiveness. In this case, the importance of user identity depends on the size of the network. In the early days of a DAO, all participants knew and trusted each other – so identity was important. The addition of users increases the variety of perspectives and influence on the Axie Infinity project. But as more and more people earn AXS tokens and enter the ecosystem, DAOs can scale from a handful of participants to thousands or more. At scale, adding more AXS holders will not add any value to the project. In other words, the value of network effects flattens or asymptotes over time, making it less defensible.

However, DAOs have other benefits. Ownership and the ability to vote on the future of a project can introduce another form of defense – emotional attachment or tribal loyalty to the success of the project/community (and the failure of others). This is a psychological switching cost, not a network effect. But in this case, it may be a more meaningful form of defense than network effects themselves.

Network Effect 4: Axie Infinity Scholarship Program (Platform)

DAOrayaki | Crypto and NFTs: Network Effects in Web3

The final network effect layer of Axie Infinity is tied to its derived ecosystem. In order to play Axie Infinity, players need to buy 3 Axies from the Axie Marketplace – the cheapest of which is around $200. This is a significant investment for many players, especially from emerging markets. To lower this barrier to entry, “scholarship” programs popped up to “rent” Axies to aspiring players. Those players then give the program a cut of what they earn from the game — not too different from student loans. The increase in the number of scholarships increases the accessibility of Axie Infinity to new players. The increase in aspiring Axie Infinity participants increases the market potential of the scholarship program. This has some characteristics of the platform, with Axie Infinity as the underlying product. However, this is not unique to Axie Infinity. Many of these programs, such as Yield Guild Games, have been extended to other P2E games, such as The Sandbox. So the network effects here are still weak and not a sustainable source of defense.

These case studies are just two of many interesting crypto and web3 projects. However, many of their network effect patterns are also present in the web3 realm — native layered network effects that are relatively less defensive. This leads me to make two initial hypotheses:

  • The first possibility is that in this era, true network effects are no longer a meaningful source of structural defense. Instead, defensiveness will depend on the tribal and psychological switching costs of each project community. While I can’t ignore the possibility, I’m skeptical. The psychological switching costs are real, but this explanation masks the amount of innovation that has yet to come in this era. Furthermore, Axie Marketplace and Opensea show that powerful network effects are still possible – even if they are now reminiscent of web 2.0.
  • The second possibility is that we are still in the early stages of the web3 cycle and cannot achieve sustainable defenses – similar to Yahoo in the early days of web 1.0 and Myspace in web 2.0. In other words, most projects are still experimenting with web3’s capabilities. And long-term winners—with stronger, more reliable network effects—will only emerge after this phase of experimentation. This is my preferred conclusion.

If point 2 is the most likely explanation, we need a broad framework to assess network effects in upcoming web3 projects. They certainly have interesting nuances, but the basic problem that defines them remains the same:

  1. Interaction: How do users interact with others?
  2. Network effects: Does adding one user increase the value of all users?
  3. Scalability: How does each new user affect value? Are there any restrictions?
  4. Defensive: How is this changing as adoption grows?

These questions are critical to assessing the potential of a web3 project. Those who combine the power of web3 with a stronger network effect layer may be the biggest winners of this era.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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