Many entrepreneurs and investors think that crypto projects can’t capture value because they are based on open source code. The thinking goes that if you develop open source code, someone will come along and copy it, luring away your users and any potential for revenue. That doesn’t seem like a good foundation for a business.
But crypto networks do adhere to a sustainable business model, and it’s one that will be quickly familiar to those who understand the dynamics behind valuable Web 2.0 marketplaces. Like marketplace companies, crypto projects seek to create defensibility via network effects that allow for fee streams and make users reluctant to switch to a competing service.
What makes crypto unique is its potential to expand on that familiar framework. The principal innovation of crypto networks is their ability to grow network effects by enabling users to share in the value they create.
Network Effects, Switching Costs, and Defensibility
Misconceptions around crypto and value capture are understandable. Open source code has enabled trillions of dollars to be generated by software companies that use it, but the communities that develop that code typically haven’t had a means to capture much of the value directly.
That’s because there is a major difference between open source code libraries, which can be easily copied, and networks that form around running open source code as a service. An open source library is an empty blueprint. It’s dead code, until it’s run as an instance and is filled with data, users or both, forming a network or service.
Many internet platforms are built using open source libraries, which are run by companies as an instance or service. With each new database entry, or user, the service becomes more valuable to each individual user, generating a network effect. This creates an inherent cost for users switching to a new, competing service. These switching costs make it harder for competitors to break through, creating defensibility. Imagine a clone of Facebook with no friends, or a clone of Uber with no drivers. It’s why big platforms get bigger while competitors get stuck.
Once defensibility is established through network effects, switching costs become the basis for fees that companies can begin to charge users, advertisers or both. This model is viable so long as the fee is below the switching cost of moving to an alternative.
Why Forking Does Not Eliminate Switching Costs
Like Web 2.0 platforms, a well-designed crypto network is a live, running service, and it too can be the basis of strong network effects that create switching costs. Given that crypto networks rely on open source code, it’s true that they can be more easily copied (or forked). But while replication of code may be free, the social cost of coordinating all network participants to move to an empty room is non-zero. Add to that the trust and familiarity that come with brand, lindy effect, and smart contract integrations, and you have a recipe for entrenching an existing service, building its network effects, and generating switching costs.
Bitcoin’s network effect derives from more people considering it a store of value, which in turn, incentivizes miners to secure the network. Ethereum’s network effect derives from developers who deploy apps — each becomes a building block that other devs can compose into higher order services, driving increased usage, and demand for ETH.
At the application layer, Uniswap, an automated token exchange, becomes more useful with each new user because additional liquidity in the marketplace results in better prices on trades. Compound, a money-market protocol for lending and borrowing, offers more competitive interest rates on loans as lending liquidity increases.
In every case, a fork of the original network will initially be technically equivalent but functionally inferior to the canonical instance. A fork of Compound would offer worse interest rates due to lower liquidity. A fork of Uniswap would have inferior pricing for the same reason. A fork of Bitcoin is less likely to be viewed as a store of value or medium of exchange and thus less likely to capture value.
This is the same basic principle of defensibility in traditional Web 2.0 platforms: attract users, build network effects, and increase defensibility through switching costs. That switching cost forms the basis for margin extraction, usually in the form of a fee:
|Bitcoin||Fee per transfer||PayPal||Fee per transfer|
|Ethereum||Fee per function call||Twilio||Fee per API call|
|Compound||Fee per borrow||LendingClub||Fee per borrow|
|Uniswap||Fee per exchange||Coinbase||Fee per exchange|
So long as a service remains minimally extractive — charging a fee that is lower than the costs to switch — its model is viable.
So what’s new in crypto isn’t the business model. It’s who benefits from it.
The Differentiator: Crypto’s Value Distribution Capability
Crypto tokens are an innovation akin to that of data packets. We can now move bits of value in the way we move bits of information: using an open standard, in very granular transmissions, instantly, to anyone, anywhere in the world. This means that valuable crypto services now have the unique opportunity to redistribute that value directly to the users who generate it.
Designed correctly, an effective distribution of a fee stream can further entrench network effects by giving users a direct economic incentive to contribute, generating more defensibility, which in turn, reinforces the viability of the fee stream in the first place. This is a virtuous loop that has the potential to result in sustainable, user-owned networks that grow in size and defensibility because of their cooperative economic model.
Crypto networks like Bitcoin and Ethereum are the very first community-owned-and-operated platforms at scale. But given the right tools, many more founders may be able to leverage this new stack as a tool to distribute economic value, build network effects and generate value for themselves, investors, and their user communities.
By making economic collaboration with users a primary feature of the product experience, founders may be able to unlock networks that are bigger, more competitive, and more defensible, while simultaneously enabling more innovation — all thanks to crypto’s open source foundation.
This post was originally published on a16z.com
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