If you’re baffled by the exponential growth of certain cryptocurrencies and wondering how you might get in on the action, then this post is for you. The truth is, you won’t find the best cryptocurrency investments using conventional company and stock valuation methods. Crypto is different. You need to take a different approach to find those projects that will reward you with potential exponential growth over the longer term.
One approach to identify potential top gainers in crypto is to pinpoint those projects with strong ‘network effects’ that drive value to users and push token prices to seemingly parabolic levels. But what are ‘network effects’, where do you find them in crypto, and how do you invest? Let’s take a look…
What are network effects?
Network effects put simply are when a product, service or platform increases in value the more people use it.
Direct network effects happen in a reinforcing loop as users join a network and in doing so bring more value to existing and future users. The value of the product grows as more users join, and more users join because of this growing value. Hence the reinforcing loop. Think a telecommunications network, or a transport network.
Users also decide to participate in a network based on the level of benefits or value from ‘add on’ or complementary products or services. This describes the indirect network effects that can come into play in platform businesses that attract complementary products and services that add on to the platform and grow it indirectly. Like with Facebook. You don’t just use it to see your friends posting. There’s messenger, marketplace, advertising, FB groups and so on…
Most importantly, for investors looking for growth assets there is a point – a reaching of critical mass – when user adoption (on multiple sides) goes exponential due to the reinforcing value loops of direct and indirect network effects.
Why network effects can lead to exponential growth
1. It’s numbers game
The number of possible connections in a network like Airbnb equals the number of users on one side (the hosts) multiplied by the number of users on the other side (the guests). Its the same for all two sided networks that produce network effects.. Every user that joins the network makes it more valuable for the next user. If you have a network with 2,000 hosts and 10,000 guests, that equals a network of 20 million possible connections between users.
The number of connections in a network represents the growth of the network and its utility to other users, as well as its value.
2. Network effects are hard to displace
A network effect, once created, is hard to displace. Why doesn’t Facebook have any real competition? Its network effects have established its incumbency – by virtue of its sheer size, reach, reinforcing value loops and sometimes built-in infrastructure. This incumbency means Facebook as a competitor is very difficult to overcome.
Another important point for investors is that incumbents with network effects enjoy large, entrenched advantages due to their existing customer base. Why is that though? According to this Harvard Business Review paper on why some networks thrive over others, an Airbnb competitor would have to enter the market on an international scale—building its brand around the world to attract travellers and hosts.
To achieve that, the competitor can’t just be a little bit better, or even twice as good as Airbnb; it has to be a quantum leap better to convince a critical mass of guests and hosts to move to it.
This is why when platforms or businesses with network effects establish incumbency they’re very tough to disrupt.
So what does this mean for your crypto investments?
Firstly, projects that enjoy network effects (with incumbency) may be around for a longer time because they are hard to disrupt.
Secondly, if you are an early investor, the gains can be exponential due to the effect itself.
Lastly, because of their levels of growth and incumbency, the stock can continue to outperform over the longer term.
Identifying network effects in crypto
One strategy for investors might be find the crypto projects greatest network effects and (potential) incumbency.
The second one – incumbency – is important and hard to nail down. Crypto is new and very few projects have achieved sufficient size or growth to establish true and authoritative incumbency over the competition.
How to identify crypto projects with network effects?
So what factors might determine whether the a particular project has the potential for network effects? What metrics will tell you that a project is being actively used, rapidly built-out and adopted at a rate of knots? Lets take a look at 5 such indicators:
- Network users & nodes – the first sign network effects may be at play is the number of project users or nodes growing quickly. Nodes are found on blockchains. Their main purpose is to verify each batch of network transactions, or blocks. They’re necessary for the blockchain to both function and expand.
- Unique addresses – the number of wallet or payment addresses for the platform token that have more than a zero balance. For example, the number of individual ETH wallet addresses. It can be used as a proxy for the number of network users. When the network is popular and people are using it, there are more unique addresses. But that’s not completely accurate as one user can have multiple addresses.
- Total value locked – or ‘TVL’ shows how much is ‘locked up’ in decentralised finance products on the network (or in the Smart Contract platform). It’s an indicator of DeFi use on the platform.
- Daily transaction volume – this is the number of transactions associated with the crypto each day. Transactions volume shows the level of user engagement with the product or platform. For network effects, the trend should be sharply upwards.
- Developer activity – if new layers, applications and protocols being built on top of it or alongside and integrating with it this demonstrates indirect network effects that in turn bring more users and more developers. Developer activity indicates confidence in the ecosystem, roadmap and underlying technology.
The best cryptocurrency for exponential growth
So, if a network effects occur in platforms or networks where each user brings additional value and more users in a reinforcing loop, where in the crypto ecosystem might this occur?
The answer: Layer 1 blockchains.
What are Layer 1 blockchains?
‘Layer 1s’ are the blockchain ‘networks’ that form the ‘base layer’ of the crypto ecosystem. They are the networks on which everything else in crypto is built!
The digital asset ecosystem requires robust, secure and distributed blockchain networks to operate on and to ensure asset immutability. Layer 1s meet this need. They are the foundational tech of that digital asset ecosystem.
Blockchain-based digital assets, such as NFTs and stablecoins, are all built and issued on top of Layer 1 platforms.
Layer 1 cryptocurrencies
Tokens native to these Layer 1 networks (such as ETH to the Ethereum network) play a role in securing the networks. Holders that stake their native tokens to support the network operating are rewarded for doing so. Tokens are also used to pay transaction fees on the network (with fees going towards rewards). In some cases, tokens also give holders a say in network decision making.
Buying these tokens are how investors can gain exposure to the Layer 1 project.
Layer 1 projects have been a strong performing crypto category since the May 2021 market correction. With crypto still in the early adopter stage and just a few hundred million users world wide, some argue the exponential growth curve for successful layer 1 blockchains has not yet begun.
There are over 100 Layer 1 blockchains in the crypto ecosystem so next we sort the wheat from the chaff in Layer 1 blockchains that we invest in for their potential network effects. Let’s look at ‘The Leaders”, “The Contenders” and “The Challengers.
How do investors in Layer 1 crypto benefit from network effects?
When you own the native token of a Layer 1 blockchain, you own a share of the future value of transactions on that blockchain. As network effects grow demand for the blockchain and expand the on-chain economy, your share of future value grows too.
Layer 1 cryptocurrencies we hold
Bitcoin is the grandaddy of cryptocurrencies. Lyn Alden gives a great synopsis of the network effects of Bitcoin. We’re not going to go over the arguments here, but we invest in Bitcoin as a store of value, border-less medium of exchange, and an instantaneous and low cost worldwide payment system (think about the avoided remittance fees globally).
Bitcoin is also the OG incumbent. Its total market cap makes up anywhere between 40% and 60% of the total crypto market cap these days. Nothing else comes close in terms leading the crypto market or influencing crypto price trends.
Network effects – tick
Incumbency – tick.
For these reasons, we hold Bitcoin in our crypto portfolio. We think its network effects will continue to play out as more countries like El Salvador recognise the potential value to local economies and to raising their citizens out of poverty. We also see regulators in more countries (like Australia and eventually the US) normalising Bitcoin investment vehicles, which will help on-ramp more users into the network.
Ethereum is like a super computer base layer for smart contracts. Critically, Ethereum also has first mover advantage when it comes to Layer 1 projects in crypto, which has given it serious incumbency over the competition. Ethereum is the Top Layer 1 smart contract blockchain by market cap, with daylight second.
Fun facts for ETH investors:
- Ethereum dominates the DeFi (decentralised finance) and NFT (non-fungible token) space. It has the most protocols and decentralised apps built upon it of any Layer 1 blockchain network.
- TVL in the Ethereum network is $172 billion. The next largest Layer 1 by Total Value Locked sits at $20 billion. That’s daylight in between peeps.
- The Ethereum ecosystem is gigantic. The biggest there is in crypto. Indirect network effects – tick.
- Daily transaction volume on the ETH network has recently surpassed the Bitcoin network, which some suggest means that ETH will ‘flippen’ (overtake) BTC on the Layer 1 leaderboard sometime in the near future.
- Other Layer 1 platforms are uniformly bridging into ETH. This cements Ethereum’s incumbency.
- A recent protocol change introduced token burning so that ETH will become a deflationary asset (more tokens burned than new tokens issued). When supply tightens and demand grows, what happens to price?
- Developer activity on platforms Github and Discord shows Ethereum development at almost double its nearest Layer 1 competitor.
- ETH has executed and planned significant network upgrades (ETH 2.0), showing strong protocol consensus which is positive for its longevity.
ETH developer activity
Eth 2.0 upgrades
Despite the hype, Ethereum suffers from one flaw that threatens its incumbency. The cost of using its network. This cost has driven hoards of users over to much cheaper Layer 1 competitors, like Solana.
Ethereum is fighting back with network upgrades (ETH 2.0) that claim to combat the gas price issues. Along with these critical upgrades, ETH also maintains its Layer 1 dominance the more it works with add on Layer 2 projects like Polygon network to extend its ecosystem reach and offer cheaper network solutions.
ETH is is a core holding in our cryptocurrency portfolio. This is not financial advice peeps – we are just sharing what we are doing. DYOR always!
Now that we’ve taken a brief look at our personal leader board, lets move on and look at some other top contenders:
‘The contenders’ are fast growing Layer 1 blockchains in crypto in terms of market cap, ex-Bitcoin and Ethereum. The two Layer 1 projects below are have been growing at pace and starting to jockey for shot at blockchain supremacy, alongside BTC and ETH in terms of market cap.
Solana markets itself as the fastest and cheapest blockchain in the world. These two factors have catapulted its token SOL into the crypto stratosphere since January this year. Solana’s high speed and low cost features have solved the problems of the Ethereum blockchain for both crypto enthusiasts and software developers. As with all network effects, the SOL price has shot up this year as more and more users and developers are attracted to the blockchain.
Solana is building out a rich ecosystem including NFT marketplaces, DeFI protocols, as well as gaming, metaverse and Web 3 decentralised apps. Some of the most popular dApps built on Solana include Aurory and Star Atlas (gaming), Raydium and Serum (DeFi), and Solarnart and Audius (NFTs).
Fun facts for Solana investors:
- Solana is highly scalable and can already process 700,000 transactions per second.
- Solana developer activity comes in second to Ethereum on Discord and third behind Polkdot on Github.
- TVL is over $13 billion which is third highest Layer 1 TVL and represents just over 5% of Total Value Locked across all blockchains.
- Solana already has around 400 decentralised apps built on its blockchain despite only being launched in April 2020.
- Solana has a thriving NFT marketplace that is growing in popularity due to the cheaper transactions costs of using the network compared to Ethereum.
- The price of SOL is already up over 13,000% this year. That’s an exponential growth rate indicating network effects may already be in play.
The biggest criticism of Solana is its lack of decentralisation. In crypto, decentralisation is often seen as an indicator a project is a safe bet over the longer term. Decentralisation is gauged by the number of validators on a network. Layer 1 incumbent Ethereum is highly decentralised with over 200,000 validators globally. Solana has just 1200 validators, showing its more centralised structure.
It’s worth knowing that the Solana network recently suffered a DDoS attack when bots targeted the network with 400,000 transactions causing it to reach max throughput and taking the network down for 17 hours. While it was a set back, the attack was of insufficient threat to affect the growth of this Layer 1 protocol, or our investment in it..
Polkadot is different to the other Layer 1s featured in this post. It’s more than a Smart Contract Platform. Its aim is to ‘enable a completely decentralized web (3) where users are in control’. Here’s how Polkadot bills itself:
Polkadot is built to connect private and consortium chains, public and permissionless networks, oracles, and future technologies that are yet to be created. Polkadot facilitates an internet where independent blockchains can exchange information and transactions in a trustless way via the Polkadot relay chain.
In a sense, Polkadot is a Layer 0 network because it provides a framework for other Layer 1s to build on and connect to each other. Polkadot’s niche in blockchain technology is ‘interoperability’. Its aim is to build the trustless network layer that links Layer 1s together, making it seamless to move through the crypto ecosystem.
Because its vision is so large, Polkadot is probably the hardest of all of the Layer 1 networks to get your head around. It is also difficult to value using the metrics we talk about above. But the enormous vision, and the calibre of its tech founders, make Polkadot an incredibly interesting digital asset play.
Fun facts for Polkadot investors:
- The founder of Polkadot is Ethereum Co-Founder and former Chief Technology Officer, Gavin Wood.
- Polkadot has a $50 billion dollar market cap and is the 8th largest crypto by market value.
- There are 142 project building inside the Polkadot ecosystem. The list includes DeFi, NFTs, DAOs, Layer 1s, Layer 2s, Metaverse projects, blockchain gaming, Oracles and so on.
- Polkadot holders have locked over $1B in the first Polkadot ‘parachain’ auctions which will determine which bespoke blockchains get to use the Polkadot network. ‘Parachains’ are the name of the blockchains that get to built on Polkadot. The Polkadot network can support 100 of them. ACALA DeFi platform won the first Parachain auction for a slot on Polkadot.
- Once it’s fully functional, Polkdot is expected to be able to handle 1,000,000 transactions per second. That’s faster than the fastest Layer 1 in today’s crypto ecosystem – Solana.
- Polkadot’s token supply is inflationary, growing by 10% a year which is not great for the DOT price longer term.
Polkadot, by its very design, is the blockchain of all blockchains. However, DOT has not experienced the same level of ripping growth this year that competitor Layer 1s like Solana and Avax. We’re excited for Polkdot’s future and hold DOT in our crypto portfolio, but building this ‘blockchain of blockchains’ is going to take some pulling off.
“The Challengers are our up and coming Layer 1 blockchains. The smaller cap projects with small but growing ecosystems of platforms, tools and dApps building on top of them.
Avalanche is the new blockchain on the block this year and its concept is a lot like the Polkadot project. It bills itself as a network of blockchains with blazing fast speeds, better decentralisation (more validators) than Solana, and better scalability than Polkadot. If Avalanche becomes all of these things it could be one to add to your radar.
Fun facts for Avalanche investors:
- Avalanche’s TVL has hit parabolic levels since August 2021, growing from a bit over $300M to $11B! 24% of that is locked in the AAVE lending protocol.
- Avalanche’s market cap is up 85% in the last 30 days, hitting $23 billion. The price of AVAX reached all time highs this week is now in price discovery.
- Avalanche has a fast growing ecosystem with loads of DeFi protocols and dApps, tonnes of exchanges and swaps, as well as a growing NFT dApp presence. Gaming is not as big on Avalanche as it is on Solana.
- Avalanche recently announced $600 million in incentives to encourage development on its network. It aims to coax developers over from Ethereum.
- AVAX token is used for network fees, capped at 720 million, and burned (on creation of blockchains, assets, subnets and payment of transaction fees). If the tokens burned exceed rewards (to validators) the tokenomics are deflationary. This is generally positive for the AVAX token price longer term.
Terra blockchain is all about creating programmable (private) money for the internet. It is a growing stablecoin payment system Layer 1 ecosystem. Terra is primarily a DeFi play, making it less versatile than other Layer 1s here like Solana and Polkadot. But it also has a clear niche and need. The Terra token used to pay network transaction fees is called LUNA. Terra’s most popular product by far is the Anchor lending protocol.
Fun facts for Terra investors:
- Terra holders can stake their LUNA and earn rewards for supporting the Terra network.
- Terra users can lend their UST (the USD pegged Terra stablecoin) on Anchor Protocol for a 20% APY with little exposure to price volatility. This one product has massively increased the popularity of Terra blockchain.
- Terra has introduced a token burning mechanism, making it a deflationary asset.
- TVL is just shy of $10 billion, with around 40% of that locked in Anchor protocol.
- Terra issues stablecoins pegged to loads of different world fiat currencies – like the EURO or Korean Won. This makes it a cheap and fast global payment system. Terra stablecoins are currently widely used for retail and commerce in Korea and use in other countries is growing. Terra claims to have 2 million users of its stablecoins worldwide.
- UST is an algorithmic stable coin. It uses an algo to maintain its peg to the USD. The algo could fail. The peg could fail. If it does, you’ll lose value in your stablecoin holdings. If the project fails, you might lose everything. So it is in crypto.
If you want to learn more about LUNA and the Terra blockchain and ecosystem, check out our article “Why Anchor Protocol is the new high yield savings account”. Anchor is a DeFi lending protocol in the Terra ecosystem with a $7B TVL. Well worth looking at.
Constructing our digital asset portfolio
Whether it’s a multichain digital asset ecosystem future, or ‘one chain to rule them all’, we have a few Layer 1 blockchains in our digital asset portfolio.
By virtue of their role in the crypto ecosystem, Layer 1 blockchains could turn out to demonstrate network effects for exponential growth.
As we’ve already discussed, network effects + incumbency can form a potent mix for future price growth.
None of this is financial advice peeps – just sharing our opinion about what we are investing in. What is the best cryptocurrency for exponential growth? Well, do your own research and reach your own conclusion.