The Network Effects and Defensibility of Crypto and NFTs in Web3

The Network Effects and Defensibility of Crypto and NFTs in Web3

Introduction:
In the world of cryptocurrencies and non-fungible tokens (NFTs), network effects play a crucial role in their success. These network effects are natively layered and combine multiple forms of interactions. However, they are weaker and less defensible compared to web 2.0 variants. In this article, we will explore the network effects in web3, the challenges they present, and the potential for defensibility.

The Power of Network Effects:
In web3, the addition of more nodes increases the capacity and value for buyers of the Ether token. As more token buyers enter the network, the value of the Ether token increases, making it more valuable for nodes to validate transactions. This creates cross-side network effects on a 2-sided interaction network, where token buyers can also be validators and vice versa. The more participants there are in the network, the more valuable it becomes for everyone involved.

Negative Network Effects and Commoditization Risk:
However, this network structure also presents challenges. Firstly, the addition of a token buyer beyond a certain point can decrease the value of the network for all other token buyers. This is because blockchains are identity agnostic, meaning the identity of each node does not matter to others. Therefore, each new node adds less incremental value as the network scales. Secondly, the absence of a matching or app store component and the reliance solely on the Ether token as the underlying product has led to a proliferation of competing blockchain protocols.

Layered Network Effects:
Web3 also introduces another layer of network effects with the proliferation of smart contracts and decentralized autonomous organizations (DAOs). The more smart contracts there are for a protocol, the easier it is for developers to build new ones. However, cross-chain composability can dilute the impact on defensibility. The value and utility of these network effects are still unclear, as experimentation and evangelism precede utility in the early stages of a technology cycle.

Case Study: Axie Infinity:
Axie Infinity, a popular NFT game, combines multiple network effects. The game itself has interaction network effects, where players interact with each other. Additionally, the Axie Marketplace creates a marketplace network effect, reinforcing the interaction network effects. The differentiated supply of Axie Infinity's marketplace makes it highly defensible. Furthermore, the emergence of DAOs in the Axie Infinity community adds another layer of interaction network effects, where identity influences defensibility.

The Future of Web3 Defensibility:
There are two possibilities for the future of web3 defensibility. The first is that network effects may no longer be a meaningful source of structural defensibility. Instead, defensibility will rely on the tribal and psychological switching costs of each project community. The second possibility is that we are still in the early stages of web3, and stronger and more defensible network effects will emerge after the experimentation phase.

Actionable Advice:

1. Evaluate the interaction dynamics of web3 projects: How do users interact with others? This will help determine the potential for network effects.
2. Assess scalability and limitations: Understand how the addition of new users affects value and whether there are any limitations to scalability.
3. Consider defensibility: Analyze how defensibility changes as adoption grows. Look for projects that combine web3 capabilities with stronger network effect layers.

Conclusion:
The network effects in web3, particularly in the crypto and NFT space, are complex and layered. While they may be weaker and less defensible compared to web 2.0 variants, they still play a crucial role in the success of projects. Understanding the interaction dynamics, scalability, and defensibility of web3 projects is essential for evaluating their potential. As the web3 ecosystem continues to evolve, projects that combine strong network effects with web3 capabilities are likely to emerge as the winners of this era.