When meeting with sophisticated investors, about getting exposure to crypto via our Index Fund, I tend to hear the standard concerns such as lack of unclear regulations, price volatility, and obscure crypto valuations model etc. Another concern I often hear is why should I invest in Bitcoin, or any cryptocurrency, when the source code is open, enabling anyone to easily copy the code, make a few tweaks, and release a new and improved cryptocurrency. They often reference Litecoin or Bitcoin Cash as examples. These are legitimate concerns for investors but ones that are ultimately misguided. The reason why simply replicating the Bitcoin source code will not give you Bitcoin status is simple: the network effect which came from being the first. Hear me out.
When it comes to technology companies, being the first to market does not mean you will stick around. For example, Friendster (yes, I’m old enough to remember this) and Myspace were some of the first social media sites but eventually Facebook toppled them both. However, Bitcoin is not a technology company. It is a currency governed by different rules. When it comes to technology, people love disruption, and what’s hot in the market today. On the other hand, when it comes to currency people like stability and continuity, not disorder. This is because switching currencies has a larger disruptive factor in your everyday life. Changing from Myspace to Facebook may be tedious and bothersome but it does not affect the price you pay for groceries or the wealth stored in your bank account. As a result, first mover advantage and network effect play a much large role when it comes to currency than it does for a technology company.
Currently, Bitcoin is listed by all the major exchanges, which creates large scale market liquidity. Once liquidity starts to be achieved in some asset class, entrepreneurs start to build infrastructure to support it. We are already seeing this with Bitcoin futures which are now trading on the CBOE Futures Exchange. More derivative products such as Bitcoin ETFs are likely to enter the market soon. These incremental solutions like derivatives will accelerate adoption by additional large investors, pushing the network effect forward. All of this only reinforces Bitcoins advantage, making it harder to push it from its perch as a store of value.
As a result, you can replicate Bitcoin but you cannot instantly replicate the community. That is because buyers want to be where the buyers are and sellers want to be where the sellers are. Building such a community takes time and cannot be simply created overnight or with a fork. For example, when you hear about Bitcoin forks, such as Bitcoin Gold or Bitcoin Private, they have become more like dividends instead of a viable alternative to Bitcoin.
Granted a cryptocurrency with a vastly superior protocol could be developed but it would have to be on orders of magnitudes better to supplant Bitcoin as the king of crypto and overcome this network effect. In addition, because Bitcoin is essentially software, market relevant updates can be made to its protocol as demonstrated during the SegWit upgrade which fixed some of the bugs and enabled a greater number of transactions within the blocks. Although the Bitcoin community is often at odds with each other, which sometimes translates to roadblocks’ for protocols improvements, they have proven they can work together.
In the crypto world, Bitcoin is perceived to be clunky technologically and having bad governance. While all these things may be true, Bitcoin has strong network effects that will maintain its status as the primary value store at least for now. To be clear, I’m not a Bitcoin ‘Maximalist’ who thinks the idea of multiple competing cryptocurrencies or tokens are undesirable. On the contrary, I think others will play a role in our future financial system. However, Bitcoin has proven to be remarkably resilient and given Bitcoin’s large network effect and its ability to adapt, it will likely stay at the font of the pack for the short to medium-term.