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CAPinside6 MIN READING TIME2018-09-03

Cryptocurrencies and the network effect: one profits from the other

The more users a product has, the greater the benefit for the members of the network: that is the core message of the network effect. And so for investors in Bitcoin and Co. with each new investor benefits. But there are also limits, especially with regard to the upcoming regulation.

Let's start scientifically: The term "network effect" (also network effect or network externality) comes from economics and means first of all only that the behavior of one person influences at least the well-being of another person. In other words, the network effect describes how the utility of a product changes for a user as the number of other uses of the same product (or adjacent products) changes. As a result, the individual value of a product is basically dependent on the total number of users.


In the case of the renowned scientists Michael L. Katz and Carl Shapiro, this sounds like this: "The more users have a product, the more often a user derives from the use of a good one." The higher the benefit for the members of the network.


The individual benefit increase by an additional other user is only marginal from a certain network size, because barely perceptible. However, with each new user, the market power and attractiveness of the network provider increases.


A popular example to illustrate the importance of the network effect is that of the phone. If a consumer is the sole user of a telephone, he does not benefit from it. Only when a certain number of people owns a telephone, so that a network has formed, the users benefit. Just as clear is the network effect, if you look at social media, no matter whether Twitter, Facebook, Xing or LinkedIn: The more users have such a platform, the greater influence, distribution and ultimately the value for each.


Also in the investment, the effects of the network effect can be observed. A recent example: cryptocurrencies like the Bitcoin. Bitcoin, the world's best-known cryptocurrency and best-known blockchain project, is profiting exponentially from a growing network. The more people use the digital currency, the greater the value. At the same time, other cryptocurrencies like LiteCoin, Monero or Ripple are forced to keep up with this trend. This can already be seen in the market capitalization: The Bitcoin was at the beginning of September at around $ 125 billion, while Ethereum comes in third place in the ranking to about $ 29 billion and Bitcoin Cash in fifth just the mark of skips ten billion dollars. At the same time, the Bitcoin price is currently around $ 7,250 despite all the fluctuations - that is eleven times as much as Bitcoin Cash, which has the second highest price of all crypto currencies.


And this trend seems to continue. With the entry of relevant investors into the currency, the development of financial products based on crypto currencies, and the establishment of Bitcoin as the liquid "reserve currency" of the crypto space, the network effect is gaining momentum. For those who are already involved, the benefits increase dramatically. Particularly since, according to industry observers, the technical infrastructures are constantly improving and thus further benefits can be created.


At the same time, there are growing signs that the European Union wants to create regulatory frameworks for cryptocurrencies. As reported by the news agency Bloomberg, the economic and finance ministers of the EU member states want to explore ways to regulate Bitcoin and Co. in Vienna on 7 September to examine, inter alia, the transparency of currencies and their role in tax evasion, terrorist financing and money laundering ,


For the Dusseldorf asset manager Norbert Schulze Bornefeld (Eichler & Mehlert) this was only a matter of time. "Cryptocurrencies are not subject to any state supervision and contradict the basic idea of ​​the monetary policy conducted by the central banks. Bitcoin and other digital currencies can not be regulated in any way so far. Of course, this significantly reduces the accessibility of states, including from the point of view of combating crime. For me, it is very questionable whether countries that want to severely restrict the anonymous payment with cash, will tolerate cryptocurrencies permanently. "


If there is a far-reaching regulation, Norbert Schulze Bornefeld is sure that this will have significant negative network effects: "Extensive regulatory requirements always lead first to a decline within a certain market. This has been demonstrated by the introduction of regulations under the Capital Investment Code for closed financial products, which is currently reflected in Mifid II, which complicates the work of asset managers in independent companies and banks and their typical activities, especially in securities advice. "


The lack of regulation is also Dr. Maximilian A. Werkmüller, Professor of Family Office Management at the Allensbach University of Applied Sciences in Konstanz. "Without regulation, of course, the laws of cold capitalism prevail. Therefore, there will be regulations for cryptocurrencies, I'm sure. "But he continues to raise the question from the capital market, what role actually behind the crypto-currency blockchain technology plays. "Without Blockchain Bitcoin etc. are not possible at all. And Blockchain, in turn, should lead to the decentralization of knowledge and the establishment of new transaction structures that make conventional processes superfluous. Therefore, there is always the question of which development options are still waiting in the blockchain and how these will affect the market participants. "


For Maximilian Werkmüller, the blockchain is the actual driver of all considerations, also with regard to positive network effects. "Blockchain projects are growing, which is a generally accepted view. But this also means that the technological infrastructure has to be created for it. We are talking about a data explosion when the blockchain prevails. This is not possible with the current network performance. However, if the infrastructural basis for this is created, it will lead to significant growth. And the more people join in, the more successful Blockchain projects become - through the approach of decentralized knowledge and forgery-proof information. "

This thought of Werkmüller follows another basic idea of ​​network externality: The overall benefit of the product is increased disproportionately by each new network participant because the additional user brings in more benefits than he receives.


Experts such as asset managers and family officers would also have to worry about the classification of crypto currencies into asset management. Finally, continued growth could also lead to interesting effects in the management of liquid assets. For Norbert Schulze Bornefeld, the currencies are a "very interesting phenomenon, but currently perverted by a variety of only very limited trustworthy lucky knights". And Maximilian Werkmüller also openly asks what cryptocurrencies really are: an asset class of their own or not? His opinion: No, they are not, but that does not mean that professionals should have no opinion. "All relevant market participants should keep a watchful eye on developments and push for answers to urgent questions. This includes, for example, the handling of crypto assets in the digital estate. Without the key, heirs have no access to it. "


The Swiss bank UBS has also recently dealt with the question of whether crypto currencies are a new asset class or money in the classical sense. The volatility of Bitcoin makes it difficult to speak of a general new asset class, nor of a global means of payment, according to the study Big Macro 11: Are Cryptocurrencies Money and / or a New Asset Class ?. Bitcoin's US Dollar rates are driven by speculation, about 70 percent of the value. "This makes Bitcoin very vulnerable to major market moves," commented Maximilian Kunkel, chief investment officer of UBS in Germany.


For a permanent establishment of cryptocurrencies as an alternative asset class and common means of payment - and thus an expansion in the sense of the network effect - various parameters must be met, according to the UBS analysis. "On the one hand, volatility must be limited and, on the other hand, legal regulation must intervene and the crypto currencies must be firmly established. In addition, the technology must be able to handle large volumes of transactions. Then the foundations have been laid for cryptocurrencies to be accepted as a means of payment and to appeal to broader groups of investors, "says Maximilian Kunkel. Alternatively, it would be conceivable that crypto currencies remained a niche topic due to certain regulatory, financial or technological limitations or could not even be used as an alternative - neither for investors nor for transactions.