Currently, every blockchain-based company is competing to build a network big enough to futureproof itself and build resilience for the volatile road ahead. The network effect doesn’t just span blockchains and cryptocurrencies themselves, but also the exchanges on which these assets are traded. In an ever-expanding industry, building a strong and wide network of users is the key to longevity for an exchange.
What are network effects?
Network effects describe the value an additional user of a system has on the entire system as a whole. A basic example of this in the digital age are social media platforms such as Facebook and Twitter, which experience compounding network effects when new users join the platform, creating a larger network for each user to interact with.
The graph of a users’ network effect on a social media platform.
The exchange liquidity problem
Since the inception of cryptocurrency exchanges, liquidity has been one of the major concerns of every new exchange on the market. Investors don’t benefit from utilizing an exchange with low liquidity, but liquidity cannot be built without a certain mass of users.
This circular issue continues to plague many crypto exchanges today which have failed to find a way to attract enough investors to bring an adequate level of liquidity to their platform. Therefore, cryptocurrency exchanges need some sort of network effect to build a solid base of users and create market liquidity.
Building mutual success
One way in which an exchange can successfully attract investors, and build liquidity as a result, is to align the success of the exchange with that of the traders and investors using that exchange.
A membership model achieves this outcome successfully. In an exchange membership model, users obtain added benefits for holding a set amount of tokens native to that exchange. This aligns users of the network to actively trade on the platform while obtaining lower trading fees for doing so, while at the same time allowing them to be stakeholders in the exchange itself. In return, these traders provide market liquidity to the exchange which can then attract more investment from a wider network.
Exchanges using incentivization
Exchanges are constantly innovating with special offers and user incentives to build network effects on their platforms, usually distributed through a native token. Where once discounts on trading fees and special access to ICOs would suffice, competition between the over 250 exchanges now in existence has gotten to a point where exchanges are even redistributing company profits to users in a bid to undercut each other.
Binance’s BNB coin is the most prominent and popular exchange token that entitles holders to lower trading fees and voting rights. This discount, which started at 50% when the exchange launched, has since been reduced to 25% and it is unclear how long this deal will last.
Several decentralized exchanges such as Waves and Bitshares use their native cryptocurrencies as go-betweens on their marketplaces. This allows anyone to create a new cryptocurrency from scratch and instantly have a market and trading pair with the exchange’s native token.
ETERBASE uses a tiered membership system based on XBASE token holdings which significantly reduces fees for traders. Every ETERBASE user pays a low fee of 0.10% per trade, but this fee can be significantly reduced, or even completely eliminated by obtaining a higher membership level.
Choose carefully in an overcrowded market
With so many cryptocurrency exchanges already in existence in a saturated market, many will not be around for the long haul. Exchanges which are unable to produce these network effects will slowly wither away and be left as zombies – still alive but little liquidity. But there are also other reasons why exchanges will not make the cut in this overflowing market.
The first exchanges to go will be the fraudulent and unsecure. Like their predecessors before them, such as Mt. Gox, BitFunder, and others, exchanges which are not fully transparent and compliant with the most up-to-date laws and regulations are likely to not exist long term. Exchanges which lack in technology and are easily hacked are not able to survive their poor reputation on the market and will also struggle to survive.
Exchanges which lag in key usability areas will not pick up the traction needed to be part of the industry ecosystem for the long haul. Things such as user experience, fiat-to-crypto trading, and diversity of trading assets, will all be a factor in the health of an exchange. This is particularly applicable to many decentralized exchanges which although offering numerous advantages over their centralized competitors are failing to meet the usability requirements of traders in the market.
This will leave only the best exchanges to separate themselves from the pack. Exchanges which provide a great deal of security, transparency and are strong in user experience will all benefit from a growing cryptocurrency market, while the others will inevitably disappear.
About the author
Aubrey Hansen is a crypto enthusiast and a freelance writer. Her primary focus is on fintech and blockchain development. She’s been investing in crypto herself and following the major trends in past couple of years. Follow her on Twitter.