Using Metcalfe’s Law to value cryptocurrencies

The value of cryptocurrencies may lie in the connection it provides between people, rather than the intrinsic physical value that companies and commodities hold. This is where ‘Metcalfe’s Law’ comes in. We explore the significance of connections between people, formalised by ‘Metcalfe’s Law’, and see if it can be used to value cryptocurrencies.

Cryptocurrency
Source: Bloomberg

Quantifying the connections between cryptos and people

How much is the internet worth? How many people need an email address for emails to be worth anything? What is the value in a telecoms network? By extension, what is the value in a cryptocurrency? These questions are very difficult to answer, but there must be a way to quantify the connections between devices and people. If we can figure out the value of a connection, we may be able to figure out how to value cryptocurrencies with the increase in their adoption.

To say that a connection has value may seem obvious, but how do we quantify that? A well-known example explores the connections between fax machines, and we could use the same example for cryptocurrencies. For instance, we know a single fax machine is useless, as you can’t send anything to anyone. Two fax machines have little value as you can only make one connection between yourself and one other. Five linked machine can give ten connections, while 12 linked machines can actually generate 66. As you can see, the more users, fax machines, computers, or nodes on a network, the higher the number of connections and the higher the value.

This, however, is only true if you’re connecting people who want to be connected. Put simply, ten machines shared between friends is great, but ten machines shared between strangers becomes useless once more. A global network of millions however, when taken with the concept of the six degrees of separation, is incredibly valuable, whether or not you’re talking about people connected on the internet, or people connected using a cryptocurrency.

What is Metcalfe’s Law and how does it apply to cryptos?

Metcalfe’s Law tries to quantify the value of the connections between telephones, fax machines and social networks, and possibly can be used to understand the value that cryptocurrencies have. The law itself was first formulated in 1993 and is attributed to the co-creator of Ethernet (the cable you used to plug into the back of your computer to connect to the internet), Robert Metcalfe. It states that the value of a network is proportional to the square of the number of connected users of the system.

For maths buffs out there, the equation is n(n-1)/2 where ‘n’ is the number of connections. This is how 12 connected fax machines have a value of 66, while double the amount (24 fax machines) has a network value of 276. If you double the number of people who own a fax, your network value increases more than fourfold. As you can see, the network effect is basically exponential, and this could, in theory, back up the price action of cryptocurrencies and their cyclical exponential increases as more and more people start to adopt them.

Understanding the exponential increase in crypto asset prices

Cryptocurrencies have seen some significant gains over the last few years in a seemingly never ending growth, sell-off, consolidation, re-growth phase pattern. To explore the effect of an increase in adoption vs price action, let’s look at the ethereum network and see if we can pull anything from the data. You can also see more on this on IG Community where we can compare Tx Growth rate, as well as the Network Hash. Log in to Community here to have your say and have a browse under the ‘cryptocurrency’ board.

Let’s look at the increase in adoption with new ethereum addresses (wallets on the blockchain, which we can quantify) vs the price of ether as an underlying cryptocurrency used on the ethereum network in a logarithmic scale. The reason we use the non-linier log scale is because, much like Metcalfe’s Law, we are multiplying by a constant. This may sound complicated, but you would probably have noticed this scale used in things like earthquake measurements or hard drive storage (e.g. 8GB, 16GB, 32GB phones).

New ether wallet addresses per day are shown below in blue, while the price of ether is in orange. As you can see, there is a pretty consistent correlation between the two. If we had known there was some sort of correlation between these two values back in December after the ether addresses peaked, would the reduction of new wallets have prompted a trade idea? You can see this data for yourself at etherscan.io and download the CSV if you want to do your own analysis.

ETH addresses vs ETH price

Conclusion

When we are looking at valuations of cryptocurrencies (which are inherently connections and payments networks between individuals), it looks like Metcalfe’s Law may be useful in understanding some of the exponential increase in prices we’ve seen recently. It may be a useful measure and an interesting way to generate trade ideas, perhaps it could someday have an important place in whichever metrics people will use to better value cryptos. Step aside earnings before interest, taxes, depreciation and amortisation (EBITDA) and cash flow, the tech matrix valuations are being beginning to be discussed.

More in this series

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