Web3 Network Effects: Challenges and Opportunities

The digital evolution from Web1 to Web2, and now to Web3, is reshaping the internet. It is more than just a shift towards decentralization; it's redefining the very foundations of value creation and markets by reconfiguring network effects.

Enabling Returns on Production

In the Web 2.0 era, platforms captured all the value through high take rates and skewed the distribution of rewards that came from network effects. They leveraged their reach to centralize profits and marginalize producers despite their significant contributions, the returns on production were nearly close to zero as platform amplification took all the value. Web 3’s protocols, armed with token incentives are enabling “returns on production” for the creators, producers, contributors, etc. The distribution of a more equitable share of the rewards through token rewards enables this based on market activity. As the market activity of a platform grows, so does the value of its tokens, enriching its active participants.

Non-fungible tokens (NFTs) also revolutionize ownership rights by verifying asset ownership, these protocols are transferring power and control back to producers. This democratization of ownership lets producers create, have, and leverage their creations, amplifying the potential for scaling production.

Consumer Freedom and Interoperability in Web3

One criticism of Web2 platforms was the trade-off consumers had to make between convenience and privacy. While these platforms reduced search and verification costs, they did so at the expense of users’ data privacy and agency.

In Web2.0, prosperity came at the cost of privacy

Blockchain protocols are poised to change this dynamic by decentralizing transaction verification- these protocols eliminate the need for intermediaries, empowering market actors to enforce contracts and verify transactions while maintaining their data privacy. Now consumers aren't bound to one platform; they have the freedom to traverse different platforms without sacrificing control over their identity or leaving their data and identity with others.

The Era of Shared Transaction History

Blockchain and distributed ledger technology offer a transparent and shared view of transactions, laying out clear records of ownership and trades. This is bolstered by smart contracts, which provide an automated, robust infrastructure for executing transactions at scale. These are foundational to manage and distribute network value in a transparent and equitable manner, something missing in Web2.

The Potential and Challenges of Network Effects in Web3

Network effects have been integral to the success of Web2 platforms. However, as we transition to Web3, opinions diverge on how these effects will play out. Some argue they'll become more potent, while others believe they may not hold water.

In Web2, platforms directly constructed their market infrastructure. Web3 mandates a collaborative approach, where the ecosystem jointly develops both market activity and infrastructure i.e., the infrastructure layer and application layer both are network-owned, and hence web3 network effects can be construed as a challenge and an opportunity.

Tokens in Web3 provide an innovative method to stimulate and scale these effects. They can incentivize early adopters, whether bringing in supply or developing core infrastructure- they bridge the void that Web2 had.

However, Web3 also presents challenges to defensibility. The ease of data portability and technological interoperability means locking in users is nearly impossible. This fluidity stands in stark contrast to the Web2 era, where platforms capitalized on their user data, content, reputation, and influence to ensure user retention and create defensible moats. We also saw this phenomenon as the bear market unfolded, token prices collapsed, and the network deserted the protocol. For example, Spotify retains users because they own the “user-created” playlists in Web2, in the Web3 version users could own their playlists and defect for a 25% discount offered by a Spotify competitor.

Web2’s strength came from its defensible network effects and the significant switching costs for users. These platforms, secure in their dominance, often resorted to aggressive strategies, extracting maximum value from their user base. But as Web3 lowers these switching costs, such aggressive tactics could backfire, potentially causing network effects to unravel.

In the Web2 realm, communities were primarily composed of platform users. Web3 amplifies this by drawing value from a more extensive community base, encompassing various layers from infrastructure and financing to governance. Contributors become critical ad creators and users i.e., contributors are the entity, creators are the P/L, and users are analogous to the cash flow in the traditional world. A proper and sustainable network effect will hold only when all three boxes are checked, and an equilibrium is established.

Concluding Thoughts

As Web3 reshapes the digital realm, stakeholders need to understand and adapt to its nuances. We stand on the brink of a more inclusive, decentralized, and equitable digital future by harnessing its potential and navigating its defensibility challenges.