The network effect, a phenomenon in which the value of a product increases as more people use it, stands as one of the most critical factors for the success of a startup. In the realm of consumer apps within the cryptocurrency space, particularly for stablecoins, the significance of the network effect cannot be overstated.
I believe that many developers within the stablecoin ecosystem do not place enough emphasis on the pivotal role the network effect plays. Consequently, alternatives to well-established stablecoins like $USDT and $USDC struggle to gain a meaningful market share. To highlight the underlying reasons for this state of affairs, I wrote several articles, and in this particular piece, we will delve into the importance of the network effect within the stablecoin ecosystem.
We aim to discover why, in the decentralized finance ecosystem, we have yet to cultivate a decentralized and censorship-resistant alternative to challenge the dominance of $USDT and $USDC.
This article will begin by explaining the concept of the network effect, subsequently delving into the specific parameters that constitute the network effect in the realm of stablecoins. Furthermore, we will review $BUSD as an example of a successful alternative that managed to challenge the supremacy of $USDT and $USDC until it fell under the regulatory scrutiny of the SEC, which ultimately led to Paxos discontinuing the issuance of $BUSD and Binance gradually reducing its utilization and support for $BUSD.
Discovering Network Effect in Stablecoin Landscape
The network effect is a concept that drives the growth and value of a product or service in a virtuous cycle. When a project exhibits network effects, each new user or participant contributes to the overall utility and desirability of the network. This creates a positive feedback loop where more users attract even more users, resulting in exponential growth.
As the network expands, it becomes increasingly valuable to each user. This heightened utility can manifest in various ways, such as a larger user base to connect with, deepening liquidity, and more trading pairs.
One of the significant benefits of network effects is the competitive advantage it confers upon the project. As the network grows, it becomes challenging for new entrants to compete effectively because users are already invested in the existing network.
With this definition, I believe that we can easily understand the reason why $USDT and $USDC continue to dominate the stablecoin landscape while new alternatives have difficulty in getting traction. Thanks to the fact that $USDT and $USDC are the first movers, most of the protocols adopted $USDT and $USDC in their platforms. As a result, most investors/traders use $USDT and $USDC, which in turn resulted in more protocols adopting $USDT and $USDC. This also resulted in investors and traders prefer $USDT and $USDC. This is a basic example of the network effect.
As the network effect helps $USDT and $USDC to be more recognizable, trustable, and preferable in the eyes of investors/traders, it becomes harder for the new stablecoin projects to get traction.
However, even though it is getting harder to have a network effect in the stablecoin space, I believe that following the paths of $USDT and $USDC can be a good way for new stablecoin projects to have a network effect.
Based on this discussion about the network effect, we can conceptualize 4 main concept that helps to develop a network effect for a stablecoin.
Deep Liquidity: Liquidity is king. A stablecoin needs to possess deep liquidity across pairs, platforms, and chains to provide a superior trading experience for both traders and investors. This also contributes to a stronger peg. Without such deep liquidity, the development of new use cases and opportunities for this stablecoin becomes challenging. Deep liquidity has a cascading effect, attracting more users and creating a positive feedback loop. Therefore, it is essential to note that to achieve deep liquidity, the issuance of the stablecoin should be capital-efficient. This implies that decentralized stablecoins using a CDP model, which demands over-collateralization and carries liquidation risks, cannot scale sufficiently to create deep liquidity due to the inherent limitations of the CDP model.
CEX Integration: CEXs are the first place where the masses interact with the crypto ecosystem. There are millions of people who use CEXs but haven’t engaged with the DeFi ecosystem. Thus, being listed on the major CEXs is a prerequisite to achieving network effect. I believe that for a stablecoin project to have a network effect, it is crucial to have deep liquidity across centralized exchanges. Currently, only $USDT and $USDC achieve that while $BUSD was able to achieve this until Binance stopped its support. As an example, when Binance stopped support for $USDC to boost $BUSD’s growth, the $USDC supply decreased by almost $10 billion within a couple of months.
DeFi Integration: Integration with the major DeFi platforms is also crucial. Without such integration, a stablecoin faces several other issues. Its utility within the DeFi ecosystem is limited, reducing demand among DeFi users who prefer easily accessible and usable stablecoins. Liquidity may remain fragmented across different platforms, diminishing efficiency. Price stability can be compromised due to a lack of arbitrage opportunities and market depth. The stablecoin's use cases become limited, making it less versatile for DeFi participants. Adoption may stall, as DeFi platforms often act as gateways for new users entering the DeFi space. A non-integrated stablecoin may also face a competitive disadvantage, missing out on opportunities to attract users and liquidity. Additionally, its exclusion from DeFi collaborations may hinder its ability to innovate and adapt to changing market demands.
Cross-chain compatibility: Stablecoins with substantial market presence invariably exist across multiple blockchain networks. Consequently, it's reasonable to assert that if a stablecoin confines itself to a single native blockchain, it would struggle to cultivate network effects. Moreover, in the event of a competitor's expansion into this same native blockchain, said competitor is almost certain to challenge the established players. This is due to the competitor's existing presence on other blockchains, providing them with a robust network effect to leverage on the new blockchain.
Established projects like Uniswap serve as an excellent case in point. Uniswap has undeniably demonstrated its success on the Ethereum blockchain. When Uniswap extends its reach into other blockchain networks, it swiftly ascends to the top position, displacing native decentralized exchanges (DEXs) and eliminating competition within that specific blockchain.
Certainly, when assessing the primary objectives of a stablecoin project, the paramount goals invariably revolve around augmenting both the stablecoin's supply and its transaction volume. In this context, the concept of a network effect emerges as a pivotal factor. It essentially initiates a self-reinforcing cycle where users are naturally drawn to trade and hold this specific stablecoin. Consequently, this surge in user demand compels exchanges and platforms to integrate and support the stablecoin in question. This organic process then precipitates the exponential growth of the stablecoin, without necessitating any contrived or artificial strategies from its issuer.
In essence, the network effect acts as a powerful catalyst, creating a virtuous cycle that propels the stablecoin's adoption, liquidity, and overall prominence in the cryptocurrency ecosystem.
Case Study: $BUSD
BUSD is a fiat-backed stablecoin that is regulated by the New York State Department of Financial Services (NYDFS). All reserves are held 100% in cash and cash equivalents; hence customer funds are always available for 1:1 redemption.
Behind $BUSD’s short but well-known success story, Binance played a huge role as it offers several benefits for $BUSD users on its platform such as:
Zero Maker fees for all BUSD trading pairs on Binance
Zero transaction fees on BUSD stablecoin pairs on Binance
Deep liquidity for BUSD trading pairs with newly-listed tokens on Binance
High APY for $BUSD holders
Farm new tokens via Binance Launchpad using BUSD
Purchase NFTs on Binance NFT Marketplace
Access Margin Trading and Binance Futures
Thanks to these benefits, using $BUSD was very profitable as the minimal fees associated with using $BUSD make it an attractive choice for traders and investors, also $BUSD has been widely used in several CeFi and DeFi thanks to the foundational network effect that Binance and Binance Smart Chain provided.
It is clear that $BUSD has taken advantage of Binance’s backing, as a result, it created a network effect in which $BUSD was available on almost all of the platforms, exchanges, pairs, and chains and had deep liquidity, so it challenged the supremacy of $USDT and $USDC.
$BUSD’s rise from $3.482 billion to $23.337 billion on November 13th, 2022, where it reached ATH is great proof that $BUSD achieved a network effect that no one has realized other than $USDT and $USDC. During that period, while the total market share of $USDT and $USDC has been stagnant at around 75-80% the market share of $BUSD rose from 5.56% to 15.07%.
The catalyst for BUSD’s success can be summarized as:
CEX Integration: With Binance backing, $BUSD was able to exist in every major CEX as the network effect that Binance provided caused other CEXs to follow suit and launch $BUSD as a pair on their exchanges. This resulted in traders and investors prefer $BUSD because it is supported by major players in the ecosystem and it offers so many use cases. Moreover, since Binance offers low or zero fees in $BUSD pairs on its platform, traders were incentivized to use $BUSD since it was more profitable for them. Considering that Binance is the biggest CEX and most of the transactions on crypto happen on Binance, it created a great volume of transactions and supply increase for $BUSD.
DeFi Integration and cross-chain compatibility: Thanks to Binance backing $BUSD was one of the main stablecoins that has been used in BNB Chain and it also led to the popularity of $BUSD in Ethereum. For example, at some point, $BUSD’s market share on Ethereum was over 20%. As a result of this strong presence in both chains, $BUSD was able to achieve a network effect.
Deep Liquidity: As a result of CEX and DeFi integration, $BUSD achieved deep liquidity across platforms, pairs, and chains which resulted in more recognition and familiarity for the traders/investors. It initiated a self-reinforcing cycle to boost the network effect of $BUSD and make $it a strong alternative to $USDT and $USDC.
In conclusion, this article's framework highlights how the network effect plays a crucial role in the stablecoin world. Currently, centralized stablecoins dominate the decentralized finance scene. To make decentralized stablecoins bigger, we need to figure out how to scale them up. This framework breaks down the four key parts of the network effect to help us understand how a stablecoin can become popular in this fast-changing space.
Working together, we can refine and expand on this framework to make decentralized stablecoins better. By sharing ideas and finding new solutions, we can move closer to a financial future that's more open and available to everyone.
Let's keep pushing the boundaries of stablecoins, bringing traditional finance and the decentralized world together to empower people around the globe.