September 17, 2013

Cryptocurrencies, Network Effects, and Switching Costs

Key materials

Recent technological advances have significantly lowered the cost of processing electronic payments. Electronic banking and digital wallets (also called e-wallets) allow individuals to transfer funds securely. Whereas these services were used almost exclusively for remote transactions in the past, the widespread adoption of smartphones has made it easier to make and receive payments in person with electronic bank accounts and digital wallets. More recently, the development of inexpensive card-reading devices has enabled virtually anyone to accept electronic payments.1 With a simple click, tap, or swipe, individuals can now transact without having to handle physical cash or write checks.

At the same time, there has been a growing concern over the safety and stability of some of the most widely used currencies. Successive rounds of quantitative easing in the United States have been met with opposition, as some users of the dollar fear the currency will be worth significantly less in the future. Similarly, instability in Europe prompts fears of the devaluation or outright collapse of the euro. Although many continue to put their trust in dollars and euros, uncertainty abounds.

In this context, a small but vocal minority has turned to cryptocurrencies. Cryptocurrencies are digital alternatives to traditional government-issued paper monies. Cryptography is used to ensure that transactions are secure, to prevent users from spending the same balance more than once, and to govern the supply of digital notes in circulation. Some cryptocurrencies are decentralized, enabling quasi-anonymous transactions and making it difficult for governments to regulate them. Moreover, the electronic nature of cryptocurrencies means they are relatively easy to use across international borders.

Given the current state of technology and skepticism regarding the future purchasing power of existing monies, why have cryptocurrencies failed to gain widespread acceptance? I offer a simple explanation based on network effects and switching costs. In order to articulate the problem that agents considering cryptocurrencies face, I employ a simple model developed by Dowd and Greenaway (1993). The model demonstrates that agents may fail to adopt an alternative currency when network effects and switching costs are present, even when all agents agree that the prevailing currency is inferior. The limited success of Bitcoin—almost certainly the most popular cryptocurrency to date—serves to illustrate. After briefly surveying episodes of successful monetary transition, I conclude that cryptocurrencies like Bitcoin are unlikely to generate widespread acceptance in the absence of either significant monetary instability or government support.

I. A Model of Currency Acceptance with Network Effects and Switching Costs

In order to explore currency competition, monetary unionization, and currency substitution, Dowd and Greenaway (1993) develop a simple model of currency acceptance. Their approach differs from earlier models in two important respects. First, they assume money is subject to a network effect.2 In other words, the value conferred to a user of a particular currency depends, at least in part, on the number of other users willing to transact with that currency. Second, they include a cost of switching from one currency to another. Switching costs might arise from the need to retool vending and automatic teller machines, update menus and transaction records, or learn to think and calculate in terms of a new unit of account. With these two features—network effects and switching costs—the authors are able to articulate a model where agents might either switch or continue to accept currencies suboptimally.

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