To understand how EPNs operate, it makes sense to take a look at a real-world example of blockchain protocol and token network effects in action.
Compound is a decentralized finance application, built on top of Ethereum, that offers users an algorithmic savings and loan experience for ETH or other currencies based on the Ethereum Network, such as USDC, DAI, REP, WBTC, BAT, and ZRX. It also has its own ERC-20 governance token, $COMP, which enables its holders — the Compound community — to participate in managing the protocol by proposing, debating and voting on changes.
At the protocol level, Compound brings together different participants with opposite, but complementary motivations. These are:
- Suppliers of tokens and cryptocurrencies seeking yield, who can earn interest by depositing digital-asset collateral.
- Borrowers of tokens and cryptocurrencies seeking utility and/or leverage, who pay interest in exchange for borrowing assets.
Compound uses on-chain smart contracts to put tokens and cryptocurrencies into secure custody and to determine the interest rates paid for lending or borrowing assets, removing the need for centralized bankers or mediated loan approvals. Because these decisions are made via an algorithm in a transparent marketplace, participants can make their own private assumptions about forward interest rates and currency valuations, deciding for themselves whether supplying and/or borrowing makes sense.
The Compound protocol’s network effects look like this:
- Interest rates adjust continuously based on supply and demand
- High liquidity from more collateral deposits incentivizes borrowing when rates are low, while low liquidity from fewer collateral deposits incentivizes supply when rates are high
- The Compound protocol rewards users for covering the positions of “borrowers” that violate minimal collateral thresholds
- The protocol’s transparency and extensive documentation and open access to the Compound team itself (including a responsive presence of their own Discord channel) has made it easy for third parties to build applications on top of Compound.
But these are the basic protocol network effects. Because Compound is an EPN, there’s another layer of effects to consider — those generated by the Compound governance token $COMP.
The success of Compound as a decentralized finance application and of $COMP as its application token, built using Ethereum’s ERC-20 token standard, also boosts the success of the Ethereum Network and its native cryptocurrency ETH. To illustrate this, consider that as economic activity increases on Compound, more people lock up ETH or other ERC-20 tokens, which makes ETH a more scarce commodity and a more commonly used exchange currency, while also requiring more ETH to pay for transaction fees. The availability of more transaction fees encourages new miners to join the Ethereum Network, thus making it larger and more secure.
Of course, there are still many ways that this system could fall apart. For example, if a player or a set of players amassed an exceptionally large amount of $COMP — enough to effectively dominate the system without challenge. But there are ways to design EPNs so that this possibility is made extremely implausible.
So, how does one design EPNs to maximize effectiveness and minimize the potential for abuse?
Want to learn more about network effects in Compound? Read our in-depth article here.