What is Metcalfe’s law? Metcalfe’s law states that the bigger the network of users, the greater the network’s value becomes. More specifically, it is proportional to the square of the number of connected users in the system. (n2).
To illustrate this, we can use the example of fax machines. A single fax machine is useless, as it cannot do much by itself, however if there are two fax machines, they can then start to communicate with each other which increases the value of both fax machines. The value of every fax machine increases with the total number of fax machines in the network, as the total number of fax machines who can send and receive documents increases. This same effect can be seen in social networks as well, as more users in the network increases the value of the service the network provides.
We can also use Metcalfe’s law to attempt to value Bitcoin, as bitcoin heavily relies on a network of users who make transactions. The larger the network, the greater the value of bitcoin. This was seen very recently in 2017, where Metcalfe’s Law nearly perfectly correlates with bitcoin’s USD price. It is estimated that during the fastest period of growth late last year, Coinbase, a cryptocurrency exchange, had 100,000 new users in one day!
Fundstrat, an American financial research organisation created a very simple model using Metcalfe’s law to predict bitcoin’s value, and it was able to explain 94% of the price variation in bitcoin from 2013 till 2017. The model required an estimate of the number of unique addresses on the bitcoin network (squared) and an estimate for the number of transactions per day.
In conclusion, Metcalfe’s law is an interesting approach to fundamental analysis, and is quite effective in determining the value of networks. Various models suggest that it is very likely that there is a high positive correlation between the price of bitcoin and the number of transactions per day, as well as the number of addresses (or wallets) at a given time. As you can see, if you have the right data, and calculate accurate parameters, the simple directly-proportional squared relationship is a very effective evaluation tool. However, that being said, it is still very important to analyse other factors, both fundamental and technical to help make an informed trading decision.