The Power of Network Effects

The engine of the industrial economy was, and remains, supply-side economies of scale. Massive fixed costs and low marginal costs mean that companies achieving higher sales volume than their competitors have a lower average cost of doing business. That allows them to reduce prices, which increases volume further, which permits more price cuts: a virtuous feedback loop that tends to produce monopolies.[1]

In supply-side economies, financial institutions achieve market power by controlling resources, continuously increasing efficiency, and resisting challenges from any of the five Porter model’s forces. The objective of this strategy is to build sustainable competitive advantages that protect the organization from competition and channels competition toward other companies.

The platform should incentivize users and innovators to use and contribute to the platform. The result is ecosystem growth and the release of network effects. Strong network effects are an important value driver for platforms as they might create “winner-take-all” situations among competing platforms. There are two types of network effects:

  • • Direct network effects describe the increased value for platform users when more users join the ecosystem.
  • • Indirect network effects emerge when new applications for the platform get introduced. They increase the value for users to join the platform.

Both types of network effects have positive feedback loops. Each time the ecosystem grows by new users or applications, the value to be part of the ecosystem gets increased, which is what attracts new users and developers for new applications. However, a good governance of the ecosystem through the platform owner is essential as network effects can also turn negative and ruin a platform and its ecosystem.

Greater scale generates more value, which attracts more participants, which creates more value. This is a virtuous feedback loop. The bad side is that it can also produce monopolies. Network effects gave us Alibaba, which accounts for over 75% of Chinese e-commerce transactions; Google, which accounts for 82% of mobile operating systems and 94% of mobile search; and Facebook, the world’s dominant social platform (for the time being).[2]

The five Porter model’s forces do not factor in network effects and the value they create. The Porter model regards external forces as “depletive” or extracting value from a firm, and so argues for building barriers against them. In demand-side economies, however, external forces can be “accretive” (Van Alstyne et al. 2016). In other words, they can add value to the platform business. The power of vendors and customers, which is threatening in a supply-side world, is actually an asset in the case of platforms. Understanding when external forces may either add or extract value in an ecosystem is central to the platform strategy.

Cofunds

"The acquisition of Cofunds is a unique opportunity to further accelerate the execution of our UK strategy. It enables us to create substantial value as the number one provider in the fast-growing UK platform market. I am proud that the number of customers we are helping in the United Kingdom to achieve a lifetime of financial security now exceeds three million."—Alex Wynaendts, CEO of Aegon[3]

The case of Aegon buying Cofunds shows the relevance and the value for financial services of platforms. Legal & General has sold Cofunds, the main investment platform in the United Kingdom for financial advisors, to Aegon for ?140 million but the British insurer will incur a net loss of about ?65 million on the disposal.[4] Aegon, the Dutch insurer, receives also the Investor Portfolio Service platform—which is a similar offering for banks and building societies—as well as the retail and institutional businesses of Cofunds. Cofunds was established in 2001. It does not deal directly with private investors but provides financial advisors with access to more than 2100 funds as well as administration services to manage portfolios on behalf of clients.

  • [1] That was the philosophy of Jack Welch in GE: He had GE cut all businesses in which the companycould not dominate the market in first or second positions. http://www.investopedia.com/ask/answers/09/neutron-jack-welch-ceo-general-electric-ge.asp#ixzz4IeWz7LB7, Accessed 28 August2016.
  • [2] https://hbr.org/2016/04/pipelines-platforms-and-the-new-rules-of-strategy, Accessed 30 July2016.
  • [3] http://finance.yahoo.com/news/aegon-acquires-cofunds-becomes-leading-053000038.html,Accessed 26 August 2016.
  • [4] http://www.ft.com/fastft/tag/companies/, Accessed 22 August 2016.
 
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