Jorge Stolfi
2021-01-02
People invest into it because they expect good profits, and
that expectation is sustained by such profits being paid to those who choose to cash out. However,
there is no external source of revenue for those payoffs. Instead,
the payoffs come entirely from new investment money, while
the operators take away a large portion of this money.
Investing in bitcoin (or any crypto with similar protocol) checks all these items. The investors are all those who have bought or will buy bitcoins; they invest by buying bitcoins, and cash out by selling them. The operators are the miners, who take money out of the scheme when they sell their mined coins to the investors.
Features 3, 4, and 5 imply that investing in bitcoin, like "investing" in lottery tickets, is a very negative-sum game. Namely, at any time, the total amount that all investors have taken out is considerably less than what they have put into the scheme; the difference being the amount that the operators have taken out. Thus the investors, as a whole, are always in the red, and their collective loss only increases with time.
The expected profit from investing in such a scheme is negative. While some investors who cash out may make a profit, that comes at the expense of other investors, who will lose more than their "fair" share of the general loss above.
Features 1 and 2 make the scheme a fraud, rather than simply a bad investment (or bad "musical chairs" gambling game). As a minimum, the operators should warn investors of the negative-sum character and negative expected profit. In the case of bitcoin (and all other cryptos), not only that does not happen, but there are thousands of promoters and "investment experts" who predict impressive price increases and/or claim that bitcoin will have massive uses in the future that would somehow make it valuable. Apart from the mendacity of those claims, those promoters never point out that such massive uses would not translate into revenue for the investors.
The observation that investing in cryptocurrencies is a ponzi scheme is not new or a cheap shot. Among many others, it was expressed in 2014 by economists Nouriel Roubini of NYU [CDK1] and Kaushik Basu of the World Bank (WB) [CDK2] and echoed by investment analyst David Webb in 2017 [CFO2] and by WB's president Jim Yomh Kim in 2018 [CFO1].
That is not the legal definition of ponzi in country X. The legal definition is relevant to understanding the legal implications: can anyone in Crypto Space be prosecuted for running/promoting/aiding that scheme in country X?
But if one wants to know whether bitcoin is a good investment, or just an old type of investment fraud with a new coat of paint, the legal definition is irrelevant. One must use a quacks-like-a-duck definition, that describes the mechanism through which fools and money are separated and the reasons why it is a fraud.
That is not the definition of ponzi from source X. Indeed there are many variants of the definition, and they may include other spurious requirements (see below). But those requirements were incidental features of almost all ponzis before bitcoin, not essential features. They are not the reason why investing in a ponzi is a very bad idea, nor the reason why ponzis are frauds rather than just bad investments.
A definition of "TV" a few decades ago could be "a device that converts electrical signals into an image on a cathode ray tube (CRT) screen." But when flat screen TVs appeared, it would have been silly to say "those are not TVs,because they have no CRT." Instead, people would have seen that the mention of CRT in that definition was spurious, and that a useful definition should capture the effect of the device, regardless of the technology.
It is not a ponzi because it does not guarantee a profit. A ponzi does not need to do that. Madoff's ponzi did not. A ponzi only needs to create the expectation of profit in enough people, which it usually does by actually paying such profits to the few who choose to cash out. Its investors will then be its main promoters.
Ponzis that guarantee a profit will catch only the most ignorant victims, because most people know that such guarantees are impossible in the world of finance; and they will be short-lived, because the cops will come knocking as soon as they see that promise.
A ponzi scheme must be a company.That is not necessary; there have been many ponzi schemes [NYT1] [UGA1] in which the victims "invested" by simply giving money to the operator(s). And also many schemes in which the company was non-existent, such as the Bitcoin Savings and Trust that Tendon Shavers ("@pirateat40") pretended to have created.
It must have a single operator. Like other spurious requirements, this has been generally true of previous ponzis, but it is not relevant for the mechanism, and is not what makes a ponzi a bad investment.
The operator must lie to investors about the source of profits. Again, while this feature has been present in most previous ponzi schemes, it is neither a necessary nor sufficient requirement for a scheme to have the effect of a ponzi (although, depending on the jurisdiction, it may be necessary for the operators to be prosecuted).
Unlike those classical examples, items 3--5 of the definition and the negative-sum character of crypto investment are obvious to anyone who cares to analyze its money flow. However, the victims of the scheme are unaware of those features because they are obfuscated by a highly complex mechanism and economic arguments that they are not able to understand. While, on the other hand, crypto promoters from Andreessen to Zhao actively spread many lies and misleading claims about the scheme, through malice or ignorance. Investment "experts" like Tom Lee, Mike Novogratz [BPR1]. and Dan Morehead [FOR1] often give extremely optimistic predictions for the price on business or mainstream media. Those predictions have no rational basis whatsoever, and, while qualified with "perhapses" an "maybes" and "not investment advice" disclaimers, they are obviously intended to promote investment in the coins.
Crypto promoters also make dozens of claims about the virtues of the currency and/or the payment system, such as that it will "one day" replace credit cards, replace national currencies, protect people's savings from inflation or confiscation by government, make banks obsolete, starve governments to death by depriving them of taxes or "money printing", enable support of dissidents in oppressive regimes, "bank the unbanked", allow free internet trade of drugs and other illegal items, end corruption, poverty, and inequality, etc. etc. etc. Ripple Inc., for instance, has boasted for many years that their XRP currency will be used by banks for international transfers. Ethereum promoters claimed that its "smart contracts" will remove the need for lawyers and courts in business deals. Creators of several cryptocurrencies, such as IOTA and Tron (TRX), falsely claimed to have partnerships with entities such as Microsoft [PYM1] and the Liverpool Football Club [TRW]. Bitcoin (BTC) promoters falsely claim that the Lightning Network will "soon" turn their crippled payment system into a "Visa killer". And so on. When one tries to debunk any of these claims, the promoters simply switch to another one.
Even if these rosy claims were to materialize, none of them would result in a source of revenue for people holding bitcoins. The value of those payment services would go partly to the users who use coins for payments, and partly to the miners in the form of transaction fees. But most crypto investors do not understand this point. They, almost "by definition", do not understand what a good investment is -- e. g. why gold, stocks, and real estate have value, and why investing in a game that is guaranteed to be negative-sum is a bad idea. And bitcoin promoters make no attempt to educate them on those points -- quite the opposite.
By that definition, stocks too are ponzis. No. Stocks have an external source of revenue, namely the profit that the company makes by selling its products and services to customers (not investors); and these profits eventually return to the investors through dividends or cash buybacks. In time, those profits are expected to exceed the amount invested, with a significant profit for all investors -- that is, they are expected to be positive-sum games. The market value of stocks reflects these expectations among investors. While some companies fail to achieve this goal, enough of them succeed to make stocks the favorite option of savvy investors.
Companies often fail to distribute profits to investors for several years -- while they are starting up, or because of mistakes or unexpected external events. The market value of their stock will then depend on the expectations by investors of the company's ability to become profitable again, and of its subsequent profits.
A company may also choose, with the approval of its stockholders, to reinvest its profit into growth. This is good for the investors because each becomes the owner of the same fraction of a bigger pie -- including hopefully bigger profits in the following years. And this growth generally makes the stock more valuable.
By that definition, real estate too is a ponzi. No. Like stocks, real estate creates value while it is being owned, namely the sheltering service it provides to those who live in it. That value returns to the investor (owner) either by him living in the property, or by renting it to others.
By that definition, gold too is a ponzi. No, gold clearly fails to satisfy that definition on two counts.
First, few if any gold investors have expectations of profits. They generally invest in gold as a hedge -- a "store of value" -- that they hope will retain its value in case other assets go sour.
Second, as a commodity, gold HAS a source of revenue besides the investors; namely, the purchases by consumers like jewelers and industry, who take gold out of the market (2/3 of the production) for uses other than re-sale. When one buys 1 oz of gold, one gets a chip of a metal that one can sell to those consumers, and thus obtain some money that does not come from other investors.
(Nevertheless, investing in gold at the current price seems unwise, since its price is many times its "natural" price as commodity and so it is more likely to go down than up. Thus it is questionable, to say the least whether it is a good "store of value". But this problem is not enough to make it a ponzi.)
By that definition the USD is a ponzi. No, national currencies too fail to fit the definition, because people do not "invest" in them with the expectation of gain. In fact, governments make their currencies slightly inflationary precisely to discourage hoarding.
It is not a ponzi because bitcoins can be earned and spent, not just bought and sold. That makes no difference for the purpose of this discussion. If you buy a $2000 laptop directly with bitcoin, for financial analysis it is the same as if you had sold the coins for $2000 and bought the laptop with that. It would count as a $2000 cash-out. Similarly if you earn bitcoins by selling a $2000 laptop, or providing a service for which you would otherwise have charged $2000: it would count as a $2000 purchase of bitcoin.
It is not a ponzi because bitcoins have intrinsic value. According to this claim, bitcoins are scarce artifacts whose unique properties, like gold's, make them exceptionally good instruments for certain uses, such as payments or store of value.
This objection usually derives from the misconception that a bitcoin is a definite pattern of bits that required a huge amount of energy to produce, and that only a fixed number of them -- 21 million -- can ever be created. And that these properties make bitcoins (or cryptocoin X) more valuable than any other cryptocoin, including any fork from it. But neither of these claims is true.
A bitcoin is not a definite pattern of bits; it cannot be printed, played on speakers, or shown on a screen. There is only a ledger with entries that assert "there are N bitcoins assigned to address Z" -- and it does not even say which bitcoins. The miners' massive hashing work does not go into creating the bitcoins, but into stamping the ledger to (allegedly) secure the record of past transactions. Once a bitcoin is moved, all that work becomes largely irrelevant; the security of that bitcoin -- more precisely, of that transaction -- will depend on the work done by miners after it was accepted.
Thus a bitcoin is not a definite artifact that somehow "contains" a huge amount of hashing work. That work is not attached to the bitcoins. So much so that each of the million bitcoins that Satoshi created on his laptop is equivalent to, and has the same market price as, the bitcoins created yesterday, each of which supposedly required 13'000'000'000'000'000'000'000 hash calculations to create.
Back in 2014 or so, when the US gov started auctioning the Silk Road bitcoins, some believers thought that those coins would fetch a higher price than "ordinary" ones -- because they would have been blessed as "legal" by the US government, and because of the "historical" value of having been owned by the greatest hero of Crypto Space. But that did not happen, precisely because bitcoins lack even the abstract "existence" of a tweet. How much would you pay for a $1.00 from my checking account that once was in Al Capone's checking account?
Contrast that with the properties that make gold a unique metal with high and lasting demand for jewelry and other uses: those properties are physically attached to each bit of the metal, and thus are truly "intrinsic".
In fact, while bitcoins are created in a fixed amount only when the miners have expended a large amount of work, the creation of those bitcoins costs nothing. The reward per block is defined by two lines of code in a program. By changing those lines, the reward could be sixty or six million bitcoins per block, with no extra work being required from the miners. Contrast that with the cost of producing gold, that is defined by geology and not by some line in a program.
It is claimed that the code lines that define the block reward cannot be changed because that would be "against the miners' self interest", or would be "rejected by the community". But neither of these arguments stands up to a critical analysis, that considers the actual reaction of that community to more radical changes that have been imposed on the protocol -- such as BTC's intentional congestion, and Ethereum's breaking of the sacred "code is law" principle.
It follows that bitcoins have no more intrinsic value than coins of any other cryptocurrency, or than the shares of Madoff's ponzi fund. These too were only an entry in a ledger, and where worthless by themselves. Unlike stocks or dollars in a checking account, none of those ledger entries gave their holders legal property rights on anything else; their value being only the right, conceded by the operators, to play the game -- that particular game -- while it lasted.
It is not a ponzi because it has recovered after each crash. Once more, that feature of past ponzis -- their ending with an abrupt, total, and permanent crash -- was a consequence of their particular features, not of the properties that made them fraudulent investments. Schemes that depended on a blatant lie, like Ponzi's or Madoff's, would crash abruptly when that lie was exposed; which usually happened when an excess of withdrawals over new investments made it impossible to honor the former. Once the truth got revealed, and confirmed by arrest of the operators, there was no further investment, and all investors demanded their money back.
However, as explained above, crypto ponzis sustain their expectation of profitability by technical and economic obfuscation, and claims about an indefinite future, rather than by a single and simple lie that implies constant income. Thus, even when new investments -- and consequently the immediate "payoffs" -- drop by 80% or more, as happened to BTC between 2017-12 and 2018-12, there will be a band of faithful investors who will continue to put all their spare money into the game, firmly believing that the price will "eventually" rise again and "go to the moon". And this money will be enough to keep the blockchain alive, even if with a lower hashrate. That is why even the most obviously broken cryptocurrencies can survive multiple crashes and years of dropping prices, and only die if and when the price finally reaches zero.
People buy for the ideology, not as an investment for profit. That is simply not true. For 99.9% of bitcoiners, when they buy bitcoins, they think they are investing -- and doing it because they expect to make big profits. One need only read what they write on forums to realize that. Those who truly buy it for ideological reasons (other than for criminal purposes) must be a very small minority.
Institutions buy it as a hedge, not as an investment for profit. That may be true in some cases, but "hedge" seems to be often just an excuse to cover other reasons. Some of those institutions may be in fact expecting to make a profit, but understandably their managers do not want to admit that they are gambling with the company's funds -- and do not want to be blamed if they lose money on that bet. (And some of these managers may well be aware that it is a ponzi scheme, but believe that, by cashing out at the right time, they can collect many millions of dollars from the faithful bitcoiners who have been putting more than 10 million USD/day into the game, rain or sunshine.) A few other big investors may be doing it for ideological reasons. And some CEOs may have found ways to personally profit from company purchases.
It should also be noted that many of the "big investors" cited by promoters are in fact bitcoin-based funds that, like Grayscale's GBTC, buy bitcoins with their clients money, not with their own; and therefore will make a profit from service and maintenance fees, no matter what will happen to the price. Once those funds are excluded, the number of "institutional" investors remains quite small.
It is hard to believe the "hedge" excuse, because such purpose requires an asset that is expected to at least retain most of its value in the short term, and whose volatility is low enough. Adding to one's portfolio any amount of an "asset" that is losing the money put into it at the rate of 10 billion USD per year, and has the highest volatility ever seen, will only increase its risk, not reduce it.
Ponzi should be written with capital "P". That is true. The word should always be capitalized, like Boycott, Lynch, Hamburger and Sandwich.
Edited on 2021-01-03: "(or any crypto)" --> "(or any crypto with similar protocol)", since e.g. stablecoins do not fit the definition.
Last edited on 2021-01-03 17:48:17 by jstolfi