Why Bitcoin is Not a Ponzi Scheme: Point by Point

Find more of Lyn’s work at lynalden.com

One of the concerns I’ve seen aimed at Bitcoin is the claim that it’s a Ponzi scheme. The argument suggests that because the Bitcoin network is contin­u­ally reliant on new people buying in, that eventu­ally it will collapse in price as new buyers are exhausted.

So, this article takes a serious look at the concern by comparing and contrasting Bitcoin to systems that have Ponzi-like charac­ter­is­tics, to see if the claim holds up.

The short version is that Bitcoin does not meet the defin­i­tion of a Ponzi scheme in either narrow or broad scope, but let’s dive in to see why that’s the case.

Defining a Ponzi Scheme

To start with tackling the topic of Bitcoin as a Ponzi scheme, we need a defin­i­tion.

Here is how the US Securi­ties and Exchange Commis­sion defines one:

“A Ponzi scheme is an invest­ment fraud that pays existing investors with funds collected from new investors. Ponzi scheme organizers often promise to invest your money and generate high returns with little or no risk. But in many Ponzi schemes, the fraud­sters do not invest the money. Instead, they use it to pay those who invested earlier and may keep some for themselves.

With little or no legit­i­mate earnings, Ponzi schemes require a constant flow of new money to survive. When it becomes hard to recruit new investors, or when large numbers of existing investors cash out, these schemes tend to collapse.

Ponzi schemes are named after Charles Ponzi, who duped investors in the 1920s with a postage stamp specu­la­tion scheme.”

They further go on to list red flags to look out for:

“Many Ponzi schemes share common charac­ter­is­tics. Look for these warning signs:

High returns with little or no risk. Every invest­ment carries some degree of risk, and invest­ments yielding higher returns typically involve more risk. Be highly suspi­cious of any “guaran­teed” invest­ment oppor­tu­nity.

Overly consis­tent returns. Invest­ments tend to go up and down over time. Be skeptical about an invest­ment that regularly gener­ates positive returns regard­less of overall market condi­tions.

Unreg­is­tered invest­ments. Ponzi schemes typically involve invest­ments that are not regis­tered with the SEC or with state regula­tors. Regis­tra­tion is impor­tant because it provides investors with access to infor­ma­tion about the company’s manage­ment, products, services, and finances.

Unlicensed sellers. Federal and state securi­ties laws require invest­ment profes­sionals and firms to be licensed or regis­tered. Most Ponzi schemes involve unlicensed individ­uals or unreg­is­tered firms.

Secre­tive, complex strate­gies. Avoid invest­ments if you don’t under­stand them or can’t get complete infor­ma­tion about them.

Issues with paper­work. Account state­ment errors may be a sign that funds are not being invested as promised.

Diffi­culty receiving payments. Be suspi­cious if you don’t receive a payment or have diffi­culty cashing out. Ponzi scheme promoters sometimes try to prevent partic­i­pants from cashing out by offering even higher returns for staying put.”

I think that’s a great set of infor­ma­tion to work with. We can see how many of those attrib­utes, if any, Bitcoin has.

Bitcoin’s Launch Process

Before we get into comparing Bitcoin point-by-point to the above list, we can start with a recap of how Bitcoin was launched.

In August 2008, someone identi­fying himself as Satoshi Nakamoto created Bitcoin.org.

Two months later in October 2008, Satoshi released the Bitcoin white paper. This document explained how the technology would work, including the solution to the double-spending problem. As you can see from the link, it was written in the format and style of an academic research paper, since it was presenting a major technical break­through that provided a solution for well-known computer science challenges related to digital scarcity. It contained no promises of enrich­ment or returns.

Then, three months later in January 2009, Satoshi published the initial Bitcoin software. In the custom genesis block of the blockchain, which contains no spend­able Bitcoin, he provided a time-stamped article headline about bank bailouts from The Times of London, likely to prove that there was no pre-mining and to set the tone for the project. From there, it took him six days to finish things and mine block 1, which contained the first 50 spend­able bitcoins, and he released the Bitcoin source code that day on January 9^th. By January 10^th, Hal Finney publicly tweeted that he was running the Bitcoin software as well, and right from the begin­ning, Satoshi was testing the system by sending bitcoins to Hal.

Inter­est­ingly, since Satoshi showed how to do it with the white paper more than two months before launching the open source Bitcoin software himself, techni­cally someone could have used the newfound knowl­edge to launch a version before him. It would have been unlikely, due to Satoshi’s big head start in figuring all of this out and under­standing it at a deep level, but it was techni­cally possible. He gave away the key techno­log­ical break­through before he launched the first version of the project. Between the publi­ca­tion of the white paper and the launch of the software, he answered questions and explained his choices for his white paper to several other cryptog­ra­phers on an email list in response to their critiques, almost like an academic thesis defense, and several of them could have been technical enough to “steal” the project from him, if they were less skeptical.

After launch, a set of equip­ment that is widely believed to belong to Satoshi remained a large Bitcoin miner throughout the first year. Mining is neces­sary to keep verifying trans­ac­tions for the network, and bitcoins had no quoted dollar price at that time. He gradu­ally reduced his mining over time, as mining became more distrib­uted across the network. There are nearly 1 million bitcoins that are believed to belong to Satoshi that he mined through Bitcoin’s early period and that he has never moved from their initial address. He could have cashed out at any point with billions of dollars in profit, but so far has not, over a decade into the project’s life. It’s not known if he is still alive, but other than some early coins for test trans­ac­tions, the bulk of his coins haven’t moved.

Not long after, he trans­ferred owner­ship of his website domains to others, and ever since, Bitcoin has been self-sustaining among a revolving devel­op­ment commu­nity with no input from Satoshi.

Bitcoin is open source, and is distrib­uted around the world. The blockchain is public, trans­parent, verifi­able, auditable, and analyz­able. Firms can do analytics of the entire blockchain and see which bitcoins are moving or remaining in place in various addresses. An open source full node can be run on a basic home computer, and can audit Bitcoin’s entire money supply and other metrics.

With that in mind, we can then compare Bitcoin to the red flags of being a Ponzi scheme.

Investment Returns: Not Promised

Satoshi never promised any invest­ment returns, let alone high invest­ment returns or consis­tent invest­ment returns. In fact, Bitcoin was known for the first decade of its existence as being an extremely high-volatility specu­la­tion. For the first year and a half, Bitcoin had no quotable price, and after that it had a very volatile price.

The online writings from Satoshi still exist, and he barely ever talked about finan­cial gain. He mostly wrote about technical aspects, about freedom, about the problems of the modern banking system, and so forth. Satoshi wrote mostly like a programmer, occasion­ally like an econo­mist, and never like a salesman.

We have to search pretty deeply to find instances where he discussed Bitcoin poten­tially becoming valuable. When he did talk about the poten­tial value or price of a bitcoin, he spoke very matter-of-factly in regards to how to catego­rize it, whether it would be infla­tionary or defla­tionary, and admitted a ton of variance for how the project could turn out. Digging around for Satoshi’s quotes on the price of value of a bitcoin, here’s what I found:

“The fact that new coins are produced means the money supply increases by a planned amount, but this does not neces­sarily result in infla­tion. If the supply of money increases at the same rate that the number of people using it increases, prices remain stable. If it does not increase as fast as demand, there will be defla­tion and early holders of money will see its value increase.”

___

“It might make sense just to get some in case it catches on. If enough people think the same way, that becomes a self fulfilling prophecy. Once it gets bootstrapped, there are so many appli­ca­tions if you could effort­lessly pay a few cents to a website as easily as dropping coins in a vending machine.”

___

“In this sense, it’s more typical of a precious metal. Instead of the supply changing to keep the value the same, the supply is prede­ter­mined and the value changes. As the number of users grows, the value per coin increases. It has the poten­tial for a positive feedback loop; as users increase, the value goes up, which could attract more users to take advan­tage of the increasing value.”

___

“Maybe it could get an initial value circu­larly as you’ve suggested, by people foreseeing its poten­tial useful­ness for exchange. (I would definitely want some) Maybe collec­tors, any random reason could spark it. I think the tradi­tional quali­fi­ca­tions for money were written with the assump­tion that there are so many competing objects in the world that are scarce, an object with the automatic bootstrap of intrinsic value will surely win out over those without intrinsic value. But if there were nothing in the world with intrinsic value that could be used as money, only scarce but no intrinsic value, I think people would still take up something. (I’m using the word scarce here to only mean limited poten­tial supply)”

___

“A rational market price for something that is expected to increase in value will already reflect the present value of the expected future increases. In your head, you do a proba­bility estimate balancing the odds that it keeps increasing.”

___

“I’m sure that in 20 years there will either be very large trans­ac­tion volume or no volume.”

___

“Bitcoins have no dividend or poten­tial future dividend, there­fore not like a stock. More like a collectible or commodity.”

-Quotes by Satoshi Nakamoto

Promising unusu­ally high or consis­tent invest­ment returns is a common red flag for being a Ponzi scheme, and with Satoshi’s original Bitcoin, there was none of that.

Over time, Bitcoin investors have often predicted very high prices (and so far those predic­tions have been correct), but the project itself from incep­tion did not have those attrib­utes.

Open Source: The Opposite of Secrecy

Most Ponzi schemes rely on secrecy. If the investors under­stood that an invest­ment they owned was actually a Ponzi scheme, they would try to pull their money out immedi­ately. This secrecy prevents the market from appro­pri­ately pricing the invest­ment until the secret gets found out.

For example, investors in Bernie Madoff’s scheme thought they owned a variety of assets. In reality, earlier investor outflows were just being paid back from new investor inflows, rather than money being made from actual invest­ments. The invest­ments listed on their state­ments were fake, and for any of those clients, it would be nearly impos­sible to verify that they are fake.

Bitcoin, however, works on precisely the opposite set of princi­ples. As a distrib­uted piece of open source software that requires majority consensus to change, every line of code is known, and no central authority can change it. A key tenet of Bitcoin is to verify rather than to trust. Software to run a full node can be freely downloaded and run on a normal PC, and can audit the entire blockchain and the entire money supply. It relies on no website, no critical data center, and no corpo­rate struc­ture.

For this reason, there are no “issues with paper­work” or “diffi­culty receiving payments”, refer­encing some of the SEC red flags of a Ponzi. The entire point of Bitcoin is to not rely on any third parties; it is immutable and self-verifi­able. Bitcoin can only be moved with the private key associ­ated with a certain address, and if you use your private key to move your bitcoins, there is nobody who can stop you from doing so.

There are of course some bad actors in the surrounding ecosystem. People relying on others to hold their private keys (rather than doing so themselves) have sometimes lost their coins due to bad custo­dians, but not because the core Bitcoin software failed. Third-party exchanges can be fraud­u­lent or can be hacked. Phishing schemes or other frauds can trick people into revealing their private keys or account infor­ma­tion. But these are not associ­ated with Bitcoin itself, and as people use Bitcoin, they must ensure they under­stand how the system works to avoid falling for scams in the ecosystem.

No Pre-Mine

As previ­ously mentioned, Satoshi mined virtu­ally all of his coins at a time when the software was public and anybody else could mine them. He gave himself no unique advan­tage in acquiring coins faster or more easily than anyone else, and had to expend compu­ta­tional power and electricity to acquire them, which was critical in the early period for keeping the network up and running. And as previ­ously mentioned, the white paper was released before any of it, which would be unusual or risky to do if the goal was mainly about personal monetary gain.

In contrast to this unusu­ally open and fair way that Bitcoin was launched, many future cryptocur­ren­cies didn’t follow those same princi­ples. Specif­i­cally, many later tokens had a bunch of pre-mined concep­tions, meaning that the devel­opers would give themselves and their investors coins before the project becomes public.

Ethereum’s devel­opers provided 72 million tokens to themselves and their investors prior to any being avail­able to own by the broader public, which is more than half of the current token supply of Ethereum. It was a crowd­sourced project.

Ripple Labs pre-mined 100 billion XRP tokens with the majority being owned by Ripple Labs, and gradu­ally began selling the rest to the public, while still holding the majority, and is currently being accused by the SEC of selling unreg­is­tered securi­ties.

Besides those two, count­less other smaller tokens were pre-mined and sold to the public.

A case can be made in favor of pre-mining in certain instances, although some are very critical of the practice. In a similar way that a start-up company offers equity to its founders and early investors, a new protocol can offer tokens to its founders and early investors, and crowd­sourced financing is a well-accepted practice at this point. I’ll leave that debate to others. Few would dispute that early devel­opers can be compen­sated for work if their project takes off, and funds are helpful for early devel­op­ment. As long as it’s fully trans­parent, it comes down to what the market thinks is reason­able.

When defending against the notion of being a Ponzi scheme, however, Bitcoin is miles ahead of most other digital assets. Satoshi showed the world how to do it first with a white paper months in advance, and then put the project out there in an open source way on the first day of spend­able coins being gener­ated, with no pre-mine.

A situa­tion where the founder gave himself virtu­ally no mining advan­tage over other early adaptors, sure is the “cleanest” approach. Satoshi had to mine the first blocks of coins with his computer just like anyone else, and then never spent them other than by sending some of his initial batch out for early testing. This approach improved the odds of it becoming a viral movement, based on economic or philo­soph­ical princi­ples, rather than strictly about riches. Unlike many other blockchains over the years, Bitcoin devel­op­ment occurred organ­i­cally, by a revolving set of large stake­holders and volun­tary user donations, rather than via a pre-mined or pre-funded pool of capital.

On the other hand, giving yourself and initial investors most of the initial tokens and then having later investors start from mining from scratch or buy into it, opens up more avenues for criti­cisms and skepti­cism and begins to look more like a Ponzi scheme, whether or not it actually is.

Leaderless Growth

One thing that makes Bitcoin really inter­esting is that it’s the one big digital asset that flour­ished without central­ized leader­ship. Satoshi created it as its anony­mous inventor, worked with others to guide it through the first two years with continued devel­op­ment on open forums, and then disap­peared. From there, other devel­opers took the mantle in terms of contin­uing to develop and promote Bitcoin.

Some devel­opers have been extremely impor­tant, but none of them are critical for its ongoing devel­op­ment or opera­tion. In fact, even the second round of devel­opers after Satoshi largely went in other direc­tions. Hal Finney passed away in 2014. Some other super-early Bitcoiners became more inter­ested in Bitcoin Cash or other projects at various stages.

As Bitcoin has devel­oped over time, it has taken on a life of its own. The distrib­uted devel­op­ment commu­nity and userbase, (and the market, when it comes to pricing various paths after hard forks) has deter­mined what Bitcoin is, and what it is useful for. The narra­tive has changed and expanded as time went on, and market forces rewarded or punished various direc­tions.

For years, debates centered around whether Bitcoin should optimize for storing value or optimize for frequent trans­ac­tions on the base layer, and this is what led to multiple hard forks that all devalued compared to Bitcoin. The market clearly has preferred Bitcoin’s base layer to optimize for being a store of value and large trans­ac­tion settle­ment network, to optimize for security and decen­tral­iza­tion, with an allowance for frequent smaller trans­ac­tions to be handled on secondary layers.

Every other blockchain-based token, including hard forks and those associ­ated with totally new blockchain designs, comes on the coattails of Bitcoin, with Bitcoin being the most self-sustaining project of the industry. Most token projects are still founder-led, often with a big pre-mine, with an unclear future should the founder no longer be involved. Some of the sketchiest tokens have paid exchanges for being listed, to try to jump-start a network effect, whereas Bitcoin always had the most natural growth profile.

Unregistered Investments and Unlicensed Sellers

The only items on the red flag list that may apply to Bitcoin are the points that refer to invest­ments that are unreg­u­lated. This doesn’t inher­ently mean that something is a Ponzi; it just means that a red flag is present and investors should be cautious. Especially in the early days of Bitcoin, buying some magical internet money would of course be a highly risky invest­ment for most people to make.

Bitcoin is designed to be permis­sion-less; to operate outside of the estab­lished finan­cial system, with philo­soph­ical leanings towards liber­tarian crypto­graphic culture and sound money. For most of its life, it had a steeper learning curve than tradi­tional invest­ments, since it rests on the inter­sec­tion of software, economics, and culture.

Some SEC officials have said that Bitcoin and Ethereum are not securi­ties (and by logical exten­sion, have not committed securi­ties fraud). Many other cryptocur­ren­cies or digital assets have, however, been classi­fied as securi­ties and some like Ripple Labs have been charged with selling unreg­is­tered securi­ties. The IRS treats Bitcoin and many other digital assets like commodi­ties for tax purposes.

So, in the early days, Bitcoin may have indeed been an unreg­is­tered invest­ment, but at this point it has a place in tax law and regula­tory frame­works around the world. Regula­tion changes over time, but the asset has reached the mainstream. It’s so mainstream that Fidelity and other custo­dians hold it for insti­tu­tional clients and J.P. Morgan gives their price targets for it.

Many people who have not looked deeply into the industry lump all “cryptocur­ren­cies” together. However, it’s impor­tant for prospec­tive investors to look into the details and find impor­tant differ­ences. Lumping “cryptocur­ren­cies” together would be like lumping “stocks” together. Bitcoin is clearly not like the others in many attrib­utes, and was launched and sustained in a way that looks more like a movement or a protocol than an invest­ment, but that over time became an invest­ment as well.

From there, folks can choose to look into the rabbit hole of thousands of other tokens that came in Bitcoin’s wake and make their own conclu­sions. There’s a big spectrum there from well-inten­tioned projects on one side, to outright scams on the other side. It’s impor­tant to realize, however, that even if real innova­tion is happening somewhere, doesn’t mean the tokens associ­ated with that project will neces­sarily have durable value. If a token solves some novel problem, its solution could end up being re-adapted to a layer on a larger protocol with a bigger network effect. Likewise, any invest­ment in those other tokens has an oppor­tu­nity cost of being able to purchase more Bitcoin instead.

Section Summary: Clearly Not a Ponzi Scheme

Bitcoin was launched in the fairest way possible.

Satoshi first showed others how to do it with the white paper in an academic sense, and then did it himself months later, and anyone could begin mining along­side him within the first days as some early adopters did. Satoshi then distrib­uted the devel­op­ment of the software to others and disap­peared, rather than continue to promote it as a charis­matic leader, and so far has never cashed out.

From the begin­ning, Bitcoin has remained an open source and fully trans­parent project, and has the most organic growth trajec­tory of the industry. Given avail­able infor­ma­tion, the market has priced it as it sees fit, out in the open.

The Broader Definition of a Ponzi

Because the narrow Ponzi scheme clearly doesn’t apply to Bitcoin, some folks have used a broader defin­i­tion of a Ponzi scheme to assert that Bitcoin is one.

A bitcoin is like a commodity, in the sense that it’s a scarce digital “object” that provides no cash flow, but that does have utility. They are limited to 21 million divis­ible units, of which over 18.5 million have already mined according to the pre-programmed schedule. Every four years, the number of new bitcoins gener­ated per ten minute block will be cut in half, and the total number of bitcoins in existence will asymp­tot­i­cally move towards 21 million.

Like any commodity, it produces no cash flows or dividends, and is only worth what someone else will pay you for it or trade you for it. And specif­i­cally, it is a monetary commodity; one whose utility is entirely about storing and trans­mit­ting value. This makes gold its closest compar­ison.

Bitcoin vs Gold Market

Some people assert that Bitcoin is a Ponzi scheme because it relies on an ever-larger pool of investors coming into the space to buy from earlier investors.

To some extent this reliance on new investors is correct; Bitcoin keeps growing its network effect, reaching more people and bigger pools of money, which keeps increasing its useful­ness and value.

Bitcoin will only be successful in the long run if its market capital­iza­tion reaches and sustains a very high level, in part because its security (hash rate) is inher­ently connected to its price. If for some reason demand for it were to perma­nently flatline and turn down without reaching a high enough level, Bitcoin would remain a niche asset and its value, security, and network effect could deteri­o­rate over time. This could begin a vicious cycle of attracting fewer devel­opers to keep building out its secondary layers and surrounding hardware/software ecosystem, poten­tially resulting in quality stagna­tion, price stagna­tion, and security stagna­tion.

However, this doesn’t make it a Ponzi scheme, because by similar logic, gold is a 5,000 year old Ponzi scheme. The vast majority of gold’s usage is not for industry; it’s for storing and displaying wealth. It produces no cash flows, and is only worth what someone else will pay for it. If peoples’ jewelry tastes change, and if people no longer view gold as an optimal store of value, its network effect could diminish.

There are 60+ years of gold’s annual produc­tion supply estimated to be avail­able in various forms around the world. And that’s more like 500 years worth of indus­trial-only supply, factoring out jewelry and store-of-value demand. There­fore, gold’s supply/demand balance to support a high price requires the ongoing percep­tion of gold as an attrac­tive way to store and display wealth, which is somewhat subjec­tive. Based on the indus­trial-only demand, there is a ton of excess supply and prices would be way lower.

However, gold’s monetary network effect has remained robust for such a long period of time because the collec­tion of unique proper­ties it has is what made it contin­u­ally regarded as being optimal for long-term wealth preser­va­tion and jewelry across gener­a­tions: it’s scarce, pretty, malleable, fungible, divis­ible, and nearly chemi­cally indestruc­tible. As fiat curren­cies around the world come and go, and rapidly increase their per-unit number, gold’s supply remains relatively scarce, only growing by about 1.5% per year. According to industry estimates, there is about one ounce of above-ground gold per person in the world.

Similarly, Bitcoin relies on the network effect, meaning a suffi­ciently large number of people need to view it as a good holding for it to retain its value. But a network effect is not a Ponzi scheme in and of itself. Prospec­tive investors can analyze the metrics of Bitcoin’s network effect, and deter­mine for themselves the risk/reward of buying into it.

Bitcoin vs Fiat Banking System

By the broadest defin­i­tion of a Ponzi scheme, the entire global banking system is a Ponzi scheme.

Firstly, fiat currency is an artifi­cial commodity, in a certain sense. A dollar, in and of itself, is just an object made out of paper, or repre­sented on a digital bank ledger. Same for the euro, the yen, and other curren­cies. It pays no cash flows on its own, although insti­tu­tions that hold it for you might be willing to pay you a yield (or, in some cases, could charge you a negative yield). When we do work or sell something to acquire dollars, we do so only with the belief that its large network effect (including a legal/government network effect) will ensure that we can take these pieces of paper and give them to someone else for something of value.

Secondly, when we organize these pieces of paper and their digital repre­sen­ta­tions in a fractional-reserve banking system, we add another compli­cated layer. If about 20% of people were to try to pull their money out of their bank at the same time, the banking system would collapse. Or more realis­ti­cally, the banks would just say “no” to your withdrawal, because they don’t have the cash. This happened to some US banks in early 2020 during the pandemic shutdown, and occurs regularly around the world. That’s actually one of the SEC’s red flags of a Ponzi scheme: diffi­culty receiving payments.

In the well-known musical chairs game, there is a set of chairs, someone plays music, and kids (of which there is one more than the number of chairs) start walking in circles around the chairs. When the music stops, all of the kids scramble to sit in one of the chairs. One slow or unlucky kid doesn’t get a seat, and there­fore leaves the game. In the next round, one chair is removed, and the music resumes for the remaining kids. Eventu­ally after many rounds, there are two kids and one seat, and then there is a winner when that round ends.

The banking system is a perma­nent round of musical chairs. There are more kids than chairs, so they can’t all get one. If the music were to stop, this would become clear. However, as long as the music keeps going (with occasional bailouts via printed money), it keeps moving along.

Banks collect depos­itor cash, and use their capital to make loans and buy securi­ties. Only a small fraction of depos­itor cash is avail­able for withdrawal. A bank’s assets consist of loans owed to them, securi­ties such as Treasuries, and cash reserves. Their liabil­i­ties consist of of money owed to depos­i­tors, as well as any other liabil­i­ties they may have like bonds issued to credi­tors.

For the United States, banks collec­tively have about 20% of customer deposits held as cash reserves:

As the chart shows, this percentage reached below 5% prior to the global finan­cial crisis (which is why the crisis was so bad, and marked the turning point in the long-term debt cycle), but with quanti­ta­tive easing, new regula­tions, and more self-regula­tion, banks now have about 20% of deposit balances as reserves.

Similarly, the total amount of physical cash in circu­la­tion, which is exclu­sively printed by the US Treasury Depart­ment, is only about 13% as much as the amount of commer­cial bank deposits, and only a tiny fraction of that is actually held by banks as vault cash. There’s not nearly enough physical cash (by design), for a signif­i­cant percentage of people to pull their capital out of banks at once. People run into “diffi­culty receiving payments” if enough of them do so around the same time.

As constructed in the current way, the banking system can never end. If a suffi­ciently large number of banks were to liqui­date, the entire system would cease to function.

If a single bank were to liqui­date without being acquired, it would hypothet­i­cally have to sell all of its loans and securi­ties to other banks, convert it all to cash, and pay that cash out to depos­i­tors. However, if a suffi­ciently large number of banks were to do that at once, the market value of the assets they are selling would sharply decrease and the market would turn illiquid, because there are not enough avail­able buyers.

Realis­ti­cally, if enough banks were to liqui­date at once, and the market froze up as debt/loan sellers overwhelmed buyers, the Federal Reserve would end up creating new dollars to buy assets to re-liquidity the market, which would radically increase the number of dollars in circu­la­tion. Other­wise, every­thing nominally collapses, because there aren’t enough currency units in the system to support an unwinding of the banking systems’ assets.

So, the monetary system functions as a perma­nent round of musical chairs on top of artifi­cial govern­ment-issued commodi­ties, where there are by far more claims on that money (kids) than money that is currently avail­able to them (chairs) if they were to all scramble for it at once. The number of kids and chairs both keeps growing, but there are always way more kids than chairs. Whenever the system partially breaks, a couple more chairs are added to the round to keep it going.

We accept this as normal, because we assume it will never end. The fractional reserve banking system has functioned around the world for hundreds of years (first gold-backed, and then totally fiat-based), albeit with occasional infla­tionary events along the way to partially reset things.

Each individual unit of fiat currency has degraded about 99% in value or more over the multi-decade timeline. This means that investors either need to earn a rate of interest that exceeds the real infla­tion rate (which is not currently happening), or they need to buy invest­ments instead, which inflates the value of stocks and real estate compared to their cash flows, and pushes up the prices of scarce objects like fine art.

Over the past century, T‑bills and bank cash just kept up with infla­tion, providing no real return. However, this tends to be very lumpy. There were decades such as the 1940s, 1970s, and 2010s, where holders of T‑bills and bank cash persis­tently failed to keep up with infla­tion. This chart shows the T‑bill rate minus the official infla­tion rate over nine decades:

Bitcoin is an emergent defla­tionary savings and payments technology that is mostly used in an unlev­ered way, meaning that most people just buy it, hold it, and occasion­ally trade it. There are some Bitcoin banks, and some folks that use leverage on exchanges, but overall debt in the system remains low relative to market value, and you can self-custody your own holdings.

Frictional Costs

Another varia­tion of the broader Ponzi scheme claim asserts that because Bitcoin has frictional costs, it’s a Ponzi scheme. The system requires constant work to keep it functioning.

Again, however, Bitcoin is no different in this regard than any other system of commerce. A healthy trans­ac­tion network inher­ently has frictional costs.

With Bitcoin, miners invest into customized hardware, electricity, and personnel to support Bitcoin mining, which means verifying trans­ac­tions and earning bitcoins and trans­ac­tion fees for doing so. Miners have plenty of risk, and plenty of reward, and they are neces­sary for the system to function. There are also market makers that supply liquidity between buyers and sellers, or convert fiat currency to Bitcoin, making it easier to buy or sell Bitcoin, and they neces­sarily extract trans­ac­tion fees as well. And some insti­tu­tions provide custody solutions: charging a small fee to hold Bitcoin.

Similarly, gold miners put plenty of money into personnel, explo­ration, equip­ment, and energy to extract gold from the ground. From there, various compa­nies purify and mint it into bars and coins, secure and store it for investors, ship it to buyers, verify its purity, make it into jewelry, melt it back down for purifi­ca­tion and re-minting, etc. Atoms of gold keep circu­lating in various forms, due to the work of folks in the gold industry ranging from the finest Swiss minters to the fancy jewelers to the bullion dealers to the “We Buy Gold!” pawn shops. Gold’s energy work is skewed towards creation rather than mainte­nance, but the industry has these ongoing frictional costs too.

Likewise, the global fiat monetary system has frictional costs as well. Banks and fintech firms extract over $100 billion per year in trans­ac­tion fees associ­ated with payments, serving as custo­dians and managers for client assets, and supplying liquidity as market makers between buyers and sellers.

I recently analyzed DBS Group Holdings, for example, which is the largest bank in Singa­pore. They generate about S$900 million in fees per quarter, or well over S$3 billion per year. Trans­lated into US dollars, that’s over $2.5 billion per year USD in fees.

And that’s one bank with a $50 billion market capital­iza­tion. There are two other banks in Singa­pore of compa­rable size. J.P. Morgan Chase, the largest bank in the US, is more than 7x as big, and there are several banks in the US that are nearly as large as J.P. Morgan Chase. Just between Visa and Master­card, they earn about $40 billion in annual revenue. The amount of fees gener­ated by banks and fintech compa­nies around the world per year is over $100 billion.

It requires work to verify trans­ac­tions and store value, so any monetary system has frictional costs. It only becomes a problem if the trans­ac­tion fees are too high of a percentage of payment volumes. Bitcoin’s frictional costs are fairly modest compared to the estab­lished monetary system, and secondary layers can continue to reduce fees further. For example, the Strike App aims to become arguably the cheapest global payments network, and it runs on the Bitcoin/Lightning network.

This extends to non-monetary commodi­ties as well. Besides gold, wealthy investors store wealth in various items that do not produce cash flow, including fine art, fine wine, classic cars, and ultra-high-end beach­front property that they can’t realis­ti­cally rent out. There are certain stretches of beaches in Florida or California, for example, with nothing but $30 million homes that are mostly vacant at any given time. I like to go to those beaches because they are usually empty.

These scarce items tend to appre­ciate in value over time, which is the key reason why people hold them. However, they have frictional costs when you buy them, sell them, and maintain them. As long as those frictional costs are lower than the average appre­ci­a­tion rate over time, they are decent invest­ments compared to holding fiat, rather than being Ponzi schemes.

Section Summary: A Network Effect, Not a Ponzi

The broadest defin­i­tion of a Ponzi scheme refers to any system that must contin­u­ally keep operating to remain functional, or that has frictional costs.

Bitcoin doesn’t really meet this broader defin­i­tion of a Ponzi scheme any more than the gold market, the global fiat banking system, or less liquid markets like fine art, fine wine, collec­table cars, or beach­front property. In other words, if your defin­i­tion of something is so broad that it includes every non-cashflow store of value, you need a better defin­i­tion.

All of these scarce items have some sort of utility in addition to their store-of-value proper­ties. Gold and art let you enjoy and display visual beauty. Wine lets you enjoy and display gusta­tory beauty. Collec­table cars and beach­front homes let you enjoy and display visual and tactile beauty. Bitcoin lets you make domestic and inter­na­tional settle­ment payments with no direct mecha­nism to be blocked by any third party, giving the user unrivaled finan­cial mobility.

Those scarce objects hold their value or increase over time, and investors are fine with paying small frictional costs as a percentage of their invest­ment, as an alter­na­tive to holding fiat cash that degrades in value over time.

Yes, Bitcoin requires ongoing opera­tion and must reach a signif­i­cant market capital­iza­tion for the network to become sustain­able, but I think that’s best viewed as techno­log­ical disrup­tion, and investors should price it based on their view of the proba­bility of it succeeding or failing. It’s a network effect that competes with existing network effects; especially the global banking system. And ironi­cally, the global banking system displays more Ponzi charac­ter­is­tics than the others on this list.

Final Thoughts

Any new technology comes with a time period of assess­ment, and either rejec­tion or accep­tance. The market can be irrational at first, either to the upside or downside, but over the fullness of time, assets are weighed and measured.

Bitcoin’s price has grown rapidly with each four-year supply halving cycle, as its network effect continues to compound while its supply remains limited.

Every invest­ment has risks, and it of course remains to be seen what Bitcoin’s ultimate fate will be.

If the market continues to recog­nize it as a useful savings and payment settle­ment technology, avail­able to most people in the world and backed up by decen­tral­ized consensus around an immutable public ledger, it can continue to take market share as a store of wealth and settle­ment network until it reaches some mature market capital­iza­tion of widespread adoption and lower volatility. 

Detrac­tors, on the other hand, often assert that Bitcoin has no intrinsic value and that one day everyone will realize for what it is, and it’ll go to zero. Rather than using this argument, however, the more sophis­ti­cated bear argument should be that Bitcoin will fail in its goal to take persis­tent market share from the global banking system for one reason or another, and to cite the reasons why they hold that view.

The year 2020 was a story about insti­tu­tional accep­tance, where Bitcoin seemingly transcended the boundary between retail invest­ment and insti­tu­tional alloca­tions. MicroS­trategy and Square become the first publicly-traded compa­nies on major stock exchanges to allocate some or all of their reserves to Bitcoin instead of cash. MassMu­tual became the first large insur­ance company to put a fraction of its assets into Bitcoin. Paul Tudor Jones, Stanley Druck­en­miller, Bill Miller, and other well-known investors expressed bullish views on it. Some insti­tu­tions like Fidelity were onboard the Bitcoin train for years with an eye towards insti­tu­tional custo­dian services, but 2020 saw a bunch more jump on, including the largest asset manager in the world, Black­Rock, showing strong interest.

For utility, Bitcoin allows self-custody, mobility of funds, and permis­sion-less settle­ments. Although there are other inter­esting blockchain projects, no other cryptocur­rency offers a similar degree of security to prevent attacks against its ledger (both in terms of hash rate and node distri­b­u­tion), or has a wide enough network effect to have a high proba­bility of contin­u­ally being recog­nized by the market as a store of value in a persis­tent way.

And impor­tantly, Bitcoin’s growth was the most organic of the industry, coming first and spreading quickly without central­ized leader­ship and promo­tion, which is what made it more of a founda­tional protocol rather than a finan­cial security or business project.