Are cryptos all just ponzi schemes?
There is a popular view among the traditional investment community that Bitcoin and cryptocurrency are Ponzi schemes, and thus not worth investing in. The argument usually goes that because cryptocurrency does not have an enterprise at the center which produces a profit, the only way that investors make money is if after buying at a relatively low price, they can sell in the future when there are simply more investors and more money in the space - regardless of actual economic activity or an underlying profit-generating enterprise. Eventually there will not be enough new investors and thus this is not sustainable.
In my view, this argument is flawed. However, it has more merit than many in the crypto space give it credit, though ultimately it is possible for cryptocurrency to generate wealth on its own merits without being purely a mechanism for passing money from later investors to earlier investors. I attempt to explore the argument and ponzi schemes in general in this series. In the first post, I will set out how real businesses and ponzi schemes work, and describe how some don't quite fit the definition of a Ponzi scheme but are effectively the same. In a future post I will discuss how cryptocurrency fits in and even how a real viable, traditional business could still end up Ponzi-like in today's environment.
How businesses work and why they can be sustainable
Normal businesses take investment, turn it into capital, use the capital and labour to produce and sell goods or services, and if they can do that efficiently, they end up with more money at the end to pay back their investors. Here it is as a sequence of steps, which for a cycle:
- Get investment.
- Use investor money to purchase capital for business (eg. machines, raw materials).
- Use investor money to pay labor to turn capital into goods and services.
- Sell goods and services
- Pay investors
- Go back to step 1 above
If the business is sound, after step 4 you will have generated more money (or at least total business value, including the capital you still have for future business) than after step 1. We call this profit (or growth if it the gains are primarily not financial gains within the same year). If you have less total value after step 4, you may be in trouble.
What is a Ponzi Scheme?
The original Ponzi scheme was a fraudulent scheme devised by Charles Ponzi, pictured above. Ponzi began a business which was intended to exploit a loophole in the postal system, where he could obtain stamps for the postal service at prices below their retail value, and in theory sell them for their nominal price. He managed to get investors to buy into this idea, and collected investment to start the business. However, while the planned business was sound in theory if he could find a way to sell the stamps at normal value, he never actually found a way to do this and eventually realized it was not feasible at all. Rather than face his early investors with the truth, Ponzi simply continued to promote the business to new investors. With the money from new investors, he paid off the earlier investors.
As you can imagine this scheme was not sustainable. After being investigated by journalists, the scheme collapsed in August 1920. Ponzi was arrested, charged with 86 counts of mail fraud and went to prison. Later in life he would repeat similar schemes several times, but eventually died in poverty.
Ponzi's original scheme forms the model that we have seen many times since, famous large scale modern examples include Enron and Theranos, which fit the core definition:
a form of fraud in which belief in the success of a non-existent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors.
Often these schemes start out as plans for a real business, discovery that the business is not viable, only to continue as if it were still viable rather than face reality. Other times they are started with no plan for a real business at all.
Using the step system in the previous section, a Ponzi scheme's cycle is like this:
- Get investment.
- ...
- ...
- ...
- Pay investors
- Go back to step 1 above
The missing steps 2, 3 and 4 are what the schemers say they are doing, like a regular business, but isn't really happening. Instead the scheme must always gather more investment in step 1 than they pay out in step 5, and the amount they need to gather will continue to grow exponentially.
Ponzoids
There are many more cases of fraud in the modern day that don't strictly fit the definition above, but they commonly get called Ponzi schemes and have the same effective outcome. For example a business that is non-viable can have the same outcome as one that is non-existent, if the success of the business is presented fraudulently, and investors are paid by future investors. Or there may not be a central enterprise, but naive investors are still buying in based on a lack of understanding, with the expectation of future returns. Examples of this are found in the crypto space, such as the Global MMM based on Bitcoin in 2015, and a little more recently Bitconnect. There are many more examples ongoing today which are frequently called Ponzi schemes but don't fit the definition perfectly. I will call these 'Ponzoids' - schemes or systems which are effectively the same as a Ponzi scheme even if the mechanism is slightly different such that they don't strictly fit the definition.
Ponzoids will still have the same basic steps as a Ponzi scheme:
- Get investment.
- ...
- ...
- ...
- Pay investors
- Go back to step 1 above
Part 2
In part 2, I will discuss how cryptocurrency fits into this in general, how they could be Ponzoids but also how they can fit in a more sustainable model like a traditional, viable and profitable business, without being strictly the same thing.