The Problem with Calling Bitcoin a “Ponzi Scheme”

As talk of Tulips and Ponzi schemes increases commensurately with Bitcoin’s price, I thought I was being clever when I sent out a tweet reading: “Rhymes with Fonzie.”

Fonzie is fun. And that was a fun tweet, but on reflection not an especially clever one. Very fortunately, it elicited this brilliant reply:

You know something, @DontPanicBurns? You’re absolutely, 100% right. we need a new term to describe what’s going on here.

I propose we use your term, the “Nakamoto Scheme.” And let’s, arguendo, explore a hypothetical critical view of the scheme from the ultimate nocoiner perspective of believing that these schemes have no value whatsoever.

The problem with calling Bitcoin a Ponzi scheme

When we talk about Bitcoin, or Ethereum or any other digital coin, for that matter, neither “ponzi” nor “pyramid” are perfectly accurate descriptions for how these systems actually work.

Ponzi schemes, as traditionally run, usually are administered by a central operator (Charles Ponzi, Allen Stanford, Bernie Madoff, Sergei Mavrodi) who is responsible for bringing in new funds and disbursing withdrawals from the scheme in an orderly fashion. These schemes fall apart when demands exceed deposits and the scheme promoter is unable to satisfy investor requests, causing a loss in confidence or a run which first ruins the scheme’s liquidity, which in turn ruins the scheme as a whole (or rather, brings the scheme to its inevitable end, since Ponzi schemes are doomed to die from the moment of their inception – none can expand forever).

Pyramid schemes, by contrast, are more decentralized in character. Each victim of the scheme, to recoup their funds, is required to become a principal in the scheme and recruit further victims, who then pay the principal and earlier principals above him. Not all multi-level schemes that are pyramidal in structure are illegitimate; see, e.g., Avon, which has a genuine product at its core  and employs a legally-sound “direct selling” structure. Other types of pyramid schemes, where licenses to recruit new members are the sole product, are illegal, whether they be small-time pyramids that target housewives such as “secret sister gift exchanges” or flagrant pyramids like the Dare to be Great scheme in the 1970s, where the product was the right to sell the product, and little more.

For this reason, it is perhaps time for the literature to describe new class of investment scam – the truly ugly nature of which will only be revealed after the coin bubble bursts – a class of fraud which uses technology, rather than a scheme operator, to mediate the interactions between an investment scam’s beneficiaries and its dupes.

Describing the “Nakamoto Scheme”

The Nakamoto Scheme is an automated hybrid of a Ponzi scheme and a pyramid scheme which has, from the perspective of operating a criminal enterprise, the strengths of both and (currently) the weaknesses of neither.

The Nakamoto Scheme draws strength from the same things which make pyramids and Ponzis so compelling, in that it promises insane investment returns, can be accessed by the man on the street with almost no effort at all, and recruits individual participants as new, self-interested evangelists of the scheme.

It has no current weakness in that the regulators, blinded by lobbying from the Valley, have seen these schemes as futuristic and cutting-edge rather than what they really are: victim factories, which in the next crash will produce hundreds of thousands of howling investors with little formal legal recourse due to four years of inaction on the regulators’ part.

1. No operator, many operators

Nakamoto Schemes have no central operator. This ensures that no single member or entity can be held liable (as with a Ponzi or pyramid) and obscures the identity of participants from law enforcement.

This also, like a pyramid scheme, has the insidious quality of turning every victim of the scheme into a new principal as they talk up their books for the purpose of recruiting new investors to subsidize their exits.

These incentives are often combined with the 21st-century software disciplines of community management and technology evangelism in a a potent mix of marketing and corporate/moneyed interests that is impossible for punters on the street to ignore (Coinbase is currently pulling in 100,000 new users per day).

2. No hypothecation

Most interestingly, Nakamoto Schemes also dispense with the need for a cashflow that gives rise to legal liability. Sometimes Ponzi, but more often pyramid, schemes involve specific funds being given to a specific person with a specific expectation of a specific return; they are, to borrow a term from tax law, hypothecated, legalese for “spoken for,” and legal liability arises because it is simple for regulators to identify the flows and attribute to them a legally improper purpose. It is for this reason that many jurisdictions penalize not merely running or starting  a pyramid scheme but the mere act of participating in one (more on that below).

Curing the damage from a Ponzi scheme, on the other hand, is an exercise in tracing transactions that passed through the scheme managers, determining whether those transactions were bona fide or fraudulent, clawing back what they can from recipients of fraudulent transactions, and then deciding the appropriate method for restitution such as, e.g., distributing proceeds ratably or allowing the losses to “rest where they fell.” Profiting from a Ponzi turns one into a victim and perhaps a recipient of ill-gotten funds, but not necessarily a principal, as participation a pyramid scheme might.

Cryptocurrency cashflows avoid these problems in that they are unhypothecated. By adding a layer of abstraction in the form of cryptocurrency exchanges, they eliminate what would otherwise be blatantly illegal cashflows and contracts, and disguise what is in all material respects an identical investment program as a generic pool of aggregate demand meeting a generic pool of aggregate supply.

So far, this structure and a lack of adequate legal tooling (or prosecutorial will) to penalize it has allowed promoters of thousands of cryptocoin schemes, some more legitimate than others, to avoid being labelled either as principals (as they might be with pyramid schemes) or as recipients of ill-gotten funds with foreknowledge (as with Ponzis).

As a result, we have seen a seemingly endless proliferation of technically weak technology boosters rolling out spurious sales arguments such as “it’s the value of the network!,” or hyping the living daylights out of a new coin by lending it the name of  prominent Valley venture funds, to justify increasing the quantity demanded of the coin and therefore their own profits, even where the schemes in question are quite undeniably destined to fail.

This is totally irrational from a software development perspective, as cryptocurrency networks’ performance is vastly inferior to what already exists:

For contrast, Bitcoin gets about 3 transactions per second, with one “currency,” and the network is currently clogged.

Which rather lends itself to the suggestion that Bitcoins are primarily purchased for resale and speculation rather than for any genuine utility.

Though inferior in raw performance than a system like Visa, the fact that these networks employ “markets” rather than specific cashflows for liquidity makes them superior for a criminal enterprise in that it’s a lot harder to prove a random, pseudonymous exchange transaction is part of a criminal enterprise than it would be to show that, say, a briefcase full of 500-euro bills, or an e-mail solicitation with instructions to wire funds to a bank account in the Cayman Islands, is being used as part of a criminal enterprise.

3. Automation

The Old Testament tells us: “there is no honour among thieves.”  Nakamoto saith: “there need be no honour among thieves.”

Blockchain consensus allows thieves to coordinate their actions and run this system without needing to trust a central operator.

This means that the activity is able to continue without any individual liability being incurred by the participants. But in order to do this, the system imposes a real and very significant cost on cheating:

Considering the alternative (using mainstream finance, being surveilled, and landing in jail), I can see how some folks might see this as a price worth paying in order to access the billions of dollars currently sloshing around in the Bitcoin markets. I include within the definition of “Some Folks” not just users of these cryptocurrencies but also some creators, mainly the ICO promoters who disclaim responsibility for their creations once they loose them into the wild (having first allocated themselves a hefty pre-allocation of their own coins, known as a  “pre-mine,” to compensate themselves for their unbridled genius).

4. Legislative responses

What are we to do if this bubble starts spinning wildly out of control and governments need to get mediaeval on digital coins? And by this I’m not talking about ho-hum enforcement of KYC/AML and securities laws like we can expect to see today. I mean, like, strict-liability, no-holds-barred, raiding-crypto-Meetups, Marsellus Wallace levels of mediaeval.

Subject to the usual caveat that I’m an English solicitor and not a U.S. attorney, the English rules are a bit blah and bound up in either common-law fraud or unfair trade practices regulations, so they’re not very Ponzi-specific and, accordingly, not well suited to this blog post.

EDIT: three years later, I am now an English solicitor and admitted in the USA. Hooray!

A previous version of this post had a legislative proposal which is no longer relevant – the original post was written after the DAO Report was published but before any meaningful securities enforcement for non-registration had taken place, which now has happened in relation to schemes large and small including Telegram, Kik, and as of a few weeks ago, Ripple. As of December 28th, 2020 we have seen very little movement on the DOJ front classifying schemes such as XRP as criminal schemes. It therefore appears that at least given current law Bitcoin itself is unlikely to be classified as such a scheme, although peripheral conduct around it e.g. operating unlicensed trading venues, KYC/AML failings, money laundering, and bank fraud are things that LEAs appear to be pursuing. TBD whether this has any impact on the markets for mainstream cryptocurrencies like Bitcoin.



Gratuitous Bitcoin stock imagery

19 thoughts on “The Problem with Calling Bitcoin a “Ponzi Scheme””

  1. Not entirely sure which arguments you’re trying to make. Let’s see if I can add a little value:

    1 – One is not granted any license (acting as an agent) to sell BTC any more than you are granted a license for scalping tickets for a concert or playstations for Christmas. For that reason I do not see existing regulatory law applicable. BTC combines the properties of token money, shares, fractional shares, and a distributor network, with zero liability on behalf of the distributor, and zero means of restitution.

    2 – If BTC are in fact fractional over-the-counter (dealer network distributed) shares in the BTC network (they are), then as long as some capital was being accumulated (I don’t see that there is, other than momentum), there is zero difference between the entrepreneurial use of shares to build BTC network and the entrepreneurial use of shares to invest in any other business. The problems are:

    (i) The product is marketed as money (false, since it has zero backing, it consist of either a token, or of a share), the novelty being that fractions of shares can be sold nearly infinitely. How this differs from Fiat (State) Paper Currency is hard to define. As far as I know, a dollar bill and a BTC function similarly enough except that you don’t need to give me change for BTC. I can make my own change (sell a fraction) of my fractional share. I believe that the understanding of the properties of money and money substitutes and the vast pool of fiduciary instruments is so rare (I literally can’t find anyone to argue intelligently with about it), that BTC promoters and producers literally do not know what they are selling and therefore cannot warranty they have performed due diligence. But ignorance is not a defense when promoting and profiting from a hazard.

    (ii) The technology is weak, and must eventually fail, which is obvious, yet over the years we have not seen innovations that solve the core problems inherent in the use of proof of work schemes, the energy cost, nor the ability to retire minor fractions of shares, nor federate the ledger (break it into pieces), nor the transaction time, nor the transaction cost, nor recovery from fraudulent transfers and hacks. Nor the ability to survive even minor hack attempts. On these terms alone, the technology fails to meet necessary and sufficient conditions to meet the implied promise of ‘money’ or a money substitute, or shares – only token money.

    3 – Therefore, IMO (if someone asked me to testify), I would argue that BTC was in fact a fraud, the product of wishful thinking rather than malice, due to ignorance, due to a failure of due diligence, due to a lack of liability, due to a lack of regulation, due to the innovation of using digital distribution of fractional shares in the BTC network, as token money – a money substitute. This is very hard to prosecute in my opinion. Because (as an expert) it is nearly impossible to demonstrate the people involved understood their fraud, rather than were excited nerds, very conscious of the corruption of the existing banking system, and very aware of the possibility and means of circumventing it, but not aware of the legal or empirical meaning of money, and the decreasing liquidity, purchasing power retention, and increasing risk of money substitutes and fiduciary media.

    The concept is fantastic. Most of us understand the problems of producing and using hard money and counterfeiting. Most of us understand that ‘money’ today is a purely digital construct, with coins and bills serving as tokens. Most problems we have in mathematical economics are related to the poor information quality of monetary transactions. Some of us understand the problem of accounting systems with fiat money (untraceable) record keeping (all accounting systems along with the federal budget, launder money out of necessity). Most people understand this, but that we do not want governments to possess that information, in order to further control us Most people understand that there is no reason any longer for most bank transactions, fees, and largely for their existence. It’s even difficult to argue that there is need for consumer interest. An independent treasury of various digital currencies and title registries would make the consumer financial sector irrelevant, and relegate the financial sector from seeking consumer rents to seeking entrepreneurial investments. I think these are understood. I don’t think the word ‘money’ is understood. And that is because the use of the term ‘money’ in the context of any exchange isn’t regulated. And that’s in part due to the historical difficulty in getting people to replace hard (commodity) money (precious metal coin) with note money (claims against coin), note money (notes that are backed) with fiat money (shares that are not ). And we are have moved from fiat money, to credit money, and now we are moving into fractional shares as token money. Which as far as I can see is the last logical step in the evolution of such things.

    BTC has only one possible exit: trading of BTC for a superior technology. In my opinion that technology is very close. But likewise, it is far easier for the treasury to acquire and implement a monolithic, federated (divided into chunks) fractional share token money system, and its equivalent title registry. In fact, it’s almost a given at this point that the next correction will require us to circumvent the banking system, and directly distribute such token money to consumers (citizens). And BTC is not technologically capable or architecturally advantageous for fulfilling that role. And should the state enact such a system (which is not very difficult) then all other digital currencies will crash precisely because they are not open to liability, restitution, and insurance by an insurer of last resort.

    There will always be a some form of black market currency. That’s true. But the future of money substitutes is in fact purely digital (it has to be). With most of us immediately converting it to something harder (commodities, commodity money, or commodity money shares) as a store of value, while trading instantaneously and transferring title instantaneously over a network run by the treasury.

    Curt Doolittle
    The Propertarian Institute
    Kiev, Ukraine

  2. To deal with Bitcoin, all you have to do is target the exchanges. Since the exchanges have to use and accept regulated currency, as soon as you stop the use of regulated currency in those exchanges they die – forcing bitcoin back to peer to peer exchanges which is far more difficult to trust.

  3. Looks like the SEC’s intervention in the Munchee ICO makes amending New York law on chain distributor schemes unnecessary…

  4. Preston, I came here snooping around for a confirmation or rebuttal of whether my conviction that Bitcoin is a giant, criminal pyramid scheme, is correct.

    What I did not find, but perhaps only because it is too obvious, is that the main reason why this cryptocurrency is a scam is its limited supply of 21 million forever, no matter how much human activity those 21 million bitcoins are supposed to represent.

    This means that whoever entered early, most significantly the secretive creator with his 1 million bitcoins, is bound to reap endless rewards as the pawns pile on at the bottom.

    Therefore, one regulatory step that is needed is to remove the 21 million cap – bitcoin will then immediately assume its real value, whatever it may be.

    Of course, with the billions of USD now at the disposal of the bitcoin overlords it will be an even more uphill struggle against possible campaigns (political and PR) in favour of bitcoin. And we may well end up with yet another scam in the legal limbo, just like most MLMs.

  5. > where the token is intended to be and is in fact primarily redeemable for money or money’s worth, rather than being a contractual right to a specific and identifiable good, service, security, license, or other tangible or intangible property other than money or money’s worth

    Bitcoin is not redeemable for money (though it can be sold at whatever price the market might bear, like other assets). Nor is it a contractual right to some good, service, etc. One might say that Bitcoin *is* money, but either way your proposed rule would not apply to it. Your rule would apply to (digital) gift certificates.

    1. I don’t disagree. The rule here is mainly aimed to constrain c-currencies with issuers. Bitcoin would be exempt as we can’t find an issuer or administrator.

  6. These Nakamoto schemes are no different to the sort of fraud one sees in a great deal of the IPOs in the LSE on AIM. Indeed one can see that the skillsets of the pump and dump crews who work the AIM forums and social media were always directly transferable to ICOs and the same usual suspects seem to spreading false information in both realms. The AIM regulators are worse than useless so I fail to see how Cryptocurrency regulation would be effective even if there were rules.

    Ultimately I think it will be banks that end up regulating this sphere. It seems to be the case that we are reaching the point that it is becoming so onerous for banks to keep sufficient tabs on their customers that have accounts with cryptocurrency exchanges that they will eventually refuse to let money flow into or out of exchanges via customers as it will just cost them too much time and effort to police this kind of customer which is their regulatory duty now. Its either that or they ditch those customers and those accounts. The other obvious routes is for the banks to stop dealing with the exchanges. I believe this already happened with Wells Fargo and the Bitfinex exchange.

    Aside from that I would call for all these blockchain applications to accurately monitor, record and publish the precise amount of energy that they are all consuming. Currently it is being left to concerned individuals to calculate likely energy usage but with over 1300 cryptocurrencies alone god knows how many other useless blockchain apps coming on stream it will be impossible to even guess at how much energy they are all collectively wasting.

    Anyway. This is a great article Preston.



  7. Nakamoto Scheme! Perfect name, I was just trying to explain to a friend the other day that cryptocurrency would be the Ponzi Scheme of the 21st century. A new scheme, totally online and with no person to blame… I just wanna see how it takes for everybody to understand it. The Ponzi Scheme was also “great”when it was first introduced, and now only a fool can ‘t see. I guess it will be the same with these “coins “some years from now.

Comments are closed.