Ponzi schemes, Business and Cryptocurrency - Part 1

in #financelast year (edited)

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:

  1. Get investment.
  2. Use investor money to purchase capital for business (eg. machines, raw materials).
  3. Use investor money to pay labor to turn capital into goods and services.
  4. Sell goods and services
  5. Pay investors
  6. 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?

image.png

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:

  1. Get investment.
  2. ...
  3. ...
  4. ...
  5. Pay investors
  6. 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

image.png

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:

  1. Get investment.
  2. ...
  3. ...
  4. ...
  5. Pay investors
  6. 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.

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 last year (edited)

Very educative.. even in my part of the world people still believe crypto is ponzi. As a matter of fact in 2017, i was in this ship. I sold my bitcoin for a far less price because i thought btc will crash like MMM. I am begining to see the similarities between ponzi and business.. waiting for the part 2.

A Ponzi scheme? I think generally no. Crypto in general has survived a whole lot and Ponzi schemes are not built to survive really long. People aren't appreciating the longevity of crypto and how it's bettered what fiat currency couldn't. I believe blockchain project bring built around crypto will give it more meaning beyond buying low and selling high.

Thanks alot for this piece! I used to have the same thinking that Cryptocurrency was a form of Ponzi... I really can't wait for Part 2 as I my knowledge on Cryptocurrency is really limited

I loved the Ponzoid word: a few are now on Ethereum Smart contract bullshit that just launched some days back. I'll say Anyone who falls for these things are in between lazy and stupid... Lazy won't do diligent research before jumping in, Stupid won't remember the history of people who lost their funds and still fall prey.

Ponzoids uh?
Waiting eagerly for part 2, let's see what fits into this group.

It's interesting how people these days throw words around without considering its history or its actual meaning. Words like ponzi & scam goes beyond "stealing". Thanks for sharing this information. Looking forward to read the part 2.

Great writing and looking forward to more. I never knew the history of the word Ponzi and I suppose a pyramid scheme is an extension of this but not exactly the same.

They are both within the category of financial scams but they are different beasts. In some cases there are pyramid schemes that are also Ponzi schemes, but the overlap is simply that people who like to do one kind of scam may be inclined to do more than one at once.

I love a good Ponzi scheme it’s like an idiot tax! It always a cult following and a feeling of discovering fools gold! It’s trickle up at its best

The world fiat system is the biggest Ponzi of all you though

The irony of life: dying poor while trying to get rich. It is the irony of life for those who try to get rich by being a crook

"Ponzoid."

That's a great word...

I know people like to throw the word "Ponzi" around... but to me the greater irony of the cryptosphere is that it's based partly in the ongoing assertion that governments are not to be trusted because they can just "print money" and thus our dollar bills have no real value...

... and yet, here we sit in an industry where people create a blockchain with an attached token pretty much out of thin air and then claims it has "value" because....?

Which is why I have long been plugging for functional use cases both for Steem, and now for Hive... if we can create an actual economy around a currency, that gives it lasting value. Hence things like SteemMonsters/Splinterlands are super important... along with the LeoShop and the proposed HiveBay marketplace...

Otherwise... when under scrutiny... we're really not all that different from a central bank printing money.

Looking forward to part 2 @demotruk!

Informative stuff, cheers :)

Very interesting. Where is part 2?

I need to finish it. Hopefully this weekend.