Ponzi Schemes In Plain English

It seems like ages since anyone has actually taken this argument seriously but every now and then a new accusation that Bitcoin is a Ponzi scheme crops up. Today’s annoying accusation comes from Bitcoin’s Wikipedia page, and there’s a roiling argument over its removal happening as we speak. The specifics of Wikipedia’s policy on sourcing of comments and whether the comment should stand isn’t something I’ve got the correct information to argue, but I do have the information to argue against the correctness of the statement itself. Also, as with all entries in the In Plain English series, I’ll do my best to avoid technical jargon and unnecessary complexity.

Now obviously in order to understand why Bitcoin is not a Ponzi scheme and correctly identify those things that are, we need a definition of “Ponzi scheme” that can serve as a checklist. Since the whole argument started on Wikipedia, let’s use their Ponzi page for our definition:

A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from profit earned by the individual or organization running the operation. The Ponzi scheme usually entices new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent. Perpetuation of the high returns requires an ever-increasing flow of money from new investors to keep the scheme going.

So if I’m running a Ponzi scheme, I solicit investments from a bunch of people, promising them insane amounts of profit, but the profit that investor number 183 sees is really just some of the investment of number 184 and so on. At some point you can’t find any more investors and the whole scheme collapses. Typically the only person who makes any money is the one person at the top who started the whole thing, though the first investors in well-built schemes may also turn a profit.

This gives us a great understanding, but not the checklist we were after. Thankfully, Wikipedia also lists some common characteristics of Ponzi schemes:

  • Extraordinary returns are promised
  • Descriptions of how the money is actually being made are vague
  • Returns for initial investors are paid by new investors
  • Withdrawal from the scheme is discouraged or even barred
  • A person or group of people run the scheme, solicit new investors and will eventually take the money and run

There are, quite importantly, a number of other schemes which are functionally similar to a Ponzi, but fail a point or two in the checklist.  The pyramid scheme, for example, is almost identical to the Ponzi but new investors are solicited by old investors rather than the person at the top. For our purposes I’ll lump all of these Ponzi-like schemes together – there’s no use proving that Bitcoin is a pyramid instead of a Ponzi after all. This requires that we change the last bullet point slightly:

  • A person or group of people run the scheme, solicit new investors and will eventually take the money and run

There is also an important similarity between Ponzi schemes and economic bubbles, but it’s important to note that the similarity is akin to that between a wrecking ball and a tornado. Economic bubbles are created by market forces typically out of the hands of any individual or group while Ponzis are willfully perpetrated. Let’s add that to the checklist:

  • Is willfully created for profit, rather than arising from market forces

Now that we have a checklist, let’s go through it with an eye for Bitcoin and see how closely it resembles a Ponzi scheme.

  • Extraordinary returns are promised
    If anyone in the Bitcoin world promises you returns, it had better be from their own business, not from Bitcoin itself. The majority of us within the community make no promises about tomorrow’s exchange rate and almost invariably tell you to treat it like gambling and never invest more than you can afford to lose.
  • Descriptions of how the money is actually being made are vague
    This one is particulary humorous since Bitcoin is one of the most transparent markets that has ever existed. The price of a bitcoin is determined by the same market forces that determine the price of any given stock and the amount of information available to potential investors on how Bitcoin works, transaction rates, historical pricing, really anything you could possibly want to know is out there – and if it’s not, chances are good that it could be and some clever person will whip up something to give you that information.
  • Returns for initial investors are paid by new investors
    This is where most people arrive at the Ponzi conjecture. Right now, Bitcoin is inflationary – 7,200 new coins are created every day so to keep a stable price or to see prices increase, either new investors or increased demand from current investors has to exceed 7,200 coins per day. If there is more investment demand than that, price goes up, if there is less then price goes down. People a) mistake this for a “need” for new investors and b) presume that a need for new investors automagically makes this a Ponzi. In truth, all inflationary assets share these exact characteristics and are not Ponzi schemes. Importantly, Bitcoin doesn’t “collapse” if investment demand doesn’t meet 7,200 coins, the price just goes down a bit, following the same laws of supply and demand that determine the price of a candy bar.
  • Withdrawal from the scheme is discouraged or even barred
    While in certain regions of the world it can be difficult to get in or out of Bitcoin, these are mostly problems of local scale/demand or interference by existing banking infrastructure. In those areas where our relatively young project has had a chance to build meaningful infrastructure it’s relatively painless to cash out your coins or to buy into the market. BitInstant is even working on a Bitcoin-backed debit card that should make cashing out as simple as swiping your card at a restaurant. It’s not only possible to cash out your coins, in most cases it’s also faster and easier than buying in.
  • A person or group of people run the scheme and will eventually take the money and run
    This is really the big important point. Whether we’re talking pyramids or Ponzis there is always someone at the top who has the power to cash out and collapse the whole thing. There was never a product, there was never a service, there was never a market, just one guy in control of the whole system who makes a big cash grab at the end and disappears. Folks often point out that early investors and miners, folks who bought in when 10,000 bitcoins bought you a couple pizzas (worth $109,500 USD at current exchange rates) have made a mint while current investors stand to make significantly less. This certainly feels unfair to those of us who weren’t around back then, but unfair doesn’t necessarily mean Ponzi. One could say the same of investors who bought Apple stock in 1980 (initial price, split-adjusted: $2.75 – current price: $544.06) but you would’t call Apple a Ponzi. In both cases, the price increase arose from simple supply and demand and like most technologies experiencing an explosive growth spurt, early investors got rich. Most importantly, though, there isn’t anyone at the top pulling the strings. Bitcoin is decentralized and explicitly designed to be impossible for any individual or group to control – the best argument against Bitcoin as a Ponzi is built into the system itself: there isn’t a way to take the money and run.
  • Is willfully created for profit, rather than arising from market forces
    No one can argue that we’ve recently experienced a sizable economic bubble. The run-up to $31 per coin was sheer insanity driven by rampant speculation – some folks got rich, a lot more lost money, and that’s what always happens in economic bubbles. Importantly, though, an economic bubble is not a Ponzi – tragic, terrible, painful to live through and costly to many they are, but a Ponzi they’re not. You couldn’t even classify them as a scam, just a certain unsustainable behavior cycle that runs away with itself for a bit and eventually gets corrected by normal market forces. Bubbles happen in all kinds of markets all throughout history including famously the Tulip Mania of the 17th century.

All checklists aside, I do understand the confusion, I really do. Ponzis and pyramids are often difficult to identify and can be found masquerading as all sorts of reasonable-sounding investments, they tend to grow in much the same way Bitcoin has grown and people are naturally suspicious. They can’t find the cause for such a massive price increase and red lights start flashing in their brain. Allow me to provide the missing link: network effect.

Bitcoin is a currency. Bitcoin isn’t backed by anything of intrinsic value (gold, silver, etc), so its value is determined by how useful it is and your confidence in the way the system works, just like the dollar or any other fiat currency. Initial investors were drawn by the way the system worked, they had much higher confidence in openly-presented math than in arbitrarily-printed governmental currencies – they bought in because they liked the fundamentals. But at this point, something was missing: the ability to actually spend the money. When less than a thousand people in this great big world of ours are using Bitcoin, no matter how strong the fundamentals are it’s just not that useful – it’s like building the world’s best mousetrap, but it can only catch the Perdido Key beach mouse - its utility and therefore its value to you depends mostly on the likelihood of your being able to actually use the thing.

Bitcoin, therefore, is a classic case of network effect. Much like telephone service, it began life as a quirky little nothing that only a few people had and they mostly bought in because they thought it was cool. As a more significant percentage of people bought telephones, they became more useful – a phone that can contact half your friends is far more useful than one that can contact a tenth. The increased usefulness increased their perceived value to new customers and therefore increased the price that could be charged for devices and service. As new users join the Bitcoin community, they give us new people to transact with. As new businesses start to accept Bitcoin, it becomes more useful – every new entry into this still-tiny marketplace increases the value of the marketplace as a whole and therefore the value of the product, thereby attracting more users who will themselves increase the value of the market and so on.

So there you have it: nothing scary, scammy or manipulative – just market forces at work.

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Comments

  1. Vitalik Buterin: It's a bet and not a financial advice – in a ponzi scheme the creator usually promises high returns and Roger Ver is not the creator of Bitcoin.

    @Topic:
    http://www.reddit.com/r/Bitcoin/comments/12v14a/c

    • Vitalik Buterin says:

      I was not talking about Roger Ver specifically. My point is that Bitcoin has plenty of cheerleaders who are trumpeting its potential to go up to $1000 in the next few years. Saying that those all don't count because they're not "officially" owners or creators of Bitcoin is beside the point; that's like saying that Bitcoin is worthless because it's not legal tender. The fact is, these are people who stand to benefit, in some cases massively, from Bitcoin going up to $1000, and do claim that it might. Perhaps this behavior has toned down in the past few months, but in 2011 especially it was very much there.

  2. Vitalik Buterin says:

    > If anyone in the Bitcoin world promises you returns, it had better be from their own business, not from Bitcoin itself. The majority of us within the community make no promises about tomorrow's exchange rate and almost invariably tell you to treat it like gambling and never invest more than you can afford to lose.

    I don't know. There are lots of people who have promised massive returns on Bitcoin itself. See this $10000 bet that it will outperform dollars, gold and silver by 100x for a perfect example:

    http://www.soundcry.com/video/gfydIbhduu0/Bitcoin…!

    • Wasn't trying to say that no one would, just that no one should and anyone who does is full of it. Just like anyone claiming to know what the stock market or interest rates will be like in 10 years is full of it, the same goes for the future of Bitcoin or really any economic vehicle.

  3. In a report made by European Central Bank it is explicitly explained that Bitcoin is not Ponzi Scheme, page 27. http://www.ecb.europa.eu/pub/pdf/other/virtualcur

  4. Felix Nawothnig says:

    "Bitcoin isn’t backed by anything of intrinsic value (gold, silver, etc)," – I'll admin that there is a certain 'intrinsic' value given the fact that gold is useful as a conductor (among other things) but I think that statement is somewhat misleading… For a long time gold and silver have been valueable because.. uh.. they have been valueable. :)

  5. A bit retro, but where's part 6 of 6?

  6. Eccentrica says:

    Bitcoin as an investment: link update: http://en.wikipedia.org/wiki/Bitcoin#Bitcoin_as_a

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