Is Crypto a Ponzi Scheme? (2024)

“Is crypto a Ponzi scheme?” It’s a tough question to answer, but answering it allows us to better understand the future of cryptocurrencies.

To start, let’s establish what Ponzi schemes are, and I’ll keep this short as it’s relatively common knowledge. The SEC describes them as follows:

A Ponzi scheme is an investment scam that involves the payment of purported returns to existing investors from funds contributed by new investors.

The premise is relatively simple. Investors are urged to make an investment, usually advertised as having very attractive returns, but the underlying investment doesn’t really exist so investors only see returns if more people are willing to pump money into the system. Famous examples include the original Ponzi scheme, Bernie Madoff’s bogus investment fund, and if we’re looking for crypto examples, BitConnect and OneCoin

[Note: OneCoin was advertised as a cryptocurrency but in reality wasn’t one, and BitConnect had been offering artificially high interest rates for owners. Both were crypto-related, both were Ponzis, and neither proves that crypto is a Ponzi.]

But What About Crypto in General?

Many have claimed that crypto is a Ponzi scheme. The argument is essentially that cryptocurrencies only hold value if people keep putting money in, and - as most investors are seeking a return - that their prices are bound to collapse once returns stop materializing. This would mean that crypto is essentially worthless and that owners don’t really intend to ever use it as currency or a store of value.

Would this be accurate? It can be, yes. If you wanted to launch a scam token, lure in some people with the false promise of high returns and then take the money and run, crypto would give you a nice platform for that. For a really crass and darkly funny example of this, glance at these Reddit and Twitter links and see how the utterly brazen MadoffCoin played out.

But a lot of coins aren’t MadoffCoin, and indeed many have been legitimate attempts to create a serious currency and herein lies a massive challenge. There needs to be a reason for people to believe that a currency has value. Historically, many currencies have been backed by a physical asset and crypto has coins like these too, including stablecoins like Circle and Tether, and the gold-backed PAXG (although the latter is not primarily designed to be a frequently spent currency). I’m going to remove asset-backed tokens from the Ponzi conversation - I don’t regard a token that’s demonstrably backed by redeemable and liquid assets to be a pyramid/Ponzi/reverse funnel, unless there’s some blatant chicanery going on.

However, the mechanisms of fiat currency allows for a more appropriate jump-off point. This is because the value of a fiat currency is linked to supply and demand, as well as the strength of the issuer’s economy (largely linked to trust in its ability to repay debt). For a cryptocurrency we can look at supply and demand but the rest is trickier. Naturally, it’s very unlikely that there’ll be an underlying economy to assess, nor can we expect one to arrive with debts or any credit history.

Instead… we might say that a cryptocurrency possesses value if enough people believe that it does, and/or if it has the backing of a significant project or network that enough people have faith in. This is not exactly the same but I think it’s close enough. Trust is key. We need social agreement that the currency holds value, will continue to hold value, and can be used for purchases (or at least will be in time) and/or is a useful store of value.

The Challenges of Scaling

We’re running with the notion that cryptocurrencies possess value if people are willing to pay for them, and/or trust that they have substance. But how many people are we talking about? If we’re looking for a localised, regional or niche community, a currency created out of thin air is probably more feasible, if you can justify the benefits of having one and incentivise its usage. The caveat is that such a currency is unlikely to be recognised outside that particular cohort. Say I create a Silly Goose coin for members of the Silly Goose club. I can probably spend it on Silly Goose merch and services, or use it to trade with other members of the community, but McDonalds aren’t letting me buy McNuggets with that.

But what if we want to create a global currency that’s widely recognised and exchanged between merchants and individuals? This is far more of a challenge, and it takes a monumental effort or an unlikely set of circ*mstances to make it happen. There needs to be sufficient demand for this currency, and there needs to be enough people using it that people outside of the network feel sufficiently interested to acknowledge it, to accept payments in it, and to feel they can hold it for a reasonable period of time without the risk of it rapidly devaluing.

How do we Incentivize it?

What if there were a longer-term incentive for holding this currency and stimulating demand, like a financial reward? The reality is that the major cryptocurrencies have achieved considerable scale through being purchased in the hope that the stonks are gonna go brrrr (or in English, that the price might go up). This takes care of the demand side of things too. ‘Why buy this cryptocurrency?’ Well, a lot of people think it’s the future of finance and it might make you rich. And even if it’s not widely accepted for payments, it might be one day, and in the meantime there’s an active market where I can sell it for currencies that are. Sorted.

This is useful, but it’s also where cryptocurrencies can look like a Ponzi scheme. There really needs to be a good reason why we believe the value of this thing is going to soar, because if the only merit in buying a currency is that its value might go up, then the whole thing is a house of cards just waiting to tumble, and only sustainable so long as people keep buying. People will look to make money here based on the Greater Fool Theory and there will come a point when the nothingness of the project will prevail, leaving a few people richer and a lot more poorer. So we do need a suitably strong narrative or project to sustain the network that’s needed for a viable cryptocurrency.

As fate would have it, the two largest cryptocurrencies, Bitcoin and Ether, have more going for them than just investment returns. Bitcoin is compatible with a libertarian financial narrative and also adds genuine utility to the financial world (whether you like it or not, and whether you think it's tasteful or not). Ether is the main currency of decentralized finance and has been used to create an entire financial system around blockchain finance and decentralization. Yes, many people have bought into these currencies in the hope of riches, but these would be incredibly bizarre Ponzi schemes. Certainly in the case of Ethereum, where the identities of the creators and their ongoing work is well documented we can say that this is not a Ponzi scheme, and beyond the ‘big two’ there are plenty of coins with sensible rationales behind them.

The Crux of it:

Now I’m going to answer the original question, and I’ll do it in bullet points because it’s 2023, this has been a long-ish read, and we’ve all got busy lives:

-There have been lots of Ponzi schemes in crypto. There will be more

-A number of cryptocurrencies are backed by ‘real world assets’. This concept, executed properly, will not be a Ponzi

-Cryptocurrencies need to achieve the network effect. It’s very difficult to do this

-But network effects can be achieved relatively quickly if people see rising prices and want to make some money

-And therefore we enter ‘fifty shades of Ponzi’ territory, even if the project wasn’t designed to be one

-To make matters worse, currencies are built on trust, and the best way to demonstrate trust in a cryptocurrency is for lots of people to ‘buy in’

-But…Crypto itself is not a Ponzi scheme, despite being home to many of them

-If you’re trying to avoid a Ponzi, make sure you properly assess why a coin exists and whether this is something that’s potentially sustainable

It would also be remiss to overlook the fact that some coins are not optimally designed for prices to go to the moon. Dogecoin, for instance, mints 5 billion new coins per year, which plays a role in lowering the value of the coin (however, the inflationary impact of this will lessen year-on-year as 5 billion becomes an increasingly smaller percentage of currency supply).

And One More Thing…:

Ponzi schemes have historically enriched the originator of them and early investors, who typically are unsuspecting if perhaps naive. In crypto, Ponzinomics allows something even more brilliant for a wannabe Madoff. Rather than creating a currency, you might be cunning enough to buy lots of cheap existing currency once it’s existed for a while. Now, if you can convince people to buy this coin en masse, either through wash trading or some other form of persuasion, its value will increase. What’s more, on some level people might want you to do this because it looks as though the network for their new currency is growing.

And on that, it’s hardly surprising that regulators are skeptical of crypto. It’s not surprising that some people see it and say “that’s a Ponzi”. But it’s not a Ponzi. It just happens to be the case that there’s no shortage of bad faith actors out there, that many people have turned to crypto in the hope of making some big returns, and that regulators have understandably struggled to get to grips with it (more on that another time). That said, I would probably be very concerned about any organization with sufficient clout to create a new global currency, not attached to a democratic government, that can be created and used without this Ponzinomics germination period.

And one more thing. It turns out that creating a new currency that might be globally accepted, which isn’t backed by real world assets of significant value or a government and/or bank, is really, really difficult. Who knew? And you’ll also need to convince a lot of people that there's a good reason to own it alongside, or instead of, the currency(ies) they’re already familiar with. While this goes on, scammers will continue to scam, and projects with bold ambitions - as is often the case in finance - will be susceptible to high failure rates. So this debate won’t go away. But that doesn’t make the whole concept of decentralised finance, or cryptocurrencies, fraudulent.

Now go outside and walk the dog or something.