Is Crypto A Ponzi Scheme?

If You Draw The Lines Narrowly, It Is

I read a great critique of cryptocurrency. It boils down to the thought that it’s just a Ponzi scheme. The author compared crypto to Bernie Madoff. I certainly think if you draw the lines around crypto narrowly enough, you can come to that conclusion.

Here is a photo of Charles Ponzi

I am a huge fan of logical dissent. It makes you think. It increases the depth of the marketplace of competing ideas. It helps you see things in a different way so that maybe you can create a better way to do what you wanted to do.

An old story. When we were working on the Commodity Futures Modernization Act (CFMA) which was passed in 2000, there was a huge argument in front of the regulators as to where to draw the lines. Where did OTC derivatives fit into the equation? If you drew the lines sharply and narrowly, the only thing that should have been regulated was listed derivatives at already regulated futures exchanges. That also made markets look much smaller than they really were. The Eurodollar market for example did close to 1MM contracts a day. The notional value of that was roughly $100B, but the contract was really a proxy for a trillion-dollar market when you looked at OTC derivatives based on Eurodollars. Those were also the days when Warren Buffett was calling derivatives, “weapons of mass financial destruction”. Buffett didn’t invest in the internet early either because he didn’t understand it but today he owns an awful big fistful of Apple stock.

Derivatives done incorrectly certainly could be weapons of mass financial destruction. However, done correctly they helped companies fix variable costs and created a lot of benefits for them. If they didn’t they wouldn’t exist.

It’s really important to understand some basic concepts when you look at cryptocurrency and innovation. They are hard to understand sometimes because we want to export our own personal values or views into the market. That causes objective judgment to go away.

For example, when you hear that a non-fungible token that is a “work of art” sells for millions of dollars, your first thought might be “that’s crazy”. But, it’s an arms-length transaction that happened. You might also think it is crazy to buy something else that is in the physical world, but it exists and there is a market for it. Otherwise, the price wouldn’t be so high and the thing wouldn’t exist.

I am going to take a little time here and try and explain the structure of the crypto world. Some if it might sound familiar if you are versed in corporate structure or economics. To oversimplify, the internet we have today is “centrally planned”. The Web 3.0 internet utilizing cryptocurrency is decentralized.

Web 3.0 is different than the internet you are used to. The internet you are used to is like the main drag in a big city. There are big buildings built on that main drag. They are trying to get you to come into their building. Once you are in, they try to service your every need inside that building. When you leave the building, you can’t take anything with you that is valuable to the building owner. Anything you take out won’t necessarily work in the next building you enter.

You also need to know that the internet works on base technology. Information passes back and forth from point to point following a pre-determined path. They call the information that goes back and forth “packets”.

Because of the structure, intermediaries can enter and create blockages where they earn outsize rents if they can attract volume. Just like brokers. Additionally, huge companies can be built on top of TCP/IP because they can build walled gardens that are difficult to get out of. Ever switch from an Android Phone to an Apple Phone? You know the pain. The switching costs are high, and most people don’t do it.

In the crypto world, it’s different. Instead of a pre-determined direct path, the information goes through a network. Picture your nervous system with lots of nodes. It passes from node to node, and the same command at the beginning often goes through the network using a different path than the one prior, or the next. The network eventually will be more efficient at moving that information from point to point.

Cryptocurrency is relatively new when we think about technological innovation. When innovation and new stuff happens there are always snake oil salespeople that flock to the area and try to separate people from their money. It’s also harder to build and execute than Web 1.0 or 2.0 because networked businesses are always harder to start than centrally planned ones.

Crypto is virtual and it is worldwide. That means MORE snake oil salespeople have access, so potentially more fraud. It is not mainstream yet. Virtually no consumer crypto-focused app has gone mainstream yet and captured the bulk of attention from the public. But, like they said before the Cubs won the World Series in 2016, “it’s gonna happen”. We also won’t have to wait more than 100 years.

When real innovation happens, there are always charlatans that show up trying to make a quick buck. Web 1.0 was like that and so is every invention in human history. Was there no fraud when rail started?

With Web 1.0 and 2.0, it seems that the porn industry, drug industry, and criminal enterprises figured out how to maximize its use first. Then, standard, respectable Chamber of Commerce industries figured out how to implement it. Crypto is similar.

It’s also mysterious because of the anonymity. That makes it easier to hide.

The fact that some governments are banning it also lends credence to the “this is a Ponzi scheme” meme. I don’t think China banned crypto for any reason other than they can’t control it. Wealth was being built outside the communist system and that is impossible for the totalitarian to understand. Instead, China issued its own cryptocurrency which reinforced the social credit system they are implementing.

Pro tip: Following the lead of China in matters such as this generally isn’t good for freedom and free-market capitalism. Look at Covid policy for evidence.

There are other unsavory and unsettling things about cryptocurrency that the article brings up. First, it’s not backed by anything except the full faith and trust of the network. This is not the first time that’s happened in human history. But, if you only look at crypto as a payment system, the full faith and trust in Bitcoin certainly pale in comparison to the Federal Reserve and the American military. Of course, the value of your American dollar has consistently been eroded by bad public policy. As we all have become aware of inflation over the past year, we feel it.

Many cryptocurrency supply lines are fixed. The price only fluctuates as demand changes, or as the miners involved with the project “mine” new tokens. Other cryptocurrencies do not have fixed supply and their only value is truly the network.
However, there might be expectations built into what that network could potentially do and since markets are efficient, those expectations find themselves into the price today.

That’s called speculation and to many people, speculation is a dirty word. I spent thirty years as an independent speculator, so I am used to challenging the misconceptions.

Cryptocurrency doesn’t work without speculation. Speculators buy and sell and provide the grease to keep the market liquid. Venture capital firms and angel investors speculate and seed different cryptocurrency projects with capital so they can get started. They are betting that they will be able to sell at a significantly higher price.

The speculators also perform another function. Because they are willing to buy and sell, they help provide a transparent price. A transparent price determined by a free competitive market is one of the hardest things in economics to understand and achieve, yet one of the simplest concepts that influence the masses’ behavior.

Transparent prices show people which cryptocurrencies might show promise, and which don’t. That helps engineers and other people decide if they want to work on a cryptocurrency project, or not. It helps speculators decide if they want to participate, or not. It helps people decide if they want to create for that market, or not.

Again, no one is doing this altruistically. Everyone hopes to earn a profit somehow. Without the profit motive, nothing gets built and the entire ecosystem stalls. You might hear code words from entrepreneurs that sound “collective” but at the end of the day, if they are truly acting in a collective fashion, they will fail. Sorry AOC crowd, capitalism isn’t about greed. It’s about the efficient allocation of resources.

Because cryptocurrencies generally have some sort of free-market attached to them, they have the potential to be incredibly efficient allocators of resources. At the end of the day, that will create the most amount of “good” for the most amount of people. Niche markets that can’t develop or are severely hampered right now could flourish with an injection of a crypto market.

The article I linked to is highly critical of Tether. Tether has had problems for a while. It’s hard to disagree because Tether is so leveraged. The industry is slowly starting to move off Tether, and into stablecoins like USD because they are unleveraged.

I was on a panel at a cryptocurrency convention once. I was the grumpy old man in the room when I mentioned that we didn’t need stablecoins since we had the US Dollar and everything was settled in dollars anyway. Stablecoins exist purely because the banking system doesn’t want crypto to exist. It’s like my friend William Mougayer says, “the gorilla is at their door”.

We have passed the “ignore it” phase in crypto. We are at the “regulate them out of existence” phase. When that doesn’t work, we will enter the “sue the bastards” phase.

Many initial efforts in crypto merely digitized existing businesses in the regular financial system. They were sort of boring. There are many things currently under construction that are out of the box, and will make a difference in your life.

It’s also important to understand that a crypto token isn’t just a medium of exchange. It’s a commodity. It’s also a piece of programmable software. It can be all three at once, or take one or two characteristics.

Participants in a crypto project can take a number of forms. Maybe all you want to do is program a machine and mine the token. Fine, but you still need a market to sell them to so you have an incentive to mine. Maybe you have no technical skills but you can add value by making a piece of art that will go on the token. You can sell that and earn money. Or, maybe you have no interest in either of those things, but just want to buy and sell. You can speculate and make or lose money.

Here is a metaphorical way to think about crypto. It’s like the Las Vegas Strip in a way. You have miners, which would be the people who build the games of chance. You have speculators, which are the gamblers who play the games of chance. You have performers who put on shows and add to the mix. Except, instead of one company owning the casino, the network of people who add value to the casino own it.

Another hard thing about some cryptocurrency projects is there is no central point of determination for decision making. No CEO. Who is the CEO of Bitcoin? Trial lawyers don’t like it because there is no one to sue! When a decision has to be made, the owners of the tokens vote. It’s democratic. Now, those of us that have studied democracy know that a full-fledged democracy can fail and become anarchy. Ask the old greeks. It is why the American Founders created a democratic republic which is a different animal. It has more staying power.

Many cryptocurrency projects instituted an organization called a DAO to help facilitate decision-making. It remains to be seen if it will actually work or not. With certain big decisions in some cryptocurrency projects, there was a lot of controversy.

My personal “a-ha” moment in crypto didn’t happen with Bitcoin. It didn’t happen with Ethereum. It happened with Helium. I mine Helium at home and bought miners for my kids.

I decided to buy some miners to experiment. But, there was another reason.

I can see them building a giant business that competes directly with the telecom oligarchy. This wasn’t possible using the existing TCP/IP internet. Sure, lots of messaging apps exist, but they are all inside walled gardens. Helium is different. Go to their website and watch the video.

I am a big fan of competition. We don’t have enough of it in any major industry in the United States. A lot of that is due to economies of scale and scope needed to compete, but much of it is because regulations make the cost impossibly high to enter markets.

The other thing I saw was how very poor people interacted with Bitcoin and other digital forms of payment. When I visited Kenya, all of our tour guides used MPesa on their flip phones. Not exactly crypto but in the same vein.

My friend Gil started a chain of Bitcoin ATMs. They received early traction in neighborhoods where lots of poor people lived. Those people would take their paychecks, deposit them in the machine, and store them in Bitcoin denominated wallets. They did it because the ATM network charged them far less in fees than the normal payday lenders and check cashers would charge them. It also helped that Bitcoin was doing nothing except going up in price at the time!

Innovation often happens in niches where you least expect it. No one would look at the unbanked and say they were sophisticated, but they understood Bitcoin.

I will admit, the crypto community has oversold crypto using statistics that don’t necessarily make sense. They do that because they want credibility. I doubt crypto is truly a trillion-dollar market. I also doubt that if you really had to get out of your crypto position, the market isn’t liquid enough to get you out at a price that doesn’t have a lot of “slippage”. Bitcoin is down 50% from its highs. I had a six-figure amount in Helium, and now it is supposedly worth five figures. You learn how liquid markets are when panic hits the boat.

In crypto, picture ten thousand fat people in a hotel ballroom trying to exit one door. Not gonna happen.

Crypto doesn’t have the bandwidth to process billions of transactions and you can’t do megacorporate multinational deals and save on bank fees, yet.

Back in my CME Board days, we had just launched the e-mini S+P. Regularly, the computers broke and they had to trade them open outcry. It was never going to work. Finally, we got some stability, and we were able to get to “27 trades per second”. Still slow compared to open outcry. However, every time we built more headroom for the contract, volume increased and capacity filled up. Now, you can trade faster than you can blink an eyelid and I have no idea what the trades per second is. They measure them in milliseconds. I think this will happen with the evolution of crypto too.

Only invest what you can afford to lose. If you invest, and the number in your wallet goes up to where it becomes really meaningful for you, it’s okay not to be a HODL and sell. As my friend Brian Lund wrote this morning on his blog,

Thinking back to the halcyon days of 2021, when stocks, indexes, and coins were hitting dizzying heights, how many of us wished for a correction in those high flyers we missed out on?

“I’d buy bitcoin hand over fist if it got back to $50,000.”

“Just give me a 20% correction in Petolton. Even 10%. Then I’d go all in.”

“I wish this market would pull back some so I can put more money to work.”

Since the 2021 highs, the SPX has dipped 11%, the Nasdaq 17%, and the Russell 2000 21%.

Bitcoin is off 50%.

Peloton is down 85%.

And it’s hard to square where we are now with how we thought we’d get here. 

Somehow, when we imagine our desired targets we always picture price floating lazily down on gossamer wings, tracing out gentle angles our charts, and sliding sideways into an inviolate support level.

But it never happens that way.

Nope. Of course, it’s easier to say Bitcoin is a Ponzi scheme when it is off 50% from its high. Plus, there are others that have said the same since Day 1. You will have friends that validate your opinion. But, is it right? Especially over the long term.

Innovation has a way of moving slowly, then jumping. What happens when quantum computing becomes commoditized and mainstream? There will be lots of innovation jumping the linear path it is currently on. It won’t only be crypto but artificial intelligence and machine learning will bring a multitude of benefits to humanity that we can only dream about today. When you think about what quantum computing is designed to do, take multitudes of variables, and piece together solutions, it sounds just like moving information through a crypto network.

We are still in the early days of crypto. Let it breathe. At this point because of the way government misunderstands it, and because of the intent of the government, I would be happier if they did nothing at all. I know crypto investors that want regulation to legitimize crypto and put up some guard rails but I think it’s better off in the wild west.

Last week, President Biden called crypto a threat to national security. He has no idea what he is talking about and neither does the lion’s share of elected representatives. They would be in charge of forming regulations for the bureaucracy to implement. Biden isn’t speaking about national security. The President is simply a mouthpiece for the big banks and large financial institutions that see a competitive threat.

I will end with the sentiments of Northwestern Law Professor John McGinnis.

“Will the State objectively regulate cryptocurrencies when cryptocurrency has the ability to topple one of the State’s greatest powers, money creation?”

Place your bets.