Busting Crypto Myths: “Bitcoin is a Ponzi Scheme”

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Busting Crypto Myths: “Bitcoin is a Ponzi Scheme” Over the last decade, countless critics have pointed the finger at Bitcoin as being nothing more than an intelligently-orchestrated Ponzi scheme. Detractors like Brazilian computer scientist Jorge Stolfi argue that the leading decentralized cryptocurrency bears all the hallmarks of a scam named after Italian swindler Charles Ponzi.

The question whether or not cryptocurrency in general is wrought with these scams remains one of the most hotly debated topics in the crypto industry and can be viewed as a major blocker to the wider acceptance of bitcoin (BTC) as a valid payment method.

What is a Ponzi scheme?

To understand the core themes of this contention, we first have to look at what characterizes a Ponzi scheme. Several criteria exist that attempt to illustrate its key aspects.

According to the legal definition provided by the United States Securities and Exchange Commission (SEC), a Ponzi scheme consists of four key components.

  1. A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.
  2. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk.
  3. With little or no legitimate earnings, Ponzi schemes require a constant flow of money from new investors to continue.
  4. Ponzi schemes inevitably collapse, most often when it becomes difficult to recruit new investors or when a large number of investors ask for their funds to be returned.

Breaking the SEC’s definition down into layman’s terms, a Ponzi scheme is a fraudulent operation that distributes money collected from new investors as profits to existing investors. 

More specifically, it involves a set of new “recruits” who pay into a system to keep a flywheel of profits going. In a typical scheme, a new recruit “invests” a certain amount and the head of the scheme, aka the top of the pyramid, pays previous “investors” with the new money. 

This type of scam usually promises high rates of return to attract fresh investment, which it relies on exclusively to sustain itself.

When asserting his argument for calling Bitcoin a Ponzi scheme, Bitcoin skeptic Stolfi adapted the SEC’s definition to include additional requisites:

  1. People invest into it because they expect good profits.
  2. That expectation is sustained by such profits being paid to those who choose to cash out.
  3. There is no external source of revenue for those payoffs.
  4. The payoffs come entirely from new investment money.
  5. The operators take away a large portion of this money.

Here, Stolfi adds that a Ponzi scheme’s operators usually stand to make the most money when compared to those who’ve managed to successfully cash out of the scheme. Outside of these definitions, other common characteristics of a Ponzi scheme may include a lack of transparency surrounding how invested money is handled and difficulty cashing out.

Is bitcoin a Ponzi scam? 

Applying the SEC rules

Using the SEC’s definition of a Ponzi scheme, we can see things don’t exactly line up when drawing parallels to bitcoin. 

  • First, there is no “promise” of high rates of return when investing in BTC. Bitcoin has a well-documented history of being a highly volatile asset, with prices rising and plummeting within very short periods of time. Any expectation of profit, therefore, can be said to be purely speculative and likely based on the asset’s previous price performance.
  • Second, while it’s difficult to refute the fact that existing bitcoin investors can profit by selling to new buyers, advances in the decentralized finance (DeFi) sector now allow bitcoin holders to generate rewards on their held assets through staking.
  • Third, institutional investors have been seen to hold vast sums of bitcoin on their balance sheets as an economic hedge – not merely a speculative asset.

Addressing the last part of the SEC’s definition, bitcoin cannot collapse in the same way that traditional Ponzi schemes do. The nature of bitcoin trading is such that in order for people to cash out of the market they would have to sell their BTC to other investors. In the end, there is no “head” of the pyramid nor is there a base. Instead, you have a standard ledger familiar to anyone with a background in standard financial trading.

Of course, if a large enough quantity of investors dumped their bitcoin on exchanges and fewer people bought them, prices would naturally crash. However, the BTC that people owned would still exist and the network would continue to function so long as a minimum number of volunteers maintaining the network were active. It wouldn’t simply dissolve like the infamous Bernie Madoff Ponzi scheme did in 2008 when investor liquidity fell and Madoff was unable to pay off his so-called investors.

Getting Critical

Critics claim investors buy into bitcoin primarily as a speculative asset that they believe will make them more money over time. By virtue of new money flowing into the market, driving up bitcoin prices and allowing existing investors to sell at profit, they argue this satisfies the fundamental component of a Ponzi scheme per both his and the SEC’s definition.

Many critics also say that because miners are able to earn newly minted bitcoin for helping to secure the network, which they invariably sell on the secondary market to cover operational costs and make a profit, they stand to make the most amount of money.

But if we dive more closely into these statements, we can see a number of issues.

The claim that an expectation of profits is enough to constitute a Ponzi scam falls flat as all investors purchase assets with at least some expectation of making a return on their investment. Nobody buys anything with a view to lose money. 

Nevertheless, many retail investors sell bitcoin at losses during sharp market declines, or remain stuck in the market at prices lower than what they originally paid. This can be seen and tracked on block explorers thanks to the completely transparent nature of bitcoin transactions. In other words, there is no promise of profit in the market.

The idea that miners make off with large amounts of money omits the fact that mining is a competition requiring a substantial investment of time, money, and equipment. With mining, a single participant is selected to propose a new block and earn rewards every 10 minutes, while the rest of the mining network goes empty handed.

Rewards earned by miners must be used to cover operational costs before any profits can be distributed. Oftentimes, even the largest outfits struggle to break even due to frequent volatile market movements.

Anecdotally, during the first half of 2022, several major mining companies in the United States were forced to sell off vast quantities of their bitcoin reserves and operating equipment just to stay afloat. Core Scientific Inc., Riot Blockchain Inc. and Marathon Digital Holdings Inc. collectively reported over $1.3 billion in losses after the bitcoin market slumped 60% in June from its yearly open.

Other factors

The uniquely transparent nature of the Bitcoin blockchain – the ledger system used for recording all transactions sent over the Bitcoin network – means that anyone can view all activity taking place at any given time. 

A classic Ponzi scheme, on the other hand, must hide or disguise its cash flow to prevent investors from discovering its fraudulent nature.

Additionally, to prevent the scheme from collapsing, most Ponzi schemes make cashing out difficult. Bitcoin, however, can be traded across a wide range of highly liquid exchanges and peer-to-peer platforms at any time of day.

Better education may be the key to settling this long-standing debate. As a new asset class that operates in a completely different way than traditional finance, it’s understandable why many are wary of bitcoin and the nascent technology powering it. Having already overcome a number of technical, regulatory and adoption hurdles during its short lifespan, there’s hope it will become increasingly clear that bitcoin is not a Ponzi scheme or fraudulent operation.

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