Who’s Your Ponzi Now? How Crypto Changed the Face of the Ponzi Scheme
Lesson 21: Understanding What Counts as a Ponzi Scheme
A moment of edification that I will never forget when reading The Lord of the Rings occured when the elf character Elrond said,
“For nothing is evil in the beginning.”
While philosophically and theologically provocative, this quote helps to contextualize the fraudulent nature of Ponzi schemes. They tragically affect people who invest in them, but at the same time such schemes do so only because investors are more or less looking for a free lunch.
In other words, Ponzi schemes are not some eruption of evil and corruption within the financial space. Rather, they are merely exploiting already existing economic incentives and behvaior that the financial space encourages.
This is important to remember in disamibguating the confusion over what counts as a Ponzi scheme and how cryptocurrency has changed its face.
What Is a Ponzi Scheme?
“Ponzi scheme” is an overused term since it tends to be employed to describe just about any fraudulent financial play where someone thought an investment was legitimate and lucrative, yet was not and resulted in the schemer running away with the invested money.
Ponzi schemes are actually quite narrowly defined by virtue of how they operate. After exploring its core defining features, we’ll see how this might apply to cryptocurrencies.
Financial Speculation
One of my favorite quotes that describes financial speculation comes from the economist George Brockaway who says that it is
“like gambling in that it creates no wealth but rearranges-often to the great profit of rearrangers-wealth that already exists.”
Essentially, financial speculation is a strategy to make money with little or no labor contributed to the production of wealth. Instead, one simply invests in a project as a way to make gains. A classic example of this is investing in land that is being used for production, where the investment entitles the investor to profits garnered from production.
And is it a coincidence that such an investment activity is that which came to define what a financial security is? No, since investing in securities is a way to profit off the labor of others (see the Howey Act).
Why is this important? Because such schemes attract people who want to invest in order to make money with little or no expenditure of their own labor. This therefore means that a Ponzi scheme is merely exploiting an existing incentive within the financial structure.
Core Features of a Ponzi Scheme
- No real asset in which to invest
- The appearance of making a profit
- The use of accruing investor funds to make periodic payments to perpetuate the illusion
The difference between bonafide investments and Ponzi schemes is that the former have a real asset underlying the investment. For example, stocks are shares in a company and entitle one to dividends resulting from . . . the labor of others within the company.
With Ponzi schemes, there is no asset and merely the appearance of one. In fact, the scheme typically takes the idea of profiting off the labor of others to the next level by allowing investors simply to provide capital without the sweat of having to figure out which investments one ought to make.
Once a critical mass of investors’ funds is contributed to the scheme, it can then give the appearance of being bonafide by using previous investors’ funds to make good on guarantee of profits. Or, in some cases the schemer can take the money and run without making any payments.
Historically, the Ponzi scheme is named after Charles Ponzi, though the fraudulent strategy was in practice long before him. In the 1920s, Ponzi guaranteed investors
“50% profit within 45 days or 100% profit within 90 days, by buying discounted postal reply coupons in other countries and redeeming them at face value in the U.S. as a form of arbitrage. In reality, Ponzi was paying earlier investors using the investments of later investors.”
Ponzi defrauded tens of thousands of people when raising an estimated $15 million in eight months.
A more recent case involves Bernie Madoff who ran the largest Ponzi scheme in history until 2008, when his last financial statement listed $64.8 billion in assets. His investment fund claimed to make profits even when the S&P was down, something that regulators noticed was not possible given the securities in which he claimed to have invested.
Ways to Notice a Ponzi Scheme
Any project or fund which
- guarantees consistent high returns with little risk, irrespective of how the market performs;
- is lacking in appropriate paperwork, such as statements, audits, and white papers;
- has official paperwork that looks like it has been plagiarized from another project — especially, one that is a hard fork of an existing and often successful platform;
- lacks business incorporation;
- keeps details about its founding team anonymous; and
- requires a fee or has some other barrier to retrieving invested funds.
Ponzi Schemes in Crypto
You’ll often hear the blanket claim that cryptocurrencies are Ponzi schemes. This allegation is true if any one cryptocurrency project meets the core criteria set out above. We’ll come back to this.
What tends to happen within the crypto space is actually more complex.
Most scams tend to be of the “pump and dump” variety and not a Ponzi scheme. In pump and dump scenarios, a specific token or coin is hyped. People buy the coin in hopes that they can get in low and sell high. Because the crypto market is not currently regulated, pump and dump broadcasting is quite common on related social media channels. “Pumpers” can use various tactics, the most common of which is to play on “the fear of missing out” (FOMO).
What you will see with pump and dump scams is an all-time high followed by a bottoming out flat line. Though still being traded, here is a meme coin that is arguably a pump and dump scam.
Pump and dump scams are also called “rug pulls”. But what’s important to note is that they are not Ponzi schemes. Why?
Because such crypto scams do not:
- claim to invest your money for you; and
- make no allusion to a real asset (apart from the token itself),
However, where such scams do make an allusion to a real asset of sorts, then arguably they can qualify as a Ponzi scheme. Let’s unpack this a little.
Playing Loose with Utility: A Transformation of the Ponzi Scheme
This is where I make the case for the idea that crypto has transformed the way Ponzi schemes can work.
Recall that historically defined, a Ponzi scheme is that which entices investors with the ideas that the schemer:
- will save the investor’s labor by investing their funds for them,
- guarantee a return with little risk, and
- even make periodic payments to investors to perpetuate the illusion.
Where the transformation occurs with crypto is under the guise of “financial freedom”. The path of least resistance to financial freedom? It’s certainly not labor. And, it’s not even having to invest in assets.
Instead, it’s simply depositing one’s money and watching it auto-compound. In other words, whatever profit one makes above the principal is automatically reinvested into the platform.
So crypto Ponzi schemes purport to provide utility via the service of auto compounding. (But note that not all DeFi platforms that offer auto-compounding are Ponzi schemes.)
For example, at the time of writing Titano advertised 102,483% APY when depositing its Titano token on its protocol. While Titano is still in operation, it highly resembles a Ponzi scheme. It may return an incredible amount in interest, but it’s token is close to worthless. Its token trading history tells the story:
Like a rug pull, a typical crypto Ponzi scheme will show a great deal of activity to start. When it hits a peak, a steep decline and then a low flat line in value follows, which suggests that the creators have cashed out on investors deposits.
Furthermore, because the token has no other value outside depositing it on the native protocol, the tokens are basically dead even if still existing on the blockchain. Hence, these are referred to as “zombie tokens”. In other words, one of the clear advances (so to speak) of the crypto Ponzi scheme is to offer payments in a token and not fiat currency. Investors assume the token is liquid and exchangeable, and while this can be the case for a certain period of time, it is not guaranteed.
Things collapse when the Ponzi schemers sell off or dump their token holdings — cashing out while lowering the price for others. So although as a Titano token holder you might have 1000 Titano tokens that were at one point worth $0.20, with a mass sell off, their current worth is $0.00009359.
Ponzis and Pyramids
Since we’re on the road to conceptually clarifying what a Ponzi scheme is and how it functions within the relatively new crypto space, let me just make one more conceptual clarification.
Ponzi schemes are distinct from pyramid schemes.
With Ponzi schemes, there is typically no valuable asset or service in which one is investing. Ponzi schemes also do not rely on the type of layered and hierarchical structure of returns on which pyramid schemes rely.
Pyramid schemes often have an asset or commodity that drives profit. However, the pyramid structure is one in which only one or a few people have control over the asset. The asset is either valuable in itself or has the potential to be valuable. Other people literally buy into the pyramid in order to gain access to the asset; and they usually only stand to realize a profit if they can sell it on to others at a higher price (i.e. those lower on the pyramid). Hence, what is key to the pyramid scheme is that early buyers pay less in price relative to those who come later.
The pyramid functions so long as:
- the asset is valuable or is seen as gaining value in the future; and
- there are other people willing to buy the asset.
It seems like point 2 would be necessarily entailed in point 1 — i.e. there is no value or future value without someone willing to buy it. This is true, but as we will see in our examples, this necessary relation is not always clearcut.
Example 1: Weak Pyramid
Orca Corporation produces the gizmo. It sells its product by relying on salespersons going to the public. It recruits its sales force with a few perks–be your own boss, create your own schedule, work as much as you want, etc. All a prospective salesperson has to do is buy the gizmo starter kit. While the salesperson makes money off selling the gizmo, there is also another time-based incentive.
Salespeople who are hired early can sell gizmo kits (and act as recruiters) to later prospective salespeople. Yet the earlier generation of salespeople sell the kits at a higher price; and likewise, the next generation does so to subsequent salespeople.
Why is this a weak example of a pyramid?
It does not solely rely on additional lower layers of the pyramid being added. This recruiting/selling scheme works so long as the gizmo product can be sold. It does not necessarily rely on there being a constant flow of potential salespeople (i.e. lower levels of the pyramid) to buy starter kits.
Example 2: Strong Pyramid
Perhaps the most prominent form of a pyramid scheme is the housing market, which is really the land market. Because land is a finite resource, commodity-wise only a relatively small percentage of the population have ownership of it. While land is essentially for livelihood in terms of having a place to live and a place to work, the land market is typically about leveraging the limited amount of land. In most urban areas, there simply is no more land to go around except at a high price. And living in rural places where there may be land available means being far from job opportunities.
So the land market is often one in which people will invest in it in order to “flip it” at a higher price to someone who wants it. Because everyone knows land is limited in amount, the pressure to buy is enormous. Land values tend to drop significantly only when the wider economy is in recession.
Why is this a strong example of a pyramid?
It requires additional buyers being added to the pyramid. This type of pyramid scheme is viable only so long as land is valuable and there are people willing to pay the price being offered. If prices remain too high, or there is simply the lack of financial wherewithal to buy land (as in a recession), then land values will drop. Not only is there no new additional bottom layer of investors being added to the pyramid, but the lack of buyers will cause those higher up on the pyramid who own land to lose on their investment.
In sum, a pyramid scheme is not necessarily fraudulent. It can be a Ponzi scheme, and a Ponzi scheme can use a pyramid structure; but the two are not identical. Pyramid schemes can be based on real value, but its hierarchical structure means that the majority of people who participate in the scheme are losers in relation to those at the top.
How This Can Be Applied
The simplest application of this article is to note the criteria defining the historical and cryptocurrency versions of the Ponzi scheme . . . and stay away. Sure, money can be made if you get in early and get out at the right time.
But then again, you might want to think of Elrond’s words about evil. You may have escaped the clutches of the Ponzi schemer, but you’ve also participated in a form of behavior that disadvantages others.
Of course, if ethics and moral conscience were ever a significant factor in the financial space, we might all be better off. Or at the very least, we might save ourselves (I include myself here) from being hypocrites — a confusion of moral saints and financial opportunists.
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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