On Ponzi’s, Equity Derivatives, and Ethereum
Many people will talk about ponzi schemes without actually thinking about what that actually means. They say that Ethereum will fail because it was founded on and funded by lies. But when it comes down to it, how are these different from that of the current central banking debt based fiat money system?
Ethereum was a project funded with 18m USD of value mostly in BTC. After writing a whitepaper and creating a proof of concept prototype, they hired developers to write it. Most of them were loaned money and worked for free but were promised exorbitant 20% bonuses after the crowd-sale. They made a windfall after selling ETH before the blockchain was even in operation in what is called an initial coin offering or ICO to the public. Once the money was raised they patted themselves on the back, and all the developers who were promised pay in stock options (ETH) simultaneously breathed a sigh of relief and cheered.
Subsequently the public puts more money into the ecosystem by buying its newly minted coins. The market capitalization of ETH grows and now reaches over 1 billion USD. The founders start looking for an exit. But they don’t want to sell ETH on the open market, so they pivot by starting a new projects and companies, paying its developers in ETH or the new coin they will create. They also promise more speculative gains from the new ecosystem that they will create which will prove bigger and better than Ethereum.
Do you see what happened here? Everyone involved just funded this whole economic exercise with…. what exactly? Dreams and promises.
Let’s recall that by their own account, Ethereum was supposed to be based on blockchain technology invented by Satoshi, and his whitepaper clearly says that one of the two functions of mining is to allocate the initial coins into the ecosystem. This is referred to as the distribution problem. But Ethereum needed to pay developers to write the system, so they deviated from this important design principle and created coins to pay themselves with. Satoshi got no BTC for his work writing the code. He started mining at the same time everyone else did. This important fact mirrors how PoW mining operates. Miners put in the initial capital investment to buy the hardware, (in Satoshi’s case, his development time), and only then do they start mining and incurring operating costs. All while hoping to make back their investment in coin sales. Ethereum did this in reverse. They sold an idea, took money for it, and used that money to pay themselves to build something. Whether or not that something would be useful, it didn’t matter to the original founders, because they would be able to exit at a profit the instant its “shares” were open to the public. ETH (the token) was created out of thin air.
ETH the token obtained value by being newly issued to people who bought initial ETH with bitcoins*. This involves accepting something of value, in exchange for an IOU of a promise. In finance, equity is nothing more than a bet on future returns or dividends. ETH is very much like an equity. Any investment in it can only make a positive return if the system as a whole becomes useful, or the future expected value of the shares appreciates resulting in others buying its stock for higher than the investor did, aka speculative value. In addition, the equity-like token called ETH besides promising dividends** and price appreciation also allows the holder to participate in the Ethereum smart contract network, although the utility of the latter has yet to be shown to have any real value.
So this presents a problem for the founders and developers, for if the promises and dreams that they sold the buyers of their ICO proved too difficult to accomplish; perhaps they set the expectations too high or they run out of runway, then they are faced with a dilemma: “Should we do more hard work? Or should we ‘pivot’ and make more promises?…The choice is clear!”.
The DAO enters the scene. It is created by a team lead by one of the original Ethereum founders. The DAO was a crowdsourced collective investment fund, which promised to invest its capital into other projects in the Ethereum ecosystem and make a return for its shareholders. It was funded by ETH tokens itself, and issued its own shares called DAO tokens to represent ownership in the fund. It managed to raise upwards of 150m USD worth of capital, in ETH. That’s a frighteningly large number, but a couple red flags here: firstly its valuation is dubious at best. It is a sort of magicians slight of hand to say that the DAO raised “150m worth” of funds if that value was actually raised in ETH. Why? Because the DAO tokens at best represent an equity derivative, which itself is based on ETH. It would be the same as saying Investment Fund Foo raises 150m worth of capital, paid for entirely with Private Company Bar’s stock! A stock that hardly trades more than 10k USD of flow in a day. At those volumes saying that you just raised 150m USD worth is a joke. It’s more like the kind of funny pricing numbers Company X buys Company Y with in an M&A deal. As initial ETH distribution was pre-mined and large amounts of ETH were given to the initial founders and developers of the project, you can think of the selling of their ETH as a sort of exit strategy for them. Also don’t forget that if 150m of ETH was suddenly unloaded onto the market, the price of ETH would fall through the floor. For large holders of ETH, shifting their token holdings into the DAO was the best way to ‘exit’ their large positions and buy into something else that could appreciate faster on speculation (the DAO token) without moving the market in ETH.
For the layperson, the DAO just seemed like a fun speculative bet, but for the people orchestrating this project, it was an ideal escape plan. The only remaining step was to sell their newly minted DAO tokens for USD or BTC on the first speculative pump, and they can retire on a beach somewhere. To be sure, there were many innocent victims of the DAO attack, but I feel that they were speculators and they should have known the risk they were assuming by buying into a highly speculative, unregulated equity derivative, with no legal recourse.
On the other hand there were likely plenty of large ETH holders and founders who were ‘gifted’ with Ether who may have been using the DAO in hopes to wash their earnings back into liquid cash. For that the DAO attacker may have done society a big favour.
Bitcoins on the other hand are mined by burning electricity, and it is _exactly_ that electricity burned which is what gives bitcoin its value.
What does all this mean in the context of ponzi schemes and debt based money printed by a central bank? Well if you look closely at the system here of ‘buying in’ to a coin created from nothing* (ETH) vs a coin that is mined (Bitcoin), you will see that economically speaking they are 2 totally different animals. Some will say that mining is just ‘buying into’ a coin, only with a couple more steps (and negative environmental externalities). They are sadly mistaken. The key difference is 2-fold. First, miners in bitcoin have 2 types of capital costs: the initial sunk costs in hardware, and the actual daily electricity and operational costs. An ICO involves just 1 cost, the upfront purchase cost of the coins which are produced out of thin air. Not only does that mean that bitcoin miners are at the get-go operating at a net loss, it also more importantly means that the value that they spend on electricity is burned, or converted, into Bitcoins giving the coins value at the onset. In comparison, ETH ICO buyers are at break even after their purchase, and the money that they used to pay for the ETH tokens are not destroyed but remain in the economy *to be potentially used at a later time*. This is _key_. This is the reason why ETH tokens holds only purely speculative value***, because the value of the money paid at ICO continues to exist in the system as salaries to the developers, being flipped by one of the founders into a new endeavour, or being used to buy groceries. The value of the buy-in was never converted, it was _just exchanged_. This is why the same value is getting rolled around within a small circle of founders and developers. And just like the central banking system, the benefits of printing money fall only on those who receive the newly minted money first.
Ethereum as a ponzi? I can’t say for sure, but it sure has a lot of the same trappings of one. But then again, by that measure, the Fed Reserve could be a ponzi, but some may still argue that it has been a net positive influence on society as a whole.
Who is to judge? Certainly not I, and you are free to do whatever you want with your own money. But I will leave you with one thought — Bernie Madoff had a LOT of smart people fooled for a very, very long time.
EOL
*Actually since launch ETH is presently a PoW system with mining being the way new coins are created. Though the mined ETH in the system is only a small portion of the total token base; about 85% of all ETH was premined, sold or gifted at ICO as of this writing
**Currently there is no risk free interest rate in Ethereum, only the mining rewards, but the Ethereum developers intend to move it to a Proof-of-Stake system which will pay interest on bonding of ETH deposits in the near future. When this happens its transformation into a mini Federal Reserve banking system will be complete.
***the case can be made that there is some utility value, though at present those claims are dubious at best as Ethereum’s practical uses are still very much theoretical
Originally published at https://www.wallstreettechnologist.com on July 12, 2016.
