A lot of people are calling bitcoin and other blockchain
tokens* Ponzi schemes or pyramid schemes. This is inaccurate, what is happening
in the token economy is a new structure with significantly different incentives
*For the sake of simplicity, I will use the term token and coin interchangeably. This is far from the most blatant generalization that I will make in this piece.
One centralized entity attracts investors by pretending
returns are higher than they are. The first few investors might get more than
their money back as proof that the fund is healthy, but those funds were not
made by the firm, they are funds stolen from later investors.
In the end, only the perpetrator of the Ponzi scheme comes
participants to recruit others: Social upside from sharing how to make
money. Little direct incentive.
In recent times:
Madoff’s investment scandal was a classic Ponzi scheme. People believed he had
a way to make consistent returns in up or down markets, but he really used new
investor money to pay out fake returns to old investors.
This wasn’t just a one map shop, there were firms called fund
of funds with an incentive to introduce their clients to Madoff’s Ponzi scheme
as they would make a percentage of their client’s returns. But these funds did
not think there was a Ponzi scheme, though many believed that Madoff was making
his money illegally.
Total size: At the
Madoff’s fund peak investors believed they had $65 billion invested in Madoff’s
fund, but the total amount investors put in was closer to $20 billion dollars.
Ongoing Ponzi Schemes:
There is also a famous Russian Ponzi scheme, MMM, which after having collapsed
in Russia it has inexplicably become popular in developing economies. It is
primarily a Ponzi scheme in which money is put into the system and is paid out
only when newcomers put in more, but the scheme has set up some incentives to
recruit other people that cause some to label it a pyramid scheme.
What to look for: There
may be many small ongoing frauds of this nature. Investors should always do due
diligence when a scenario seems too good to be true. Understanding the strategy
and making sure the fund has a respectable auditor can help avoid some of these
schemes. More generally, funds trading very illiquid asset classes in which
they are the main participants might act as accidental Ponzi schemes. If investments
from one source are driving up the market value of the fund, and fees are being
paid out on this increased value, then the scenario may act exactly like a Ponzi
In a pyramid scheme, the person at the top benefits from everyone
below him in the scheme. The people below the top person are incentivized to
recruit other people below them to increase their payout.
participants to recruit others: Incentives are siloed, someone recruited by
the top guy doesn’t care if a person he did not recruit is successful, he
shares no gains in the scheme’s success except to the extent that he is
directly introducing new people into the scheme.
In recent times:
Bill Ackman’s fight against Herbalife has been one of the most publicized looks
into whether or not a company is a pyramid scheme. His presentation can be
As of January 7, it still has a market capitalization of $6.1 billion.
Legitimate form: Multilevel
marketing companies, in which companies recruit consumers to both sell products
and recruit other people to sell products have varying levels of legitimacy. To
the extent participants make most of their money by selling goods that generate
significant consumer surplus the company can be said to be a legitimate MLM
company. Some people suspect that Bill Ackman’s mistake in going after
Herbalife was in not understanding the benefits from communities enabled by
Herbalife’s MLM system. Despite some questionable practices and relatively high
prices the MLM system is creating significant consumer surpluses.
Total Size: The top
ten multilevel marketing companies, from Amway to Tupperware, had a
combined 2017 revenue of a bit over $40 billion dollars.
What to look for:
The more money that is sourced from recruiting additional people and selling to
those recruits, the more likely it is to be pyramid scheme.
The blockchain tokens that we have seen recently have a
significantly different dynamic from Ponzi and pyramid schemes. In a Ponzi
scheme, it’s only the guy pulling off the fraud that really benefits from
attracting more people. In a pyramid scheme, each silo is separate, and people
below someone in a pyramid scheme do not typically get any advantage from that
person becoming more successful.
participants to recruit others: In a token scheme, everyone is paddling in
the same boat. Early adopters take ownership of space on the ledger,
represented by tokens, and lobby everyone to buy more. Wealthy latecomers,
rather than being stuck at the bottom of the pyramid, can choose to take on a
more significant stake if they invest the capital. And when that capital is
invested and drives up the price, the existing holders all win. Each of the
newcomer’s tokens has the exact same status as the tokens of the early
adopters, and everyone is expected to work together to push up the value of the
systems that they have bought into.
When individuals start
to think that the value of the network is going to fall and internal collective actions cannot prevent it they are
incentivized to be the first to jump ship without letting the others know they have
decided to defect until after they have exited.
The incentive structure enabled by token schemes are very
powerful. They can be used to incentivize people to all contribute towards a
central project, like the people building on Ethereum and other projects where many
talented people are trying to develop useful decentralized system. Token scheme incentives are
also the driving force behind many obvious scams.
This type of environment created by token schemes forms cult-like behavior. The
early believers are told to “HODL” (buy and hold) and
not sell any of their tokens into the market, helping drive up the price as new
entrants are only able to purchase token that are being flipped. The general
community reaction to critiques of any of the token schemes is to accuse the
critic of spreading FUD (Fear, uncertainty and doubt), like the way a priest
might accuse a scientist of heresy. And a market that has gone up over 1000x
has only strengthened these dynamics.
The analogy to stocks:
Many observers view blockchain assets as analogous to stocks. The might
interpret a coin’s market capitalization, the amount of coins outstanding
multiplied by the most recently traded price, and view it through the lens of a
company’s valuation. In the case of the healthiest blockchain projects, there
are companies and individual engineers putting in lots of work to develop and
update the codebase or build products on top of the existing infrastructure. The
token itself retains its fundamental value so long as the projects that will eventual create value remain on
top of the token’s blockchain ecosystem.
While a decentralized blockchain generally does not convey
ownership of real assets the way that owning Exxon’s stock conveys partial
ownership of oil producing assets around the world, there is a closer analogy
to technology companies. Technology companies derive most of their value from
their intangible assets and not their real assets. Investors in technology
companies worry that they will lose their best employees who are creating value
within the company or that employees who leave might create or enable competitors, so they incentivize
the employees with stock options and hope their employees believe that their
compensation combined with helping the company achieve its mission is enough to keep working. In the case of blockchain, the main thing keeping
technologists working on a token that is not directly tied to a company is their personal token holdings in place of options, and the goal of achieving their project's vision in place of their company's impact.
But unlike stock, tokens do not have the same type of end
game. A company like Whatsapp can be acquired for $19 billion, there is no
equivalent liquidity event that can reward token holders. Liquidity events only
occur when new money enters the system and token holders chooses to leave
instead of letting new money push the price up to even higher levels. While
they do not have an endgame, tokens have a much quicker mid-game, as many blockchain
programmers are able to cash out in the seven to eight figures thanks to the extreme
price appreciation of the major tokens. Start ups have historically been wary
of letting employees cash out life changing amounts too early in the
development process, as the employees may be more tempted to work on their own
projects when they have sufficient capital to choose to work on anything they
want. But even if some contributors drop out to due to options from their
wealth creation, this scale of wealth creation attracts new workers looking for
similar upside. Some companies have started vesting tokens to employees over time in way
similar to how companies grant employees stock options. The longer-term
stability of these projects is only threatened once token price appreciation slows
down significantly, and that’s a situation that tech companies without traction
also face. The bigger risk for the ecosystem is that if obviously bad tokens are rising with the good tokens, then the good tokens can later fall when the price of bad tokens crash.
Thinking about token market capitalization can be misleading,
and not just because acquisitions aren’t as feasible in token-space. Blockchain tokens
can be almost permanently lost in ways that stock is not lost. The lost tokens
are still counted towards the market capitalization even when their permanent
absence from the market is one of the factors driving the price of tokens
higher. Despite being potentially misleading, there does not seem to be a
better readily available metric or name. There are significant differences when
talking about a company’s market capitalization and it should not be confused
with a coin’s market capitalization. That Ripple’s company is valued at a
couple billion dollars when its coin holdings are supposedly worth well over
$50 billion is illustrative of that difference.
The analogy to
currency: Many people think the main use case for blockchain is
decentralized currency, or a decentralized store of value. In the case of
traditional fiat currencies, the demand for money is likely to stay within an order
of magnitude of the expected range as each currency is tied to the economic
activity of a geographic region. The local state collects their taxes in their
own currency, ensuring demand. Over the long term the question is if the supply
of money will get out of control as it did at times in the Roman Empire and the
Weimar Republic or more recently in Zimbabwe and Venezuela.
For blockchains like Bitcoin, the targeted supply at a given
date can be forecasted with relative accuracy. The bitcoin outstanding will
increase by about 4% in 2018.
The total amount will never be more than 21,000,000. It is the demand that is
the unknown factor. Morgan
Stanley estimated that hedge funds put around $2 billion into the token
economy in 2017. The amount from institutions and people not tracked by Morgan
Stanley was likely much larger. 2018 may be even larger, but it is an open question
if the money flow can continue to increase through 2019 and 2020. If the miners
sell every bitcoin they mine in 2018 and everyone else holds bitcoin, there
needs to be around $10 billion in new investment at current prices to keep
prices stable. For reference, a calculation done at the start of 2017 would have found that $700 million dollars would be needed to keep bitcoin at approximately the same price. Continuously growing demand is dependent primarily on continued high
prices and benign neglect by governmental agencies who may be concerned at the law
breaking behavior enabled by various blockchain networks. The networks currently using the
protocols could be as stable as Google, but many could just as easily be Friendster
For fiat currencies, the demand is certain and future supply
drives price uncertainty. For blockchain, the supply of a specific blockchain
is known, the demand is unknown. There may be uncertainty on the supply side.
Alternative blockchains and forks effectively add blockchain assets to the
ecosystem. Bitcoin has forked quite a few times, and to the extent that
investors deploy money to forks, such as Bitcoin Cash or Bitcoin Gold, the
supply of blockchain assets can also be said to be increasing. However, this
interpretation is not how the market reacted to forks. The price of Bitcoin on
announced forks generally stayed level or increased, as if the forks merely increased
demand and did nothing for supply. Many people even started equating forks with
dividends. This dynamic of assuming the increased supply from forks and
additional blockchains being accretive in value to existing blockchains does
not seem sustainable.
Current use cases:
Avoiding capital controls, black market exchanges, cybercrime enablement, grey
market money storage
Additional use cases:
Corporate gift cards for products under development, Security-ish tokens, automated
contracts, online gambling, cryptokitties
over $800 billion across the publicly tracked tokens. (It would be very interesting to find estimates for total capital committed)
What to look for: First,
there are the obvious scam signs. A whitepaper
might include significant plagiarized work, promotional material making false
or illegal claims and people who attached to the project being attached to
other types of scams are all giant red flags.
Sometimes things aren’t quite scams, just unlikely to be
good investments going forward. The most obvious example is the companies who
change their name to something blockchain related hoping to attract fast money.
More subtle case involve scenarios where the token itself is incidental to the
process seen as valuable (as seems to be the case with Ripple),
or companies selling a blockchain token it retains full control over to do a
task that a distributed database would do the job better. In the case of Doge
coin, a token designed as a joke, the market capitalization hit
$1 billion despite it being abandoned by its creator.
Just as legitimate MLM companies adopt aspects of a pyramid scheme
to make something useful, there are some token schemes that have the potential
to create real consumer surplus. Some of these projects might even be designed
to facilitate legal activity in ways that are more efficient than what trusted institutions
are currently doing. And some of those projects might even have a legitimate
reason that their tokens should appreciate in value outside of a speculative
When it comes to understanding the dynamics behind
blockchain tokens, even the blatantly useless or fraudulent ones, it is important to
realize that they cannot be fully understood by analyzing Ponzi or pyramid scheme dynamics.
They are token schemes that have their own unique and much more powerful dynamic.