Could Bitcoin be a Ponzi scheme? I'm not so sure that it is

I've had a crypto-related experience that I'm assuming many crypto-enthusiasts have had. I recently mentioned to my parents that I was learning about Bitcoin and cryptocurrency. The response: "isn't Bitcoin a Ponzi scheme?" The Ponzi scheme accusation is often launched at Bitcoin and I want to understand whether it's fair.

What is a Ponzi scheme?

A Ponzi scheme is fraudulent investment set up. The Ponzi scheme mechanism pays returns to investors from funds paid in from newer investors. Without funds from new investors the Ponzi scheme is unable to generate enough returns to pay existing investors from any actual investment business.

As an example, person A puts $1,000 into a Ponzi scheme promising to repay a 50% return every year. However, the manager of the Ponzi scheme does not actually use the money to generate a return. Instead the scheme manager uses the money himself for discretionary spending.

However, in order to keep the scheme going the manager needs to make the fund look successful. As such, the fund manager keeps the scheme open and welcomes new funds from person B. Person B puts in $1,000 into the scheme as well. The fund manager pays the $500 return promised to person A from person B's contribution.

The fund manager pockets all of the remaining funds. Therefore, in order to continue to pay the huge returns to investors, the scheme manager needs to encourage new investors to join the scheme. Clearly, investors can only earn a return from the capital contributions of new investors. There is no actual investment growth earning a return for investors, instead the fund rests on its ability to attract new investors.

Ponzi schemes are considered fraudulent and illegal in most countries. The reason it's considered fraud is because investors are not made aware of the risks in the scheme. The scheme does not actually invest in any income producing assets. As such, the whole investment could fall apart at any moment. The fund must continue to grow exponentially or risk complete implosions. In which case, investors will lose all of their investment.

Ponzi Scheme

The Bitcoin Ponzi scheme argument

Bitcoin is often accused of being a Ponzi scheme because to some, it appears to exhibit similar qualities to a Ponzi scheme. The first argument is as follows. The returns earned in Bitcoin do not rely on any actual income producing assets, similar to a Ponzi scheme.

Furthermore, Ponzi schemes entirely depend on additional investors in order to pay earlier investors. The argument goes that Bitcoin's return relies on newer investors believing that the price will rise ever higher. Older investors capitalise on the presence of newer investors and cash out once they have required enormous returns.

The final argument for Bitcoin as a Ponzi scheme argues that new investors are being deliberately defrauded out of their cash. New investors believe that they will earn a great return after hearing stories of older investors earning hefty amounts.

Bitcoin is not a Ponzi scheme

It is fair to argue that the purchase of Bitcoin does not actually produce a cash stream. However, it is unfair to claim that it is a Ponzi scheme as a result. There are plenty of assets in the world that do not necessarily produce a cash stream and yet we do not necessarily claim that they are fraudulent. Examples of non-income producing assets are start-up businesses, precious metals such as gold and platinum and other commodities, and currencies. Bitcoin is often compared to gold and referred to as a digital currency. As such, the lack of cash returns does not necessarily make Bitcoin a Ponzi scheme.

The argument that the valuation of Bitcoin relies on additional investors is unfounded. Unlike an investment or share in a Ponzi scheme, owning a Bitcoin does actually mean that you own something with scarcity. There will only ever be 21 million Bitcoins in existence and as such, owning a Bitcoin means that someone else can't have one.

Additionally, Bitcoin does in fact have a use, unlike an investment in a Ponzi scheme. You can actually transact with a Bitcoin. Irrespective of how successful Bitcoin is at achieving it's aim, it was created with a purpose. Bitcoin's purpose is to replace fiat money and decentralise the banking system. Consequently, the valuation is based on something, as opposed to a Ponzi scheme whether there is no underlying use of the investment…other than to attract more investors.

Finally, Bitcoin's attraction to new investors is not based on a concerted effort to deceive them. The valuation is based on Bitcoin's projected ability to either replace gold as a store of value or to replace escrow services or fiat currency's ability to transact. Whether the price of Bitcoin is out of whack to it's underlying valuation is irrelevant in this debate. The point is that there must be a value to the encryption software of the Bitcoin blockchain. This is despite the fact that some people are only investing because they believe that the price will go up. Speculators are rife in many financial markets, however this does not automatically make the underlying asset a Ponzi scheme.

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