Calling Bitcoin a Ponzi Scheme is Lazy Thinking

There is a more nuanced way to look at the issue, especially when you take a step back and take a broader view.

Is Bitcoin a Ponzi Scheme? (Photo by Afif Kusuma from Pexels)

Table of Contents
1. Premise
2. Bitcoin Is Unique in the History of Financial Assets
3. What Are Zero-Coupon Perpetual Bonds?
4. Buying Bitcoin Is Like Buying a Call Option
5. Summary
6. Endnotes

Premise

The question of whether Bitcoin is a Ponzi scheme is one of the longest-running debates in the cryptocurrency world. One of the most famous proponents of the “Bitcoin is a Ponzi scheme” position is Jorge Stolfi, a professor of computer science, who put out an article stating his reasons why he believes this to be the case.

Original article by Jorge Stolfi: Bitcoin is a Ponzi
Rebuttal to Jorge Stolfi by Lyn Alden: Why Bitcoin is Not a Ponzi Scheme: Point by Point
Counter-Rebuttal by Jorge Stolfi: Yes, Bitcoin is a Ponzi

According to Stolfi, a Ponzi scheme is a type of investment fraud with these five features, and I quote word-for-word:

1. People invest into it because they expect good profits,¹ and

2. that expectation is sustained by such profits being paid to those who choose to cash out. However,

3. there is no external source of revenue for those payoffs. Instead,

4. the payoffs come entirely from new investment money, while

5. the operators take away a large portion of this money.

If we take Jorge Stolfi’s claims at face value, Bitcoin does seem to fulfill those criteria. Many people have written arguments for and against Bitcoin being a Ponzi scheme.² Yet, when we take a broader view of Bitcoin and compare it with other financial securities, the claim that Bitcoin is a Ponzi scheme starts to run into several problems.

Bitcoin Is Unique in the History of Financial Assets

Robert McCauley, a non-resident senior fellow at Boston University’s Global Development Policy Center and an associate member of the Faculty of History at the University of Oxford, argues that “Bitcoin is worse than a Madoff-style Ponzi scheme.”

Notwithstanding the value judgment in the title of the article, McCauley correctly points out that Bitcoin makes no promises — despite Jorge Stolfi’s cries to the contrary that Bitcoin promoters somehow sell the promise of Bitcoin as an investment — and cannot end as a Ponzi scheme ends. He also correctly states, in my opinion, that Bitcoin is unique in the history of economic speculative assets.

Stolfi’s fifth observation — “the operators take away a large portion of the money” is a zero-sum game view of Bitcoin. Here, McCauley states his position that while Ponzi schemes are “redistributive — zero-sum,” Bitcoin is “negative-sum.”

This is because huge amounts of electricity are “wasted” to generate new Bitcoins in the hashing process. Business Insider reported that Bitcoin uses 0.5% of global electricity in the process of mining. Due to Bitcoin’s proof-of-work hashing algorithm, most of the energy is not used to perform useful work or even to mine new Bitcoins.

The wastage of energy is a feature of Bitcoin — it forces miners to expend energy to earn the chance to record new transactions (and “mine” new Bitcoins) — thereby making it expensive for hackers to alter the ledger (the so-called 51% attack which would allow hackers to double-spend, i.e. “counterfeiting bitcoins”).

While this article won’t discuss the environmental costs of bitcoin mining, what is relevant is that unlike a Madoff-style Ponzi scheme, where Madoff simply transferred money from new investors to existing investors without actually investing in anything, Bitcoin miners need to invest in equipment, real estate, and energy.

Additional note: The specialized hardware required for Bitcoin mining also generates e-waste as well.³

For more information on the environmental costs of Bitcoin, check out: Bitcoin Energy Consumption Index - Digiconomist

This makes Stolfi’s fifth point tenuous at best — while Bitcoin miners and early investors do take away some of this money, the providers of Bitcoin mining equipment, real estate, and energy are also taking money away from this setup.

McCauley concludes, somewhat ironically, by saying:

“To conclude, an economic analysis of bitcoin must recognise its uniqueness in the history of manias. As an object of speculation, bitcoin is unprecedented in the degree to which there is no there there [sic. I assume he meant “no other”] This post-modern mania features big prices for entries on nobody’s spreadsheet. A zero-coupon perpetual has arrived not as a joke but as a trillion dollar asset. Unlike a Ponzi scheme, bitcoin cannot end in a run.” (emphasis mine)

What are Zero-Coupon Perpetual Bonds

Interestingly, McCauley is not the first to suggest that bitcoins resemble zero-coupon perpetual bonds. The same argument has been made before, about cryptocurrencies in general, by Martin C. W. Walker, in the article “Impossible Finance — The Perpetual Zero Coupon Bond.”

What are zero-coupon perpetual bonds? They are a type of bond that, in theory, combines the features of zero-coupon bonds and perpetual bonds.

Zero-coupon bonds: Bonds that do not pay interest but are issued at a discount vs the nominal value of the bond. On maturity, the bond issuer pays back the nominal value of the bond.
Perpetual Bonds: Bonds that never mature. As long as the issuer is solvent, the issuers will continue to pay coupons forever, at least in principle.

Bitcoins are compared to zero-coupon perpetual bonds because bitcoins never pay any kind of interest, and they never mature. Only the nominal value (face value) is being traded.

Note: While holding Bitcoin in and of itself does not pay interest, some crypto-companies do offer to pay interest on Bitcoin if you loan out your Bitcoin to them). This undermines Stolfi's fourth claim that the only way to profit from Bitcoin is by selling it to new investors. As always, there are risks with doing this. Please note that this is not investment advice.

Zero-coupon perpetual bonds are not just a theoretical concept. They have been proposed as a practical solution to the problem of government debt. Former US Federal Reserve Chairman, Ben Bernanke, suggested this when he visited Japan in 2016. The idea was for the government of Japan to issue zero-coupon perpetual bonds for the Bank of Japan (the central bank of Japan) to buy.

This would have the effect of monetizing the Japanese debt. The government of Japan would have been able to “print” unlimited money. The key difference is that since they are non-marketable, they would only be sold to the Bank of Japan.

Central banks and governments cannot be the perpetrator of Ponzi schemes even with the issuance of zero-coupon perpetual bonds. For one, central banks wouldn’t be buying these bonds to make a profit. Second, the central bank of a sovereign country that issues its own currency can never default, since it can create as much money needed to continue buying these bonds. Like Bitcoin, government-issued zero-coupon perpetual bonds cannot end in a run either, because the central bank can always create more currency needed to keep buying them.

Regardless, going back to Stolfi’s definition, the following must be true:

According to Jorge Stolfi’s definition of a Ponzi scheme, a Ponzi scheme must depend on the subjective orientation of the buyers.
The profit motive that drives investors must be present for something to be called a Ponzi scheme.

Since Stolfi’s argument about Bitcoin being a Ponzi scheme seems to hinge entirely on the expectation of profit, an interesting way to think about the psychology of buying bitcoin is to compare them to call options.

Buying Bitcoin is More Like Buying a Call Option

Thomas Hale makes an interesting observation in his article “The Nothingness Value of Cryptocurrencies;”

“In its current form, it [Bitcoin] is a rare example of an unconstrained security, valued as a pure projection of psychological volatility in a secondary market. Such things are usually referred to as “bubbles”, but they can offer a perverse kind of value.”

Thomas Hale goes on to write,

“Extreme returns are possible in unconstrained securities because there is no basis for their value in the first place. The upper bound is some unknown quantification of psychological appetite for speculation.”

There is one financial instrument that behaves like this.

Call options.

Call options provide asymmetric, unlimited upside with limited downside. They even seem to echo Stolfi’s Ponzi scheme criteria:

1. People buy call options because they expect good profits

2. that expectation is sustained by such real asymmetrical pay-offs, especially for out-of-the-money options. However,

3. there is no external source of revenue for those payoffs. Instead,

4. the payoffs come entirely from the losses of option writers (other people's money), while

5. the operators (option writers and brokers) take away a large portion of this money - it is said that 90% of options traders lose money

The difference? Call options have an expiration date — bitcoins don’t. But, call options are not referred to as Ponzi schemes. We don’t talk of people investing in call options when they buy them, even though there is nothing very different about the mechanism (and the psychology of buying call options).⁴

If Bitcoin is something equivalent to a call option, what is the “underlying asset?” The underlying is the generalized expectation that:

the future will be decentralized and trustless,
that the monetary revolution unleashed by Bitcoin will be unstoppable,
and that Bitcoin will continue to remain at the center of this revolution for the conceivable future.

Whether that will turn out to be the case, whether the future will be dominated by Central Banks Digital Currencies (CBDCs), or some other more traditional monetary formats remains to be seen.

Summary

Bitcoin is best understood as a unique asset in history so it is difficult to compare it with other instruments; still, there are some interesting ones to compare with.
Bitcoin seems to behave like a zero-coupon perpetual bond that trades only based on its value measured in fiat currency — but it is not issued by governments and can only be “mined” via a predefined algorithm.
Bitcoin also seems to behave like an indefinite call option; the underlying is the belief in a decentralized, trustless future where Bitcoin will have an important role to play.
Is Bitcoin a Ponzi scheme? If we go by Jorge Stolfi’s premise, it seems to depend on whether Bitcoin is something you “invest” in or not, and from whose point of view. Since Bitcoin miners also have running costs, it is qualitatively different from a re-distributive Madoff-style Ponzi scheme.
The debate is sure to continue.

[UPDATED Feb 14, 2022] An earlier version of this article claimed imprecisely that “Like Bitcoin, government-issued fiat currency cannot end in a run either, because the central bank can always create more currency.”

This should read “Like Bitcoin, government-issued zero-coupon perpetual bonds cannot end in a run either, because the central bank can always create more currency.” This has been edited.

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Endnotes

[1] One can also invest in Bitcoin by buying specialized hardware to set up a Bitcoin mining business, but I suppose that Jorge Stolfi is talking about “investing” as in “buying or trading” Bitcoin. Stolfi also does not seem to mention that miners are themselves spending a lot of money to buy specialized mining equipment and pay for energy costs, and could very well make a loss for their operations.

[2] For the additional arguments on why Bitcoin IS a Ponzi scheme:

For additional arguments on why Bitcoin is NOT a Ponzi Scheme:

[3] de Vries, Alex & Stoll, Christian. (2021). Bitcoin’s growing e-waste problem. Resources Conservation and Recycling. 175. 105901. 10.1016/j.resconrec.2021.105901.

[4] There are many uses to call options. Professional fund managers sometimes buy call options as a hedge for a short stock position. Yet, since Jorge Stolfi’s definition of a Ponzi scheme is a subjective definition of a Ponzi scheme based on the assumption of investment, and ignores the many uses of Bitcoin (such as sending money, as an intermediary currency on peer-to-peer markets), I have also adopted a similar assumption in my discussion of call options. One must compare apples to apples.

Disclaimer: This is not financial advice to buy or sell any asset, digital or otherwise. Please do your due diligence before trading or investing in any digital or non-digital assets. All opinions expressed belong to the author. At the time of writing, the author does not hold any Bitcoin.

The author writes on a wide variety of topics. His key topics are Japan, society, culture, modern work, and cryptocurrency. Discover his most-read stories here.

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