Cryptocurrencies, Blockchain and Ponzi Schemes
When you read and learn about cryptocurrencies (e.g. Bitcoin, Ripple, Ethereum), there are some commentators, politicians and others who characterize cryptocurrencies as a “Ponzi” scheme. Some countries have banned cryptocurrencies. The issue of cryptocurrencies, like many other issues, is nuanced, and not so dogmatic. As I like to say, there are benefits and there are risks. Let’s address a number of the risks and lay them out on the table.
First off, cryptocurrencies, by definition, are not Ponzi schemes. However, cryptocurrencies, like many other types of currencies or investments, can be used to carry out a Ponzi scheme. Charles Ponzi, the original fraudster, supplied his last name as the original Ponzi schemer when he built a financial scam that was built on a simple proposition – generate large returns for original investors through revenue paid by new investors and avoid legitimate business activities or financial trading profits. Cryptocurrencies can be used for Ponzi schemes, just like any other fraudster who promises significant returns without engaging in legitimate business activities or financial investments.
Second, cryptocurrencies are built on the blockchain or a distributed ledger system. By eliminating the conventional (and trusted) middle person, like a bank, from the transaction, distributed ledger systems reduce costs and offer potential economic benefits while enhancing security. The blockchain revolutionizes ledger technology with a network of distributed ledgers. However, the lack of a middle person also comes with a variety of downsides. For one, once transactions are recorded in the blockchain, they become permanent – there is no way to reverse a transaction. While some banks are able to reverse fraudulent transfers, the blockchain cannot. While some banks are able to reverse transactions if your debit card number falls into the wrong hands, the blockchain does not have a central authority to do the same. If your private key – essentially your identification on the blockchain – falls into the wrong hands, there’s no recourse.
Building off that last point, realize that decentralized blockchains are essentially computer programs, running off lines of code. Most cryptocurrencies are open source, meaning their code is publicly available for all to review. This code can be (and should be) audited by third parties. This ensures that there are no subversive purposes and that there are no glaring security holes. However, if it’s not open source, then there are no guarantees that the code will actually do what its creators claim it will.
And most obvious to anyone who dabbled in the markets over the past few years, the emotional fervor surrounding the incredible financial gains and losses cause investors to act irrationally. Con men thrive in these environments. Take the cryptocurrency Bitconnect as an example. Bitconnect is now the poster boy for ignoring all the warning signs of a Ponzi scheme. No one really knew what the coin even did or why it was useful, the only thing that mattered was that its creators promised guaranteed returns (uh-oh). Its creators would release videos that were just charismatic characters yelling and claiming that paradigms would forever shift and all sorts of other buzz words. They prepared a slideshow for investors that literally had a slide that depicted a pyramid scheme – really, the slide had a pyramid that showed that guaranteed returns were a tiered structure that would increase by inviting friends. Bitconnect’s market cap was once well over $2 billion before eventually plummeting in value overnight.
So, there are significant risks. It’s still hard to figure out who to trust, as some of the cryptocurrency exchanges have even suffered hacks and online theft. The Mt. Gox exchange suffered a real and significant theft of currency value, resulting in the illegal transfer of hundreds of millions of dollars in Bitcoin. This exchange provided a startlingly insufficient level of security and protections for its customers, and those that trusted its owners suffered major repercussions. Exchanges absolutely must ensure the necessary technical protections are in place, while also ensuring the regulatory controls are in backing those up.
The challenge for global regulators is to stay abreast of technology. It is difficult and law enforcement and regulatory agencies are often playing catch up. But that does not mean banning cryptocurrencies is the proper course – indeed, there are real and significant economic benefits that the blockchain can provide for the economy. It is when the technology is used for nefarious purposes that law enforcement and regulators need to act to protect the public interest. Cleaning up the dirty side of the industry will do well to help the technology grow and thrive.