How Bitcoin Has Become A Decentralized Ponzi Scheme

The mainstream media has finally taken notice of the cryptocurrency world. Or perhaps more accurately, the cryptocurrency world has crashed onto the stage and into the spotlight. Some people who believed in the technology and bought into it just a couple of years ago have stood to make huge gains. Bitcoin’s meteoric rise in the last year — over 1600 percent at the time of this writing, though it changes wildly by the hour — has captured the public’s attention. And someone who bought just a couple hundred BTC before it was valued at over $100, if they’re still holding, are quite literally millionaires — in fiat currencies.

But where is this run-up coming from? Is Bitcoin really worth a quarter of a trillion U.S. dollars, as suggested by its market cap? The institutionalization of the currency through futures approved by U.S. financial bodies, perhaps to be mirrored in other countries, could stoke further interest. How can an open platform be worth as much as some of the world’s most valuable companies?

Maybe it’s not.

The Representation of Value

All currencies represent value. Exchanging a £5 bill for an item indicates the buyer believes the item’s value is equal to whatever is required for the seller to amass £5 in wealth. For some, £5 indicates a significant investment of time and money, while to others, £5 may be less effort than breathing. Things like food and water have obvious value and utility to each person. Services have more widely dispersed value and utility to different people. Currencies, on the other hand, are the basis of this representation of value, because barter systems are not very efficient. The £5 bill is simply a mechanism to store value, not valuable in and of itself.

Cryptocurrencies were originally intended to be just that: representations of wealth. In short: “I trade you 1 BTC, and you’ll give me some kind of item or service.” However, it is difficult to remove the connection between nation and currency from society. Hence, cryptos have become: “I will give you 1 BTC, and you’ll give me $20,000 USD.” For true currencies, both sides of the trade can use the currency in everyday life. If I change GBP to EUR, I can buy things in the Eurozone. Until cryptos are widely adopted, they’re more like commodities or non-cash assets, not currencies.

This leads to the problem that BTC is not really a representation of value at all. If BTC is a currency, it is experiencing hyperinflation. But real prices for real goods and services are not skyrocketing along with the currency, and, therefore, it seems BTC is not really a currency at all.

Bitcoin as a Ponzi Scheme

So if BTC is not a currency, it must be another asset class. However, there is no business operation in Bitcoin. There are no profits, no cash flows. It is a system, and money is flowing into the system. The system’s value is entirely based on perception. It is somewhat like gold for a store of value, but without a physical counterpart.

When the seller received cash for his BTC, he can still purchase items or services with it. Money is flowing from the late entrants to the early entrants. This is similar to a digital, decentralized Ponzi scheme, with no one orchestrating the scheme except society’s perception. Everyone can see the massive price increases, and they all want to participate. This drives the price up further.

Like any business operation, cash outflows must be matched to cash inflows. For Ponzi schemes, which don’t generate any revenue, the only cash inflow is from new investors. As members of the public clamor to buy Bitcoin, many without any understanding of the blockchain or cryptocurrencies, the price will continue to rise. As many institutional investors now wading into the market, they will hype the technology in order to bring more people on board. And as the price moves even higher, older investors will cash out, pulling money off exchanges and out of the system. Once the price begins its descent, the late entrants will be left with worthless virtual coins. At least with gold, they could in theory make jewelry or sell it for electronics scrap.

There are literally hundreds of other coins and tokens to choose from. The number of transactions processed on the Ethereum network has exploded and is rapidly surpassing Bitcoin’s level and others. And a large number of altcoins are enjoying price increases, but not like Bitcoin. Why?

The Fear of Missing Out

Seemingly everyone now knows Bitcoin. It has become mainstream. Everyone also knows about the extremely high growth it has experienced in the last couple of years. People read of friends of friends on social media who have made thousands of dollars just investing a few. For most people, making a deposit of $500 and seeing it become $5,000 over a year is thrilling. It offers far better growth than any traditional asset. So, many people are buying small amounts of BTC and hoping for massive percentage increases. This only serves to sustain the positive feedback loop.

The institutionalization of Bitcoin, especially in regards to futures, is seen as a signal that Bitcoin is finally becoming a true currency. Advocates believe money will pour into the coin, and prices will continue to grow exponentially. However, futures contracts don’t pump money into their underlying — they pump money into the derivatives markets. With most futures using cash settlement and not physical delivery, banks can skirt the security risk in actually owning cryptos and instead bet on their price movements without affecting the price itself.

So What Does This All Mean?

There are many issues for Bitcoin to overcome. Sustainability, scalability, speed, adoption, and security are just a few. Bitcoin also faces significant pressure from competitors that implement better technology or any number of the problems plaguing Bitcoin.

Bitcoin is not the future of cryptos. Blockchain is important, and it will be the future. But the reigning blockchain currency will not be Bitcoin. For now, there’s money to be made in the mania. We might still be early in the Ponzi scheme’s execution.

Ruzbeh Bacha is the founder and CEO of FinTech startup CityFALCON and London Value Investing Club. He has been investing in the stock and other markets for the last 20 years.