Johannesburg, 12 Jun 2023
A Ponzi scheme is a type of financial fraud where earlier investors are paid from the funds brought in by new investors, thus perpetuating the appearance of profitability for as long as new victims join in sufficient numbers. In many cases, organisers do not bother to make actual investments, limiting their activity to redistributing funds between their “customers”. This model has some similarities to a pyramid scheme, but unlike a pyramid, a Ponzi doesn’t require an investor to recruit others.
Typically, a Ponzi scheme will promise a return at a later date. Some investors will receive their returns, but ultimately the system collapses, leaving most investors stripped of their capital. The scheme is named after Charles Ponzi, a fraudster who gained notoriety with one of the US’s most famous examples of the scam.
Ponzi schemes exist across industries
The key to debunking today’s myth is understanding that a Ponzi scheme can’t span a whole asset class or industry. Rather, it is simply a model for defrauding victims out of their money that can exist in any setting that enables investment activity.
There are, of course, examples of Ponzi schemes in crypto right from the early days of the technology. OneCoin and Bitconnect were two of the biggest and most well-known cases. However, the overwhelming majority of the most notorious Ponzies occurred in the world of traditional finance. The billion-dollar schemes run by the likes of Bernie Madoff, R Allen Stanford and Tom Petters, among many others, disguised as regular investment funds or brokerages that solicited fiat deposits. And yet, we don’t call all investment funds or the entire financial industry a Ponzi.
The technology that powers crypto-currencies does not contain any attributes that make this asset class inherently more or less prone to Ponzi schemes. It is nefarious actors – who can be found in any corner of finance – that create and drive investment fraud preying on ill-informed individuals.
Many blockchain projects have robust technological underpinnings, strong founding teams and the drive to solve real-world problems. Even if they can go through periods of volatility, their assets have undeniable utility, which makes them viable and valuable as both technology and business endeavours. The notion that marquee assets like BTC, ETH, BNB and many others depend on new investors' money to pay off early adopters couldn't be further from the truth and sounds outlandish to anyone who understands how the digital economy works. Making a blanket statement that “crypto is a Ponzi scheme” is grossly reductive.
That said, as with putting your faith in any product or investing in any asset, with crypto, you must do your own research (DYOR) to always make informed and sound decisions.
A label applied too broadly
Some people stretch the term Ponzi scheme to describe any asset with a higher-than-average risk. With such assets, some investors manage to make profits, while others may lose much of their initial capital.
Even legitimate stocks or digital tokens can have poor technological or business fundamentals. They may appear valuable by way of sophisticated marketing or riding a social media trend, but ultimately they often fail to live up to their promise and end up losing value. It is not necessarily a sign of fraudulent behaviour or being a Ponzi scheme – sometimes, it is simply the result of bad business practices and poor management.
Thus, slapping a Ponzi scheme label on any high-risk asset or on any investment that resulted in people losing money is unhelpful and can spawn misconceptions.
Crypto’s risk profile
Now, is crypto at a higher risk of being mislabeled as a Ponzi because of being an especially high-risk asset? Let’s look at crypto’s risk profile and understand the real situation.
Some researchers observe that, when considered an investment, the risk profile of crypto assets (other than fiat-backed stablecoins) is similar to those of oil prices and technology stocks. For example, a 2022 study by Coinbase Institute attributes two-thirds of last year’s decline in crypto markets to worsening macro factors and only one-third to the weakening outlook for crypto-currencies themselves.
While it is true that, generally, the correlation between digital assets and equity markets is now greater than it was in the early years of crypto, we must consider the contribution of riskier assets (eg, growth stocks) to innovation and economic growth. These markets are still maturing, and the fact that they are currently volatile doesn't mean that these assets don’t have a positive impact on consumers and society at large. Risks posed by such assets should be appropriately managed without restricting responsible competition, choice and innovation.
So, it seems two factors are at play here that have built up the crypto-as-a-Ponzi myth. The first is that crypto is perceived as an especially risky asset and some people are quick to apply the Ponzi label to such assets without much regard for the term’s precise meaning. As mentioned, many other assets don’t get this high-risk reputation despite offering comparable risk levels.
Second, insufficient risk management can often lead to investors experiencing more significant losses when dealing with riskier assets. This tends to happen when inexperienced retail investors get attracted to projects that are poorly managed or have weaker fundamentals than they are trying to represent. Crypto has huge potential for innovation, but it is still in its nascence as an asset class and needs to be treated responsibly by investors.
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