Friday, April 26, 2013

Is Bitcoin a Ponzi scheme?

There are frequent accusations on various blogs and bulletin boards, and in various news articles that Bitcoin is a Ponzi scheme.

A Ponzi scheme is a pyramid scheme in which the scheme operator uses money from new investors to pay old investors, and needs to keep recruiting further new investors in order to keep the money flowing. By its very nature a Ponzi scheme will eventually collapse because either the scheme will come to the attention of the authorities (who will shut it down), or the stream of new investors dries up because there's aren't any more suitable people to invest, and the money stream dries up.

Charles Ponzi, the person this kind of fraud is named after, was promising investors that he was buying food stamps in Italy at a low price, and selling them in the US at a higher price, thus making a profit. In actual fact he was doing no such thing, and the money from the increasing numbers of investors was used to pay fantastic "profits" to the older investors.

So how could Bitcoin be a Ponzi scheme?

Firstly, there is no operator. The Bitcoin system is open - the mathematical and economic ideas behind it are openly published, as is the block chain containing all the transactions, and no one controls the system.
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Secondly, the Bitcoin system is not designed to take money from the newer investors and hand it over to the older investors. Bitcoins are a finite resource that are created at a steadily decreasing rate. Exchanges exist to give people who don't want to buy mining equipment or spend time setting it up the chance to buy them with cash. There's still a technical and capital threshold for setting up a profitable mining operation. It's comparable to gold - I don't want to go panning in Lapland or buying mining equipment, land and refining equipment to get hold of gold: it's easier for me to buy it (and I'm better at making money by testing software - my chosen profession). Similarly, a car mechanic or novelist or dentist who wants Bitcoins will want to buy them.

So claiming that because increasing prices mean early adopters of Bitcoin are somehow profiting from a Ponzi scheme is like claiming that gold, or even Beanie Babies are a Ponzi scheme.

That doesn't mean that at some point in the future the whole system might no crash (due to a fatal design flaw yet to be exposed, or an attack from a hostile government, or even a large meteor strike that takes out the internet). But the same risk exists if you buy Apple stock, or US dollars, or collectible stamps. If for one reason or another the public interest in any of these disappears, they collapse and people who invested at the end lose out. But that's a "bubble" - not a Ponzi scheme.

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