Why Bitcoin Isn’t a Ponzi Scheme

Recently the SEC delayed its decision on approving a bitcoin ETF, likely due to the complex nature revolving around security. During the review process the public was free to submit comments expressing any concerns around the ETF. 

One critic submitted a comment about how Bitcoin is like a Ponzi scheme or penny stock. This is a common fallacy that gets circulated amongst naysayers, so here’s a rebuttal to his arguments.  

Bitcoin as a Penny Stock and Ponzi Scheme

The critic makes the following statements regarding Bitcoin as a penny stock or Ponzi scheme: 

“Thus, bitcoins are more like “penny stock”, shares of a company with no assets, no products, and no staff; or shares in a pure ponzi schema, like Madoff’s fund. The value of bitcoin is supposed to come only from the existence of an
(allegedly) secure ledger that records the distribution of coins among numerous accounts (“addresses” in the system’s terminology), and therefore allows their use as a means for internet payments. But penny stocks and ponzi funds offer that capability, too.”

Like all money, bitcoin derives its value as a medium of exchange, based on a social contract amongst the participants of a society. The blockchain keeps an immutable public ledger, which allows it to operate without the backing of a bank or nation state. 

Let’s take a look at the exact technical definition of a Ponzi scheme and penny stock. 

According to Black’s Law dictionary a Ponzi scheme is:

“A fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors. Money from the new investors is used directly to repay or pay interest to earlier investors, usually without any operation or revenue-producing activity other than the continual raising of new funds.” 

The main problem with Ponzi schemes is that they implode due to market saturation. Pyramid type investment structures funnel money to the top, while leaving the majority of participants at the base as bag holders.

Bitcoin does not fit the definition of Ponzi scheme for various reasons:

  • There are no paid dividends to any investors.
  • The purpose of using bitcoin isn’t to recruit new participants.  
  • There’s no centralized body that funnels money up to the top. 
  • Unlike Ponzi schemes, Bitcoin will still have value and continue to function even if no new participants join the ecosystem. 

So is bitcoin like a penny stock? According to Investopedia, the technical definition of a penny stock is:

“A penny stock typically trades outside of the major market exchanges at a relatively low price and has a small market capitalization. These stocks are generally considered highly speculative and high risk because of their lack of liquidity, large bid-ask spreads, small capitalization and limited following and disclosure. They often trade over-the-counter through the OTC Bulletin Board (OTCBB) and pink sheets… The SEC, however, has modified the definition to include all shares trading below $5.”

Bitcoin is not like a penny stock for multiple reasons: 

  • It’s not a stock and doesn’t represent a company. 
  • If it were a stock, it would be considered a mid-cap stock with a market capitalization of around $10 billion. 
  • Bitcoin doesn’t trade for under $5 and has much better market liquidity than most penny stocks. 
  • Many penny stocks lack disclosure of information, whereas Bitcoin is open-source and completely transparent. 

The critic goes on to say…

“The market price of bitcoin, like that of a penny stock or ponzi fund, is entirely speculative, based on expectations of traders about future prices, which will be based on expectations of future expectations…”

Welcome to the global economy. Speculation on future profit potential is the backbone of commerce…

  • Entrepreneurs start businesses by speculating on future profit potential. 
  • Investors purchase stocks, bonds, commodities and currencies based on making speculative returns. 
  • The price of everything is determined by buyers and sellers who make a market by trading. 

The critic furthers his arguments with…

Unlike legitimate stocks and bounds, that infinite regression is not ultimately grounded on fundamentals — because bitcoin does not have any. In fact, its primary use as speculative financial instrument causes extreme price volatility, that prevents its use as a currency.”

Bitcoin is a new paradigm unlike anything history has seen before. It can be used as a currency, commodity, network and immutable public ledger. As its own economy, Bitcoin absolutely has fundamentals such as: 

  • Daily transaction volume.
  • Electricity, hardware, bandwidth and storage used to secure the network.
  • Network difficulty.
  • Supply, demand and rate of inflation.
  • Number of Bitcoin businesses and their fundamentals. 
  • Amount of investment capital used in the Bitcoin ecosystem.
  • Market liquidity.

The argument also states: 

“Ownership of bitcoins does not yield any dividends or interest. While eventual users of bitcoin as a currency would be required to pay transaction fees, those fees will not be paid to bitcoin holders, but to the “miners” that maintain the public ledger.”

Miners collecting transaction fees doesn’t make Bitcoin a Ponzi scheme. Miners operate like a business and offer the valuable service of securing transactions on an immutable public ledger. By that logic we could call NASDAQ, NYSE, Banks, Paypal and just about any business that charges a fee a Ponzi scheme. 

Another argument made is…

“The only way to make a profit by investing in bitcoins is by selling them to other investors, for more than their purchase price. Thus, bitcoin has the essential character of a penny stock, or a pyramid schema: the profit of early investors comes entirely from the investment of later ones.”

The only way to make profit on anything is to sell it for more than what you payed for it. In fact this is the very definition of the word…

Profit: a financial gain, especially the difference between the amount earned and the amount spent. 

Last but not least…

“Investment in bitcoin does not contribute to mankind’s real wealth or well-being: it does not finance the creation of any material goods or real services. On the other hand, it has ruined many naive investors who have been induced to put their savings into it, by spurious promises of fantastic price increases in some undefined future.”

Bitcoin as a currency can finance many things. Bitcoin can be used to finance startups and pay for goods and services. People don’t need to “invest” in bitcoin in order to use it. As far as contributing to mankind’s well-being, Bitcoin can be used to donate to many charities such as the Red Cross, Greenpeace, ChildFund International etc. 

Yes, people who speculate on bitcoin as an investment run the risk of loss, as they would any investment. We could easily flip that story and say that people who invested $100 in bitcoin in 2010, made $1.8 million at the end of 2013. Or perhaps a speculator who shorted at $1200 made money by the price going down. 

People also lost a lot of money when the dotcom bubble crashed but we’re not making arguments to do away with the internet. Investing can be dangerous and making rash decisions without managing risk can lead to a financial loss in all markets.  

Rocky

I have a passion for Bitcoin and the crypto markets. I work full-time as a cryptocurrency trader, investor and analyst. I also run a crypto trading school at skillincubator.com
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