Pyramids and Ponzis

Some folks have argued that Bitcoin is a pyramid scheme. That’s true in one important respect, which is that if you buy Bitcoin early and if more people buy it later, then you will benefit financially from their purchases. That’s because the supply is strictly limited, and an increase in demand moves the price upward as more people buy in. Furthermore, this creates an incentive for you to pitch other people on the virtues of the asset so that they buy in.

However, this incentive structure is true of any limited-supply asset whose potential has not yet been fully realized. No rational investors bought Amazon stock in 2003 because they were excited to collect nice dividends the following quarter. Amazon wasn’t paying dividends or even generating cash flow. Investors bought Amazon because they expected it to generate cash flow someday in the future once its growth potential had been realized. Bitcoin is similar. As discussed in Chapter 10, Bitcoin is still a juvenile in development. If you don’t think that Bitcoin has room for improvement (including through novel uses for programmable digital money, and direct improvements to usability being built on top of it, such as the Lightning Network), then you should be much less interested in owning it, all else being equal.

Bitcoin also has an important feedback loop mechanism that actually improves its value just from people buying it and driving up its price. The higher the price, the more profit miners can make. This induces existing or new miners to bring more computational resources to the network. This increase in mining hash power increases the security of the network and makes attacking it more difficult. Greater network security implies that network should be more valuable as a system for storing or transmitting value. This positive feedback loop means that more people buying Bitcoin actually makes it more secure and therefore makes it more valuable. Moreover, the more people that own Bitcoin, the more likely it is to be used as the medium of exchange it was intended to be because its “network effect” is improved. If I have bitcoins and you have bitcoins, we both speak the same Bitcoin language. Maybe if I sell you a good or service, you pay me with bitcoins or vice versa.

Some people have called Bitcoin a Ponzi scheme. In a Ponzi scheme, new participants fund the payouts of earlier participants based on a promised or reported investment return that exceeds the investment return actually realized. For example, if someone (such as Bernie Madoff) takes investor funds and either reports or promises a 10% annualized return while only achieving a 5% return, then the claims on assets now exceed the actual assets available to satisfy the claims. The only thing that can keep the scheme going is to bring in more money to pay the existing claims. Bitcoin is not a Ponzi scheme because the rate of return is fully transparent to the users. Indeed, since it is open-source, the entire software and ledger of ownership is fully transparent to the entire world.