Tuesday, March 11, 2014

Dear Nouriel Roubini, Here's Why Bitcoin Is Not A Ponzi Scheme

NYU professor Nouriel Roubini, famous for his prediction of the 2008 financial crisis, tweeted today that bitcoin is, among other bad things, a "Ponzi game." Roubini is not the first and won't be the last person to make this accusation, so it may be worthwhile to briefly explain why this belief is mistaken.

Briefly put: Bitcoin looks like a Ponzi scheme in the same way that a whale looks like a fish. In reality, though, they are two entirely different animals.


What's the logic of a Ponzi scheme?

The person who operates the Ponzi scheme tells prospective investors that he will invest their money in such a way that the risk is low while the returns are consistently high. But in reality he doesn't actually invest their money, or he does invest it but doesn't achieve the success that he tells his investors he has achieved. The result is that he has less money than that he owes. 

He has two sources of hope:

1. He can attract new investors and use their funds to pay those who want to take their money out.

The investors who take their money out in time gain at the expense of those who don't. The latter group will find that their money is no longer available as it was used to pay the high returns earned by the former group.

2. At any given time, only some of the investors will take their money out. As long as the Ponzi schemer has enough money left to pay them, and as long as his clients don't start to doubt that all their money is still there, he can survive.

The Ponzi schemer's main problem, however, is that with each new investor he attracts and with each day that goes by, the gap between what he has and what he owes only becomes larger and larger, both in absolute and in relative terms. Eventually, this scheme cannot but implode as it requires an exponential growth in the number of new clients. 

Why does bitcoin look like a Ponzi scheme?

Bitcoin may look like a Ponzi scheme because 

1) in the early phases many people buy bitcoins mostly as an investment, for speculative reasons and they will only be rewarded if new people enter the bitcoin market so that the bitcoin price increases

2) these early adopters' gain comes at the expense of late adopters in that early adopters see their bitcoins increase in value while late adopters will see their dollars decrease in value. Purchasing power flows from the latter to the former.

Why is it not in fact like a Ponzi scheme?

What makes bitcoin different from a Ponzi scheme is that this is in fact a scenario that is sustainable in the long run. In the process of bitcoin's monetization (i.e. as it gradually becomes a universally accepted medium of exchange, and an appreciating or stable store of value) it gradually changes from a speculative investment with a high risk and high ROI to a stable money with a low risk and a low to zero ROI.

Unlike a Ponzi scheme then bitcoin can in principle survive an end in the growth of its user base. While the speculative use of Bitcoin levels off [with the growth in its user base] and ultimately ends as no new users enter the market, its value as a money becomes primary.

Early bitcoin investors keep their high returns (in the form of increase in the purchasing power of their bitcoins) while new buyers of bitcoin will enjoy a stable purchasing power. 

The gains achieved by those holding bitcoin come at the expense of those who hold other currencies (such as dollars) that are partially or fully replaced by bitcoin. The later people make the switch from a depreciating currency to an appreciating currency the more they lose or the less they gain.

This also means that if the early investors get out by selling their bitcoins for dollars they will miss out on the appreciation in the price of bitcoins that will occur after they've sold theirs and they will be stuck holding dollars that become worth less and less. 

Contrast this with a Ponzi scheme: While in a Ponzi scheme it only pays if you get in early and get out early, in the case of bitcoin it pays to get in at any point and it never pays to get out. The earlier you get in, the more you win. The strategy that pays least of all is to never get in at all. If you follow that strategy you'll be left with a wallet full of worthless dollars.


Do note that the above scenario assumes that bitcoin actually becomes a universally accepted medium of exchange, which is a bit of an heroic assumption.

The point of using this scenario, however, was to compare it to the logic of a Ponzi scheme: While bitcoin could actually survive an end in the growth of its user base, a Ponzi scheme not only require continuous growth in its user base, but an ever increasing rate of growth. This makes bitcoin fundamentally unlike a Ponzi scheme.

In reality, of course, the successful monetization of Bitcoin is far from certain and still exceedingly unlikely. So what would happen if instead we assume that the bitcoin price will collapse at some point or first reach a peak and then decline (until it has become either entirely worthless or stabilizes at some lower level)?

Well, I could generalize my point by rephrasing it as follows: To the extent that the bitcoin price increases or stabilizes, all of the above holds. To the extent that the bitcoin price decreases, it will be the case that only those who got in early and got out in time won, and that their gains come at the expense of those who came in later and who see the value of their bitcoins decrease.

But that alone is not enough to accuse bitcoin of being a Ponzi scheme: After all, these features are hardly unique to a Ponzi scheme. If you invest in a company whose stock price first rises and then collapses, then you will have won if you got in early and then sold for more, while everybody who bought before the stock started crashing will have lost. And nobody would accuse the owners of the company of running a Ponzi scheme on that basis. The same holds for bitcoin.

(this article is a shorter and updated version of this earlier article)

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