Why Cryptocurrencies Are Worse Than Pyramid Schemes
Why did so many smart people fall for them?
The $32 billion cryptocurrency exchange, FTX, which declared bankruptcy 11 days ago, appears to be the second-largest pyramid scheme in history after Bernie Madoff’s scheme, which was discovered in 2008. The Madoff case provides optimism that a significant amount of the money lost by FTX could be discovered and recovered. The legal custodian to the Madoff fortune found and returned a remarkable 88% of the assets to Madoff’s more than 40,000 victims. This morning, Reuters reported that Bankman-Fried and his parents bought over $120 million of Bahamas real estate properties, including seven luxury beachfront homes worth nearly $72 million, over the past two years. The custodian-CEO of FTX, John Ray III, who oversaw the Enron cleanup, will likely announce many such discoveries in the weeks to come.
FTX is not the first apparent crypto pyramid scheme. OneCoin cryptocurrency, founded by Ruja Ignatova, took in over $4 billion. As such, the FTX scandal raises an important question: are all cryptocurrencies pyramid, or Ponzi, schemes? Many on the Right and Left alike believe they are. “I’m a major skeptic on crypto tokens, which you call currency, like Bitcoin,” said JPMorgan CEO, Jaime Dimon, in congressional testimony in September. “They are decentralized Ponzi schemes.” The progressive Substack columnist Matt Stoller wrote earlier this month, “At the top of the market, back in December 2021, I wrote a piece very explicitly saying that crypto was a set of Ponzi schemes.”
A Ponzi scheme is a kind of criminal fraud in which investors in a business are paid by new investors who go on to recruit new investors, and so on. There is little to no real economic value created by the business. It’s just investors giving their money to existing investors, thereby creating the perception among participants that they are in a real business, even though they are creating no real value. It’s called a pyramid scheme because it depends on a growing base of investors to funnel money to the top of the organization.
Defenders of cryptocurrencies say FTX was a unique case and that most cryptocurrencies aren’t Ponzi schemes because they are decentralized. Bitcoin is a blockchain technology, which means it’s a computer code held in a peer-to-peer computer network that cannot be altered. “Bitcoin cannot be a Ponzi Scheme,” writes a defender of the technology. “Due to the nature of blockchain, anyone at any time can verify all transactions made on the Bitcoin network, dissimilar to a Ponzi Scheme where ‘investments’ are shrouded in secrecy.” Writes another, “if Bitcoin were a scam, there'd be a nefarious person or people behind it actively profiting from the scheme.”
In fact, there are nefarious persons profiting from Bitcoin and other cryptocurrencies, and it’s their decentralized nature that makes them so useful to lawbreakers. “Criminals,” warned Europol, the EU’s top law enforcement agency, “have become more sophisticated in their use of cryptocurrencies” in order “to obfuscate money flows as part of increasingly complex money laundering schemes.” In late August, the FBI warned investors that “cyber criminals are increasingly exploiting vulnerabilities in decentralized finance (DeFi) platforms to steal cryptocurrency, causing investors to lose money.” Crypto also helps dictators to evade sanctions.
Even Bankman-Fried himself described cryptocurrencies as Ponzi schemes. In an interview with Bloomberg reporter Matt Levine in April, Bankman-Fried said that many or perhaps all cryptocurrencies were pyramid schemes. “You start with a company that builds a box,” said Bankman-Fried. “Pretend it does literally nothing. It's just a box…. This box is worth zero obviously … But on the other hand, if everyone kind of now thinks that this box [cryptocurrency] token is worth about a billion-dollar market cap, that's what people are pricing it at and sort of has that market cap.”
Levine, a former investor and one of the leading crypto reporters in the U.S., interjected, “You're just like, ‘Well, I'm in the Ponzi business and it's pretty good,’” to which Bankman-Fried said, “I think that’s a pretty reasonable response… that's one framing of this. And I think there's like a sort of depressing amount of validity.”
All of this and yet Bankman-Fried remained one of the most trusted players in the crypto world, winning support not just from inexperienced investors like Tom Brady, Giselle Bundchen, and Larry David but also from Sequoia Partners, one of the most respected venture capital funds in Silicon Valley, and from Levine himself. “I came away from that conversation,” where Bankman-Fried described cryptocurrency as a Ponzi scheme, “bullish on FTX and Bankman-Fried,” said Levine.
And he wasn’t alone. Experienced tech journalist Adam Fisher spent several days with Bankman Fried and wrote a 14,000-word essay about him for Sequoia. “I’ve been talking to founders and doing deep dives into technology companies for decades,” wrote Fisher. “It’s been my entire professional life as a writer…. After sitting ten feet away from [Bankman-Fried] for most of the week, studying him in the human musk of the startup grind, and chatting with him between beanbag naps, I couldn’t shake the feeling that this guy was as selfless as he appeared to be.”
Why is that? Why did so many smart people fail to see Bankman-Fried, FTX, and cryptocurrency for what they are?