Bitcoin vs. Madoff

Robert McCauley explains Why bitcoin is worse than a Madoff-style Ponzi scheme and it is a must-read. Below the fold, discussion of some of his key points.

Jorge Stolfi argued that Bitcoin is a Ponzi:

A Ponzi scheme, or "ponzi" for short, is a type of investment fraud with these five features:

1. People invest into it because they expect good profits, and
2. that expectation is sustained by such profits being paid to those who choose to cash out. However,
3. there is no external source of revenue for those payoffs. Instead,
4. the payoffs come entirely from new investment money, while
5. the operators take away a large portion of this money.

Investing in bitcoin (or any crypto with similar protocol) checks all these items. The investors are all those who have bought or will buy bitcoins; they invest by buying bitcoins, and cash out by selling them. The operators are the miners, who take money out of the scheme when they sell their mined coins to the investors.

Stolfi points out that:

Features 3, 4, and 5 imply that investing in bitcoin, like "investing" in lottery tickets, is a very negative-sum game. Namely, at any time, the total amount that all investors have taken out is considerably less than what they have put into the scheme; the difference being the amount that the operators have taken out. Thus the investors, as a whole, are always in the red, and their collective loss only increases with time.

He acknowledges that he was far from the first:

The observation that investing in cryptocurrencies is a ponzi scheme is not new or a cheap shot. Among many others, it was expressed in 2014 by economists Nouriel Roubini of NYU [CDK1] and Kaushik Basu of the World Bank (WB) [CDK2] and echoed by investment analyst David Webb in 2017 [CFO2] and by WB's president Jim Yomh Kim in 2018 [CFO1].

The canonical Ponzi scheme is Bernie Madoff's:

Prosecutors estimated the size of the fraud to be $64.8 billion, based on the amounts in the accounts of Madoff's 4,800 clients as of November 30, 2008. Ignoring opportunity costs and taxes paid on fictitious profits, about half of Madoff's direct investors lost no money. Harry Markopolos, a whistleblower whose repeated warnings were ignored, estimated that at least $35 billion of the money Madoff claimed to have stolen never really existed, but was simply fictional profits he reported to his clients.

It isn't just that the headline number for the Bitcoin Ponzi, currently at a "market cap" of around $923B, is over 14 times Madoff's headline number that makes it worse. McCauley writes:

Many are unaware that a bankruptcy trustee, Irving H. Picard, has doggedly and successfully pursued those who took more money out of the scheme than they put in. He even managed to follow the money into offshore dollar accounts, litigating a controversial extraterritorial reach of US law all the way to the US Supreme Court. Of the $20bn in recognised original investments in the scheme ..., some $14bn, a striking 70 per cent, has been recovered and distributed. Claims of up to $1.6m are being fully repaid.

Madoff paid investors a return of about 1%/month, and they could cash out on demand. But, the first difference of the Bitcoin Poinzi McCauley notes is:

Bitcoin is bought not as an income-earning asset but rather as a zero-coupon perpetual. In other words, it promises nothing as a running yield and never matures with a required terminal payment. It follows that it cannot suffer a run. The only way a holder of bitcoin can cash out is by a sale to someone else.

In most cases the "someone else" is on an exchange; Yogita Khatri reports that:

Centralized crypto exchanges, which hold customers' private keys unlike decentralized exchanges, reported more than $14 trillion in trading volume in the year 2021, according to The Block Research.

That figure is a massive 689% increase compared to 2020 trading volumes, based on data as of December 24.
...
Binance ... facilitated 67% of total volumes this year, i.e., over $9.5 trillion.
...
decentralized exchanges saw more than $1 trillion in trading volumes in 2021, representing enormous 858% growth compared to their 2020 trading volumes.

While it is true that Bitcoin can't suffer a run, centralized exchanges certainly can. In most cases their terms of service say they can suspend withdrawals at any time for any reason, so for example getting from USDT to USD is not guaranteed. And at times when BTC is crashing exchanges tend to have mysterious "outages" preventing getting from BTC to USDT. But the scenario McCauley postulates is plausible:

it is not hard to imagine a big stablecoin “breaking the buck”, as occurred with a regulated money market fund that held Lehman paper in 2008. This could so disrupt the whole ecology of crypto that there could be no bids for bitcoin. The market might close indefinitely.

In this event, there would be no long-running legal effort to chase down those who cashed in their bitcoin early in order to redistribute their profits to those left holding bitcoins. Holders of bitcoin would have no claim on those who bought early and sold.

What McCauley seems to miss is that the BTC-USDT market is dwarfed by the market in its derivatives. See Prof. Carol Alexander's blog posts Tether and Bitcoin Ponzi Ecosystem Stage 1: UP and Tether and Bitcoin Ponzi Ecosystem Stage 2: DOWN for details. The players in this market are professionals at Wall St. firms, who can be sued and have the resources to sue.

McCauley's second difference is:

On the second count, another big difference between bitcoin and a Ponzi scheme is that the former is, from an aggregate or social standpoint, a negative sum game. To the extent that real resources are used up to make bitcoin run, it is costly in a way that Madoff’s two- or three-man operation was not.

His point is that the cost of running a Ponzi scheme is negligible, so that the results of Madoff's operations were to transfer parts of a fixed total sum from losers to winners. But:

About 900 new bitcoin a day require most of $45m a day in electricity. Thus, the negative sum in the bitcoin game is in tens of billions of dollars and rising at over a billion dollars per month. If the price of bitcoin collapses to zero, the gains of those who sold would fall short of the losses of holders by this growing sum. To liken bitcoin to a Ponzi scheme or a pump-and-dump scheme, both basically redistributive, is to flatter the cryptocurrency system.

Thus:

In a crash, the holders of bitcoin will collectively have lost what they have paid the miners for their bitcoin. This sum may be not far from the sum originally invested with Madoff, after accounting for inflation. But bitcoin holders will have no one to pursue to recover this sum: it will simply have gone up in smoke, a social loss. The holders of bitcoin would then only wish it had been a Ponzi scheme.

Of course, as I pointed out in my Talk at TTI/Vanguard Conference, this inevitable social loss is only a small part of the externalities cryptocurrencies impose on the world.