Tuesday, August 23, 2022

Investment Frauds

It appears that Preston Byrne, inspired by @DontPanicBurns, coined the term "Nakamoto Scheme" in 2017's The Problem with Calling Bitcoin a “Ponzi Scheme”:
The Nakamoto Scheme is an automated hybrid of a Ponzi scheme and a pyramid scheme which has, from the perspective of operating a criminal enterprise, the strengths of both and (currently) the weaknesses of neither.

The Nakamoto Scheme draws strength from the same things which make pyramids and Ponzis so compelling, in that it promises insane investment returns, can be accessed by the man on the street with almost no effort at all, and recruits individual participants as new, self-interested evangelists of the scheme.
Byrne made no suggestion that the fraudulent aspects were intentional, and in riffing on Byrne's post David Gerard amplified the point:
The problem with calling Bitcoin a “Ponzi scheme” or “pyramid scheme” is that a Ponzi conventionally has a mastermind at the top, making the money.

Bitcoin doesn’t have that. (And Bitcoiners are very big on this as a reason not to call it a “Ponzi”!) Satoshi Nakamoto appears to have been completely sincere in setting up Bitcoin.

Even given Nakamoto’s extensively documented political aims for Bitcoin — an anarcho-capitalist reimplementation of the gold standard, with banker conspiracies along for the ride — he was disconcerted at just how rabid the fans got about the possibility of profit. He even asked them to hold off on video card mining because it would spoil things for getting everyone involved.
Now, in THE STRANGE CASE OF NAKAMOTO'S BITCOIN - PART 1, Sal Bayat repeats Byrne's analysis in much greater detail but does suggest that Nakamoto intended the fraud. Below the fold I critique Bayat's post

Bayat proposes a hierarchical classification of investment frauds, and places Bitcoin in it based on this summary of its attributes:
Bitcoin is not a form of electronic cash. Bitcoin is not a store of value. Bitcoin is not a hedge against inflation. Nor is it digital gold, the future of finance, or an investment. Bitcoin is a type of Nakamoto scheme, a form of investment fraud which leverages an unsound economic premise to enable transactions where no utility is exchanged. The scheme is characterized by several unique properties:
  • The tethering of a speculative digital token to a cost in order to create the illusion of an investment.
  • The creation of a mechanism which can distribute stake in the scheme so that there are multiple co-operators instead of a single operator, i.e. a distributed open investment fraud.
  • Virtual investment rewards are delivered to co-operators, these returns are not fraudulent to participants operating within the system’s context (to an outside observer they are fraudulent returns).
  • As the scheme provides no underlying mechanisms to generate revenue, virtual returns can only be converted into real returns if participants become co-operators in subsequent investment frauds which enable the inflow of fiat liquidity. A built in mechanism which allows the transfer of the digital token is used to convert virtual returns into goods and services or fiat currency.
These properties can be used to distinguish the scheme from more traditional forms of investment fraud like Ponzi and pyramid schemes.
The details of Bayat's analysis are interesting, but I'm extremely skeptical of his assertion that the fraud is the result of Nakamoto's deliberate design rather than emergent properties of a design that simply failed to meet its goals:
Bitcoin failed at every one of Nakamoto's aspirations here. The price is ridiculously volatile and has had multiple bubbles; the unregulated exchanges (with no central bank backing) front-run their customers, paint the tape to manipulate the price, and are hacked or just steal their user's funds; and transaction fees and the unreliability of transactions make micropayments completely unfeasible.
Bayat provides a concise definition of Bitcoin:
Bitcoin is a strange amalgam, and can best be described as an extensible sub-fiat distributed virtual investment fraud hybrid, more easily referred to as a type of Nakamoto Scheme.
And justifies it:
It is extensible because Bitcoin is a digital network and can be used as a scaffolding onto which other forms of investment fraud can be grafted (Ponzi, Pyramid, Pump and Dump). It is sub-fiat, in that the initial investment in the scheme is not made with dollars, but with a commodity, as electricity is wasted during the mining process, giving the scheme a naturally occurring fiat on-ramp and valuation mechanism. It is distributed, as the mining process creates a level playing field, a fair market, where a stake in the scheme can be purchased. It is virtual, in that the scheme provides virtual returns which can only be realized via fraud which enables additional fiat on-ramps. It is an investment fraud hybrid, in that it shares many of the same characteristics and mechanisms that are found in related investment frauds.
Bayat discusses four aspects of Bitcoin as an investment fraud, starting by contrasting Bitcoin with Hashcash, Adam Back's revival of Cynthia Dwork and Moni Naor's Pricing via Processing or Combatting Junk Mail thus:
Firstly, Nakamoto inverted Hashcash’s PoW. Instead of being used to provide utility, the electricity expended by PoW could be tethered to the value of a digital token by a reward mechanism. In Nakamoto’s incarnation, participants have a chance to receive a reward in the form of bitcoin by conducting PoW calculations. This process is referred to as mining, and it transforms the expenditure demanded by PoW from a cost into an ‘investment’ in the mind of the Miner. To participants, the bitcoin they mine has intrinsic value equal to the amount of money spent to mine it (electricity + capital + other operating costs). This gives the token a concrete value for everyone who participates in the mining scheme, and creates the foundations for a market by providing a universal valuation mechanism.

As it does not concern itself with providing utility, Bitcoin’s only goal is value. A price floor is created based on the amount of electricity used to generate a bitcoin. To realize returns, Miners must exchange the tokens for a greater amount of value than the cost of electricity used to generate them.
Bayat doesn't acknowledge that the fundamental reason for Proof-of-Work is to defend against Sybil attacks; the price floor he describes is a synergistic effect of the Sybil defense. It is hard to believe that Nakamoto regarded the "price floor" as the primary justification for PoW, since the entire system depended upon PoW's Sybil defense for its security.

He describes how the "investment" and the "price floor" drive the scheme:
In a Ponzi scheme, the more you invest, the greater your potential returns, investors are limited by the amount of money they have to contribute. In a pyramid scheme, the more you work to recruit, the greater your potential returns, investors are limited by the amount of work they can do. The Nakamoto scheme is unique in that its PoW implementation produces a blend of psychological elements from both schemes. Potential returns are only limited by the amount of money Miners put to work, the scheme can appeal to their greed, as well as depend on a sense of entitlement to their returns as they have ‘worked’ for them. The Nakamoto Scheme achieves the best of both worlds, it produces the psychological buy-in we see from pyramid schemes and creates a ponzi like investment structure that is less constrained as it benefits from indirect recruitment.
Bayat makes an important and often overlooked point as regards the motivation for mining:
Secondly, Nakamoto combined bitcoin rewards with PoW to create a distributed scheme. Running a distributed confidence game has many benefits but it also poses problems. Sharing profits in the scheme helps to legitimize it and produce a network effect. This greatly increases the reach of the scheme, which results in greater total liquidity invested into it, and as a consequence leads to greater returns extracted by co-operators. Trust is an issue though, and the creator of the scheme needs a way to place themselves on even footing with potential co-operators. Understandably, potential participants are less likely to trust in the scheme if up front demands for money are made.
Instead of investing by giving money to a centralized authority, interested parties are asked to waste resources as a proxy for investment. By requiring the consumption of a commodity to buy in on the ground floor and acquire stake in the scheme, Bitcoin is able to create a fair playing field as the PoW mechanism does not favour a particular participant. This is an ‘honest’ way of determining stake in an open investment fraud. As no central operator is taking the money invested, the stake acquisition process is more trustworthy and attractive to potential co-operators.
Except that, as Alyssa Blackburn et al revealed in Cooperation among an anonymous group protected Bitcoin during failures of decentralization:
Between launch and dollar parity, most of the bitcoin was mined by only 64 agents, collectively accounting for ₿2,676,800 (PV: $84 billion). This is 1000-fold smaller than prior estimates of the size of the early Bitcoin community (75,000) (13). In total, our list included 210 agents with a substantial economic interest in bitcoin during this period (defined as agents that mined bitcoin worth >$2,000 at the time.) It is striking that the early bitcoin community created a functional medium of exchange despite having very few core participants.
Thus it isn't the case that in Bitcoin's initial stages there was a level playing field for miners. In fact, for the whole of 2009:
the agent with the most computational power (at the time this was Agent #1, Satoshi Nakamoto) had sufficient resources to perform a 51% attack.
Blackburn et al estimated:
the effective population size of the decentralized bitcoin network by counting the frequency of streaks in which all blocks are mined by one agent (bottom-left) or two agents (bottom-right). These are compared to the expected values for idealized networks comprising P agents with identical resources. The comparisons suggest an effective population size of roughly 5, a tiny fraction of the total number of participants.
Thus while Bayat's point about miner's motivation may be true in theory it wasn't how things turned out in the real world. In the early days very few miners consistently devoted significant resources to mining. Further, as I've been pointing out since 2014, it isn't true that "the PoW mechanism does not favour a particular participant". Economies of scale mean that PoW favors the largest participant. And thus mining pools evolved, and thus the centralization of Bitcoin continued from its beginnings to today. Today's "interested parties" are large corporations with bulk access to ASICs from Bitmain and to cheap electricity. No-one else can profitably mine Bitcoin, and at present even they can't:
Top public miners sold 14,600 coins in June whereas they produced 3,900, Mellerud said. Core Scientific sold nearly 80% of its coins to cover operational costs and fund expansion in June. Bitfarms sold nearly half of its holdings to pay down a $100 million loan in the same month."
In keeping with the cypherpunk ethos, Nakamoto's concept of mining was "one CPU, one vote". Even in the early days he was wrong, but he certainly didn't foresee industrial-scale mining with custom ASICs and Chinese mining pools:
Six out of the largest mining pools are registered in China and have strong ties to Bitmain Techonologies, which is the largest producer of Bitcoin mining hardware
Neither Dwork and Naor's nor Back's PoW schemes could have led to this kind of industrialization.

Bayat explains how in good times the halvening pushes the Bitcoin "price" moon-wards:
Thirdly ... Proof-of-work creates the investment vehicle, but it is the halving schedule which guarantees virtual investor returns. A Miner who generates 50 bitcoin by using $50 of electricity will value their bitcoin at $1. However, due to the halving schedule, in 4 years, to acquire another 50 bitcoins, the Miner will need to invest $100. As they are fungible, any bitcoin mined before the halving date is mined at a discount. After the halving date passes, the Miner must invest $2 per bitcoin in order to mine them. The Miner has doubled their money in 4 years, equivalent to approximately 19% APY.
Moreover, because other Miners have started participating over those 4 years, the hash rate and hence difficulty of finding the correct hash has increased. This means that overtime it has become more expensive to earn a bitcoin, meaning that it is possible that your investment has more than doubled after halving. The halving doubles the value of a bitcoin at the time the halving occurs. Referencing our earlier example, if the Miner had invested $1 per bitcoin mined, but just before halving it took $4 of electricity to mine a bitcoin, post halving, the value of a bitcoin would be $8. The Miner is up 8x on their initial investment.
Well, yes, but 19% APY is dwarfed by the wild swings in the Bitcoin "price". But the bigger effect of the combination of the halvenings and HODL-ing driven by the conviction that Bitcoin is headed moonwards is to drive the Gini Coefficients Of Cryptocurrencies to extremes, destroying their supposed "decentralization" and "democratization".

Finally, Bayat gets to Nakamoto's actual goal:
Fourthly, Nakamoto realized that PoW could be used to provide the utility of irreversible bitcoin ownership transfers, allowing participants to realize virtual returns either by trading bitcoin for goods and services, or for fiat currency. Bitcoin’s distributed append-only ledger allowed Miners to trade their bitcoin to one another, or to speculators, and no double spending meant a fair playing field to realize returns through fraud. This created a speculative marketplace where outside liquidity could be on-boarded into the scheme, the value of a mined bitcoin would not be constrained by the amount of electricity used to produce it. This is the mechanism that enables the ponzi and pyramid like aspects that we are familiar with in Bitcoin and the reason why the scheme is dependent on disinformation, propaganda, and indoctrination, as recruitment is necessary to realize returns.
Miners trading Bitcoin to each other wasn't a goal, and except in rare cases never happened. The goal was to trade Bitcoin for goods once merchants could be persuaded to accept it, or in the meantime fiat on the way to goods, as in the famous pizza transaction, or the Lamborghini. Initially the cost of mining was negligible, it was more the hassle factor that kept the effective mining population down to 5. Thus the current need for miners to sell their rewards for fiat to recoup their costs was not a significant consideration.

The history of the technological and philosophical underpinnings of Bitcoin make two things clear. First, while ingenious, Nakamoto's innovation was squarely in the mainstream of work on digital currencies for the previous quarter-century. Second, the libertarian goal of the cryptocurrency movement was to implement Austrian economics and thereby avoid the need to trust government and corporate institutions. Nakamoto clearly shared this goal. One can argue that fraud is an inevitable consequence of the libertarian program, but that does not make it the goal of libertarians.

Bayat makes his case for Nakamoto's malice aforethought explicit:
Have you ever wondered why Bitcoin makes such a poor payment network? Why Nakamoto ignored or sidestepped questions on the transactional performance of Bitcoin and instead would focus on bandwidth? What about the transactional profile of Bitcoin being far closer to something used to register real estate transactions, rather than a global payment network? The answer is clear, transactions in Bitcoin are not meant to facilitate payments in the typical sense, they are useful insofar as they allow Miners and speculators to realize returns on their investments.
The bandwidth issue is a red herring. Bitcoin's gossip network is expensive in bandwidth and, back in 2008 when Nakamoto was expecting miners to be using desktop PCs, most would be at the far end of a DSL link with restricted bandwidth. It is true that as Bitcoin stands now its transaction rate is limited to ~7 transaction/sec but in the early days that was more than adequate, and if it wasn't the fix was obvious. The limit is not in fact transactions per second but minutes per block. All that would have been needed to raise the rate was to increase the block size.

A speculative and deflationary ‘asset’ makes for a poor currency, people are disincentivized from using it today, as it might be worth considerably more tomorrow. This very criticism was leveled against Bitcoin on the BitcoinTalk forums in February 2010, as the design of coin rewards combined with the halving schedule rendered the protocol useless as a currency. Few would spend something whose value appreciated 19% every year. Nakamoto participated in this very forum thread and was well aware of the criticism, but shrewdly chose not to address the issue directly, ever careful to misdirect, lest too much attention be paid to Bitcoin’s fatal flaws.
Note the date Bayat cites. This was 15 months after Bitcoin launched, when the idea of making a major change to the design, and in particular one that conflicted with Austrian economics, would have been understandably unpopular. Only a month or so earlier Nakamoto had still had more than 50% of the mining power. The nascent network had much bigger issues to deal with than the long term conflict between Austrian economics and reality.

More than 13 years later, Bayat's 20/20 hindsight correctly identifies a set of Ponzi and pyramid scheme attributes of Bitcoin. These were not so easy for libertarian cipherpunks to see at the time. He offers no real evidence for his allegation that Nakamoto intended Bitcoin to be a fraud. Were this to have been the case, surely at least some of Nakamoto's stash of about 1M Bitcoin would have moved in the intervening years. It is a strange fraud from which the fraudster refuses to benefit.


  1. I will be reusing this: "One can argue that fraud is an inevitable consequence of the libertarian program, but that does not make it the goal of libertarians."

  2. From the "papering over the problem" department comes Brandon Vigliarolo's DeFi credit scores: Coming soon to a blockchain near you:

    "Where web3 credit scores differ from their analog ancestor is in how they define identity, and how easy it may be to fool them. Web3, cryptocurrency, and DeFi are all about anonymity, which makes it tough to see how credit scoring – a necessarily intrusive concept – can eliminate rampant web3 fraud without upsetting many of its advocates."

  3. The crptocurrency industry is running out of "greater fools", as Steven Zeitchik reports in Crypto’s massive marketing efforts have drawn few new investors:

    "Over the past year, crypto companies like FTX, Coinbase and Crypto.com have shelled out tens of millions of dollars to attract new customers. “Fortune favors the brave,” Matt Damon famously said in a Crypto.com TV spot as he tried to induce Americans to open their digital wallets.

    Now a core metric of how successful they were has been returned, and experts say it’s an eye-opening one: not successful at all. The number of people who invested in crypto has not expanded since last September before the push began, according to a new study led by Pew Research Center."

  4. I have responded to Dr. Rosenthal's critique.