Are Cryptocurrencies Ponzi Schemes?

With the recent collapse of trading company FTX, the question has often been raised of whether cryptocurrencies are Ponzi schemes. A short answer to this question is that some are and some aren’t, just like some stocks are suitable investments and others are not. 

Although people talk a lot about cryptocurrency and blockchain, many know very little about blockchains, especially if they have never written a single line of blockchain programming code. For example, had they done the programming, instead of making a statement such as “public blockchains will survive but not cryptocurrencies,” they should have realized that running a code on a public blockchain most likely requires a certain amount of the cryptocurrency associated with the blockchain (e.g., the “gas” in the ethereum network in terms of ether) to pay for every operation within the code, such as addition, multiplication, sorting, etc. Therefore, these public blockchains (that support smart contracts) and cryptocurrencies (that pay for programming codes) go together: They will burst together or survive together. 

To appropriately answer the title’s question, one has to go back to the genesis of cryptocurrencies used to solve the double-spending problem. There are two main difficulties in creating an anonymous digital currency. First, just as people can easily copy music and movie files (but aren’t supposed to), how do we prevent people from copying digital currency tokens electronically? Second, how do we prevent the double-spending problem in which a single digital currency token can be spent more than once to settle liabilities? The first problem can be solved by using modern cryptography. The second problem is much more difficult.

Double spending simply means the same money is spent twice. For example, A pays $100 to B for a product. However, after B delivers the product to A, A may revise the original transaction record and claim that the $100 was paid to account A' (which could be another account owned by A) rather than to B. If A can successfully do this, the $100 is spent twice, resulting in double spending.

A computer science revolution started in the bitcoin network is that the double-spending problem may be solved in a probabilistic way by using blockchains and “mining” (a form of proof-of-work), with the cryptocurrency bitcoin being introduced to incentivize people to do mining. Another breakthrough came in late 2013 when Vitalik Buterin (born in 1994!) extended the idea of bitcoin by introducing “gas” to create the ethereum network, in which people can write smart contracts more generally. Smart contracts can be executed online automatically without a central authority. The cryptocurrency generated and circulated on the ethereum platform is ether. The gas in the ethereum network refers to charges in ether for every programming operation within the code, such as plus, minus, multiplication, sorting, etc. In this regard, ether is like airline mileage that one can buy and sell, although it has much more liquidity. Just like airlines can go bankrupt, a cryptocurrency can be worthless.

One can buy cryptocurrencies from online exchanges or ATMs inside grocery stores. There are hundreds of cryptocurrencies, if not thousands. This is the main problem.

Here is a comparison: Euro is a single currency that is used by about 20 countries. However, it took years for economists to understand its monetary and fiscal impacts before officially launching the euro, not mentioning the tremendous legal and legislative efforts. A Nobel Prize was given to Robert Mundell for doing just that. In view of so many cryptocurrencies, one important decision society has to make is choosing between enacting new laws or better educating consumers and investors. This is similar to how we treat diseases: Should we invent new drugs or enhance people’s immune systems?

Thus, we should be astonished that the dust created by so many cryptocurrencies used in hundreds of countries can be quickly settled any time soon. Therefore, there will unavoidably be many Ponzi schemes related to cryptocurrencies. In the meantime, let us recall what Isaac Newton had legendarily proclaimed when asked about stock markets: “I can calculate the motions of the heavenly bodies, but not the madness of the people.”