Ponzi Schemes, Pyramid Schemes, and Multi-Level Marketing

“Bitcoin is a Ponzi scheme!”

With those five words you have inescapably labelled yourself as clueless both about Bitcoin, and Ponzi schemes.

But fear not — by reading this article you can educate yourself, and as an added bonus, gain valuable weaponry in your war against all things cryptocurrency and blockchain token related.

Introduction

A common accusation leveled against blockchain token and cryptocurrency projects is that they are Ponzi schemes. This accusation is often made by people who don’t seem to know what a Ponzi scheme truly is, although very very rarely they are inadvertently right.

Other times, what they are describing is a pyramid scheme, and sometimes the project may actually fall under the umbrella description of a multi-level marketing system. But most of the time, cryptocurrencies and blockchain tokens are none of these.

I think the best way to explain all of this is to start at the legal and acceptable end of the business spectrum, and work backwards.

Business and Sales 101

If I have a product (which could be a real physical thing, such as moisturizer or cleaning supplies, or a virtual thing, such as insurance, a sandwich shop franchise, or lottery tickets), as a business operator I want to sell these things at a profit. As an individual sales person there is a limit to how many people I can reach in a day, and therefore how many sales I can make.

As a result, one approach I can take is to hire more sales people, and provided the amount I pay them is less than the profits I make, such an approach can significantly amplify my gains.

This is perfectly legal, and a common approach taken by businesses both large and small. By paying a commission, namely a percentage of the profits, I can ensure that I don’t hand over more to cover sales costs than I make, and as an added advantage, commissions incentivize my sales force to make more sales.

Although my net income percentage is reduced by paying commissions, if the overall revenue and profits increase, such an approach is probably worth taking.

As an aside: note that it is not illegal to sell something that has no use and no value as far as the average person can ascertain.

Multi-Level Marketing

I am still limited by the number of sales personnel I can recruit — after all, I also only have so many hours in a day to spend on recruiting. Enter multi-level marketing (or MLM).

In multi-level marketing, not only do I farm out the sales process, I also farm out the recruiting process, by offering my sales people a reward for bringing in more sales representatives. The downside of this is that a larger percentage of my profits go to the ever-growing sales department, but again, if that growth brings in profits which exceed my non-MLM approach after commissions and recruitment rewards are paid, it may still be a tactic worth employing.

Typically a sales representative will now get a commission for the sales they make, and a percentage of the sales that the representatives they recruit make. Sometimes the recruitment rewards trickle up the pyramid several levels, which really incentivizes representatives to go out and bring more fresh meat into the fold, because it dangles the dream of passive income in front of them — if you recruit enough people who recruit enough people, and so on, then eventually you may not have to go out and sell anymore, because your personal sales force will be doing that for you.

The problem with multi-level marketing is that the incentive structure has to be carefully thought out, and this is rarely done.

If the rewards for recruiting are perceived to be substantially higher than the rewards for selling the product, then the sales representatives may end up focusing most if not all of their efforts on recruiting more sales people.

Although this makes sense at a local level, globally it results in no product sales, hence no profits, and the whole structure becomes unsustainable.

Building a pyramid

This is what happens in a pyramid scheme. The underlying product is ignored (either on purpose, or because of bad incentivization), is unprofitable, or does not even exist. If you take an MLM system and add in a payment requirement for joining the scheme, you are heading deep into pyramid scheme territory.

The system may look profitable, because the earlier tier of representatives are receiving an income from the later tiers, but that income is also unsustainable. More and more tiers need to be added every cycle, because the input of funds from those later tiers is what provides the profits for the earlier tiers.

Eventually the pyramid scheme runs out of people to recruit, income dries up, and the whole thing collapses. All that has happened is that the wealth of the lower tiers has been redistributed to the higher tiers.

This is clearly a scam.

And so the risk to valid MLMs is that they often become pyramid schemes.

But what about Ponzi schemes?

In a Ponzi scheme a fraudster masterminds a scam by presenting a fake investment opportunity, and uses funds from later “investors” to pay out returns to earlier “investors”, making the fake investment opportunity seem profitable. The investors are passive — they hand over their funds, and wait for the promised returns.

The scheme eventually collapses, because the only influx of funds is from future investors. If those can’t be found, the existing ones can’t be paid, and even if the fraudster has not withdrawn any money to finance their own lavish lifestyle the scheme cannot be sustained.

There are no real profits, and so the fraudster is required to fake them, while shuffling money around to make it seem like everything is legitimate. Ponzi schemes thus involve deception.

So how do Ponzi schemes and pyramid schemes differ?

If the fraudster adds a bonus for signing up more investors, requiring the investors to put in some effort for recruitment, then the Ponzi scheme has become a pyramid scheme, especially if there is a chain referral bonus, where investors get some of the gains obtained by their recruits signing up further investors.

Of course, early investors may recruit more participants by word of mouth because they are so pleased with their returns and they like to brag. But in that case, there are no explicit bonuses for recruitment — those are implicit in system, and the investors are usually not even aware of the fact that their returns are coming from subsequent investors.

The fundamental differences between a pyramid scheme and a Ponzi scheme are thus:

• the lack of an explicit or formal reward structure for recruiting further members in Ponzi schemes, and
• the fact that Ponzi schemes always involve the falsification of reports of profits, whereas pyramid schemes may report the actual flow of funds accurately.

The resemblance between Ponzi schemes and pyramid schemes is further complicated by the fact that pyramid schemes do not have to be structured as pyramids. They can be set up as a chain (i.e. the pyramid is a tower), or by pooling the tiers, that is, every participant gets a equal share of the influx of funds, or a share proportional to how long ago they joined, rather than how many participants there are between them and the scheme founder.

Apples and oranges

Finally, it is worth noting that buying something inexpensive and selling it at an increased price is not a Ponzi scheme. If I buy apples when they are cheap and sell them on to you when the price of apples rises, and the apple price subsequently drops before you can sell them, I am not operating an “apple Ponzi scheme”.

I am just a shrewd wholesale market greengrocer.

Are stocks and shares Ponzi schemes?

A company registers with the regulators (for example, the SEC in the USA) for an initial public offering (IPO) of shares. The market goes wild, the stock price rises, and more people buy in to this fantastic opportunity, causing the stock price to rise even more.

Eventually the market cap of the company is hundreds of times its annual revenue, and it is clear the company is never going to earn enough to justify that. The stock price collapses.

Is this a Ponzi scheme?

No, provided the company was honest about its accounts and its revenue sources. The fact that the early stock buyers managed to offload their shares at a great profit to them, and a terrible loss to the later buyers is just an aspect of public marketplaces.

Is it a pyramid scheme?

No. There is no explicit formal reward scheme paying early purchasers of shares for encouraging later investors to buy shares too. The profits are an emerging property of the marketplace, not a result of the company bylaws.

Is it unfortunate for people who bought high, and had to sell low?

Yes. They should probably consider a career in a field other than trading.

When is a blockchain token or cryptocurrency a scam?

Most blockchain token projects that are labelled as Ponzi schemes are, at worst, pyramid schemes because blockchain tokens are, generally speaking, implemented on an open public ledger. As a result, anyone can investigate the mechanism whereby tokens and money flow from new investors to old investors.

And remember — for something to qualify as a Ponzi scheme there needs to be deception by forging accounts or making up sales or imaginary external profits for the scheme.

For something to qualify as a pyramid scheme, there has to be an explicit reward structure for recruiting new participants. Again, some blockchain token projects offer affiliate token awards, which might make them pyramid schemes, but most don’t, preferring to rely on the exchange prices signaling to potential buyers that their token is hot.

In a blockchain token project, the gains made by individual participants are typically realized on those exchanges, which are external to the project (centralized or decentralized), in the same way that share profits are realized on stock exchanges.

This is neither fraudulent, nor an explicit reward structure.

For a blockchain token to be labelled as a Ponzi scheme, the project founders would have to engage in willful deception, for example, through market manipulation or by announcing fake news concerning buy-in by respected or admired investors.

None of this matters

Those of you who read my articles will know by now that I usually end them with a twist, and in this one the twist is that it doesn’t really matter if a blockchain token or a cryptocurrency is a Ponzi scheme (which it most likely won’t be), or a pyramid scheme (which it might be).

Ponzi schemes and pyramid schemes are not prosecuted for being Ponzi schemes or pyramid schemes. They are prosecuted for fraud, money laundering, tax evasion, insider trading, market manipulation, or being an unlicensed security.

In the same way that Al Capone wasn’t prosecuted and convicted for being a mobster, but for tax evasion.

Blockchain token projects and cryptocurrencies may not be Ponzi schemes or pyramid schemes, but they are frequently unlicensed securities, by virtue of the fact that the token or cryptocurrency is available to be bought publicly with the expectation of profit. And it does not matter how tortuous or circuitous the route to public accessibility is, if the public can buy it and there is reasonable expectation that buying it will result in gains, then it can also be reasonably argued that the offering is a security.

Similarly, if the project is using “staking” as a means to inflate the token price, that could be argued to constitute market manipulation. As can wash trading and churning. Fortunately for the project founders, those latter two are usually conducted by shady exchanges of their own volition.

Conclusion

So the next time you want to lambast a cryptocurrency, don’t say: “It’s a Ponzi!”

That just makes you look like a grumpy person who doesn’t understand blockchain and doesn’t want to, because they’re happy with the way our current financial and economic systems have distributed wealth.

Say instead, “It’s an unlicensed security!”

Because that is much more likely to strike fear into the hearts of the project founders and their supporters.

Which is, presumably, what you are trying to achieve.