History’s Biggest, Dumbest Pyramid Scheme. (Q: Is It Crypto?)

Hello, friend. How’d you like to get rich — like, really, really rich — just by selling some crap?

You’ll have to pony up a little to buy the crap from someone who got in before you. But don’t worry; all you have to do is convince enough other people to join you in supporting our crap business, and you’ll be able to turn around and re-sell it at a huge mark-up down the road.

Sure, that only works if there are enough people left who still want to buy it before word gets out that it’s… well, crap. But that could never happen here, because this is no ordinary crap.

It’s on the blockchain!

I make no bones about being in the crypto skeptic camp. Maybe it’s the cynicism that comes from working at the SEC for 16 years. You see enough come-ons about how this hot new thing is gonna make us all millionaires, and alarm bells go off when everyone starts shilling some technologically-complex paradigm-changer they can barely explain but which is guaranteed to go up, up, up.

Now, I don’t just defer to the government line on this. I spent the other half of my securities litigation career on the defense side, representing clients contending with government investigations. So I’m no stranger to SEC enforcement overreach, nor to the ways in which the agency’s notoriously slow rule-making process can create regulatory uncertainty. Indeed, when I returned to private practice in 2013, I had clients in the crypto space, and I observed firsthand how legitimate players trying to operate in the still-nascent blockchain economy were stymied by the regulators’ lack of guidance.

Still, while I have sympathy for serious people trying to devise applications for decentralized Web3 architecture, it’s hard for me to shake the realization that… well, pretty much the whole thing is a colossal sham.

Some crypto skeptics impugn crypto as one big Ponzi scheme. They’re wrong; it’s not a Ponzi scheme.

It is, however, a massive pyramid scheme.

Yes, these things are (sort of) different.

A Ponzi scheme is a non-legal term used to characterize any fraud where the illusion of an investment’s profitability is maintained by funneling a portion of the money raised from new investors back to earlier investors in the guise of legitimate returns. (The balance of money is kept by the perpetrator of the fraud, almost invariably being spent on cars, jewelry, Vegas trips, and prostitutes. Honestly, of the countless Ponzi schemes I investigated while at the SEC, I can’t think of many where most of the money wasn’t blown on cars, jewelry, Vegas trips, and prostitutes.)

The late Bernie Madoff perpetrated the largest Ponzi scheme in history by taking new investors’ funds and sending some of it to prior investors, characterizing it on bogus account statements as returns on a successful trading strategy that, in reality, did not exist. As long as investors saw regular returns, they were willing to re-invest in Madoff’s business, or refer it to their friends and family… who supplied further capital to allow Madoff to keep the scheme going for more than two decades.

Of course, a Ponzi scheme can only endure as long as new money keeps rolling in. Once it stops — as happened for Madoff when the 2008 market collapse led investors to demand redemption of their existing investments — the whole thing blows up. Madoff’s investors were out billions of dollars when he ceased making payments to them.

So is crypto a Ponzi scheme? Not really, if only because most people aren’t getting anything back to create the illusion of profitability. Most crypto purchasers are simply taking it on faith that the tokens, or NFTs, or whatever mythical blockchain-based instrument they’ve bought, will one day be worth a lot of money. That said, there have been crypto Ponzi schemes, where scammers have sold interests in phony crypto-related investments and made Ponzi payments to carry out the scheme; but to call crypto an inherent Ponzi scheme isn’t correct.

But pyramid scheme? That’s a different story.

A pyramid scheme is a type of scam where investors receive a cut of the money invested by anyone they recruit to the enterprise. Perhaps you’re familiar with the concept of multi-level marketing (MLM) — Amway, Avon, Herbalife, and so on? You pay fees for the “privilege” of selling a product to friends and neighbors (Cosmetics! Vitamins! Colorful leggings! Tupperware!) — but the real money is made by recruiting some of these friends to also start selling the products, and you get a cut of the fees they pay, as well the fees paid by their “downstream” recruits further down the pyramid.

MLM isn’t itself illegal. (Though it’s usually very, very dumb. Please don’t do it.) Where it crosses the line — at least in the eyes of the SEC, the Federal Trade Commission, and other law enforcement authorities — is when the only way to turn a profit is not through sales of dubious homeopathic remedies or lipstick or whatever, but by recruiting new salespeople and generating fees for yourself (and those higher up the pyramid) from these recruits. In this respect, pyramid schemes have some overlap with Ponzi schemes — the profits made by earlier participants are generated not by legitimate business activity, but out of the payments made by newer participants.

And, like Ponzi schemes, pyramid schemes only work as long as there are new dupes… er, work-at-home entrepreneurs… willing to buy into the enterprise. Once those dry up, anyone who has yet to recoup the fees they paid up-front — much like Madoff’s investors, whose principal couldn’t be recouped from newer investors — is, in technical terms, shit out of luck.

Of course, some MLM schemes dispense with the fiction of selling a product entirely; much like chain letters where you send a dollar to everyone already on the letter and add your name to the bottom of the list, they expressly promise that you’ll get rich simply by recruiting new investors and getting a cut of their buy-in. These make absolutely no economic sense as a matter of basic math or logic, yet people still fall for them. I investigated a few of these frauds in my SEC days, and the common refrain was, “Ok, it may be a scam, but I’m getting in early enough that I’ll get my money back.” Not surprisingly, they usually didn’t.

Which brings us to crypto.

Maybe you’re putting your money into some cryptocurrency that has no real value today, but is sure to find some fantastic “use case” down the road. Maybe you’re buying a .jpg of an ugly cartoon monkey. Ultimately, the value of this investment is wholly dependent on recruiting more and more people to that particular token or project or NFT, driving up its value so you can exit at a profit. But like the poor fool who paid a fee for the honor of buying a garage full of dietary supplements they’ll never resell, at some point there’s nobody left interested in joining their little enterprise, and current holders are out their money with nothing to show for it but for a few lines of code on a blockchain.

Yes, I know, some crypto is “real.” There are established use cases; there will presumably be more. But unless you desperately need to convert your fiat currency (read: actual money) into Bitcoin so you can order heroin on the dark web, or pay off the hackers who locked you out of your online accounts, the only reason most people are buying crypto is because they think it will rise in value; and the only way this will happen is if the current crypto holders convince enough people that they, too, need to put their money into this particular token or digital taco. The day that stops working… well, you get it.

That’s why you see so much cheerleading for crypto, whether from anonymous Twitter accounts with those creepy laser-eye avatars or from some of the most prominent VC funds in Silicon Valley. When someone invests in a mutual fund, they don’t immediately turn around and tweet, “Dude! Vanguard S&P Index! To the moon 🚀 🚀!” Why? Because (at least in theory) the return on that investment will be based on the financial performance of the various companies held by the fund. But for the latest, greatest token out there, it will only pay off if they get enough of their online friends (or Sand Hill Road golfing buddies) to also jump in.

That’s what makes the debate about whether or not cryptocurrencies are securities so amusing. A lot of crypto buyers are out of breath yelling at the SEC to get out of the way of innovation, chatting up all the ways this hot new cryptocurrency will change the worlds of finance and beyond and should be out of reach of regulators. Yet none of them are buying the tokens to change the worlds of finance and beyond; they are buying because they think the token will increase in value, and this will only happen if they can convince enough other people to also buy the tokens.

Bottom line: Yes, I’m painting with a broad brush here. Decentralized blockchain technology may be able to solve certain identifiable problems. Alternative currencies may find some legitimate, non-heroin and ransomware-related acceptability. But for the most part, crypto investors are paying to buy into an enterprise with no intrinsic value aside from the hope that downstream investors are also willing to make that gamble. And when that stream dries up — because investors have moved on to the next get-rich-quick fantasy or the regulators step in to halt a violation of the securities laws — they’re going to be left with little but the digital equivalent of a closet full of unwanted energy drinks.