Bitcoin: New Asset Class or Pyramid Scheme?

By Jonathan Harris, CFA Posted In: Alternative Investments, Economics, Portfolio Management, Standards, Ethics & Regulations (SER)

Merriam-Webster defines a pyramid scheme as “a usually illegal operation in which participants pay to join and profit mainly from payments made by subsequent participants.”

The former general counsel of the Federal Trade Commission (FTC), Debra A. Valentine, said the following:

“Pyramid schemes now come in so many forms that they may be difficult to recognize immediately. However, they all share one overriding characteristic. They promise consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public.”

Does a vehicle that provides no cash flows, transfers no tangible or intangible property rights, and is marketed through claims that new buyers can be persuaded to drive up prices fit this description?

I believe bitcoin is such an instrument.

Bitcoin is too inefficient to be a currency. Certainly, no government has any plans to use it as one. And when bitcoin fuels actual transactions — other than those of the speculative variety — it is often to keep the transaction off the radar of the legal authorities: think ransomware, skirting anti-money laundering laws, or evading capital constraints.

Thus the sole way most promoters will realize value from their bitcoin holdings is through new entrants into the market. Public statements by speculators illustrate this:

“If every millionaire just said, ‘I want one bitcoin,’ the price would go non-linearly higher.” — Bill Miller
“Even if they never believe in it as an asset class, they’re smart enough to recognize the alpha opportunity.” — Ari Paul

Store of Value?

The “store of value” argument also depends on new buyers coming in to support those who want to liquidate their holdings. Again, this suggests a pyramid scheme, albeit one that doesn’t promise explicitly high returns. Whatever it is, it is not a legitimate investment.

Stock appreciation ultimately implies that people owning the shares earn increasing profits. Commodities are more than just “stores of value.” Governments require the use of fiat currencies. With a few notable exceptions, governments stabilize their currencies and don’t sell them to the general public as speculative investments. For these exceptions, more stable currencies are available.

Some say bitcoin is similar to gold. In the best of cases, should ownership stabilize, bitcoin and gold would share certain characteristics: Both would be volatile investments with poor long-term returns.

But gold has other uses: To fashion jewelry and other art, for example, or even as doomsday currency should electricity and internet become unavailable. Bitcoin can’t serve either of these roles.

More likely, after the supply of new buyers is exhausted, the final investors in the pyramid will find themselves with assets that decline in value as others sell because the one thing that they expected from bitcoin — higher prices — ceases to materialize.

Social Value?

Does investing in bitcoin have any social value? Investing in the securities markets provides capital to firms, governments, and other entities. Speculation in commodities creates markets that allow their users to hedge their exposure to price fluctuations.

Bitcoin can help people evade government restrictions on currency and capital. But even that dubious distinction rarely enters the discussion among bitcoin supporters. Still, we cannot ignore laws and regulations we disagree with or governments we disapprove of. Furthermore, the same mechanisms that can help people avoid capital controls through bitcoin can also help them avoid government sanctions against unsavory regimes and engage in money laundering and ransomware schemes.

Perhaps these excesses could be tolerated if they were mere side effects. But other than for speculation, bitcoin has no utility beyond such activities. No doubt some will point to blockchain and claim that it is the silver lining to the crypto cloud, and demonstrates bitcoin’s merits as an investment. But bitcoin provides no rights to use or profit from blockchain technologies. Whatever they have to offer, one does not need to purchase cryptocurrency to use blockchain.

So encouraging the purchase of bitcoin by invoking the benefits of blockchain is clearly misleading.

How is bitcoin different from other pyramid schemes, say, those run in penny-stock boiler rooms? The only distinguishing characteristics are the record-keeping method — a “proof of work” blockchain — and a large marketing effort that uses the media instead of the telephone.

In my view, most of those who invest in bitcoin are effectively participating in a pyramid scheme either as a future victim or a perpetrator. Some no doubt truly believe that bitcoin will function as a currency for enabling transactions, rather than a “store of value.” But I wonder whether such people truly understand economics, our monetary system, or our business environment

These critiques are not unique to bitcoin, but apply to all cryptocurrencies. Some could offer value as electronic coupons to purchase yet-to-be-developed services. However, that does not constitute a new asset class, but rather an existing asset class with a new record-keeping system. So investors must apply the same due diligence as for other investments to assess what legal rights they are purchasing and the ability and willingness of others to deliver on their commitments.

It is not my intention to play the thought police here. My point is investment managers need to consider these issues before investing in or promoting cryptocurrencies. So should those responsible for personnel decisions about managers.

Because the fact is, if it looks like a pyramid scheme and sounds like a pyramid scheme, we should treat it like a pyramid scheme until proven otherwise.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.