[FAQ] Is BitCoin a Ponzi or pyramid scheme? (Newbie-Friendly)

[eMansipater]

Q:  Is BitCoin a Ponzi or pyramid scheme?

A:  No.  Like any other currency, BitCoin is designed to be used as money, not as an investment.

A Ponzi scheme is a type of confidence scam where people who think they are earning unusually high returns on an investment are actually being paid from their own money and that of later investors.   If investors try and withdraw their original investment from the Ponzi operator, the scheme collapses because no actual profits exist and there is not enough money to return the deposited amounts.  Alternatively the Ponzi operator may simply leave and take the investors' money with them.

Similarly, a pyramid scheme is a type of confidence scam where people who "enroll" by paying a certain amount of money are made to believe they can make a large return on their investment by recruiting other people and receiving some portion of their enrollment fee.  The scheme collapses because it requires exponential growth, so it quickly runs out of new people to enroll.  The person starting the pyramid scam, who didn't have to pay an enrollment fee, makes money off of all their referrals; while the people at the bottom parts of the pyramid, who cannot find anyone new to refer, are left with no return.

Unlike either of these situations, BitCoin has no person "at the top" who collects money paid for bitcoins, or has to pay out when bitcoins are sold.  Neither is there any kind of scheme in BitCoin to harvest money off of unsuspecting people in complicated ways.  Instead, bitcoins are bought and sold on public exchanges amongst members of the general public who must all obey the same rules.  If someone has told you that BitCoin is a moneymaking scheme, they have misconstrued it--bitcoins follow the same economic model as any other finite commodity and over time will tend to approach a price that reflects the value people ascribe to being able to use them.  People who have made money off of buying and/or selling bitcoins are either lucky or have correctly predicted an increase in demand for them.  People who earn bitcoins through "mining" are being paid for verifying and securing network transactions in a highly competitive market.  In neither case is any kind of fraudulent activity or confidence scam happening.  For more details on earning money through BitCoin, see the "Where do I get the free money?" thread (coming soon).

Despite the fact that BitCoin itself is not a scam, caution is strongly advised when entering into transactions with untrusted entities.  As with any other valuable commodity, there are many people willing to separate your bitcoins from you in sneaky or fraudulent ways.  Remember that for all practical purposes BitCoin works just like cash.  Bitcoin Ponzi and pyramid schemes do exist and if you fall prey to them you will suffer the consequences.

In addition, bitcoins are a very new and unproven type of money.  Because their value depends on how widely they are accepted, they are susceptible to the same types of economic bubbles as any other commodity that is surging in popularity. The Bitcoin software is still in beta, and bitcoins should be considered "high-risk" from a financial perspective.  You should not invest money into bitcoins or BitCoin-related technologies unless you can afford to lose it!  Even firm believers in BitCoin tend to think it will take a while for the value of bitcoins to stabilise, and no one knows at what value that stabilisation might occur.  Trade and transact safely!




Note:

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[Dusty]

Thank you for excellent explaination, I translated it in Italian and put it online on my website, now mainly orientated toward Bitcoin, and being the biggest source of information in Italian language:
http://ilporticodipinto.it/faq/bitcoin-%C3%A8-uno-schema-di-ponzi-o-uno-schema-di-marketing-piramidale

I tell you this in case you want to link the italian version to your index page.

Please tell me if you want me to credit you for the original text, if you want a link to this page or whatever.

I plan to translate other faq as well in the feature.

Thanks!

[evoorhees]

Very well written!

[tomcollins]

While not intended to be an investment, BitCoin certainly can be treated as one.  In particular, it is a speculative investment.  This means if Bitcoin becomes more useful, it's value may increase.  If it turns out that the usefulness is overestimated by the investors, then the value may go down.  Speculative investments are not Ponzi schemes, though.  A speculative investment IS very risky and you could lose a great portion of your investment (even all of it).  This does not make it a scam, though.

There are some similarities between speculative investments and Ponzi schemes that make some people have trouble telling them apart.  In a speculative investment, you are betting that people in the future will want to invest (or use) what you are buying.  There is no guarantee that happens.  In a Ponzi scheme and Pyramid scheme, you are betting that other people will come after you (if you are aware of what you are in).  The difference is there is no actual possible value in a Ponzi or Pyramid scheme.  You are either fooled into thinking what you are buying is valuable, or you think that there will be greater fools that come after you.  A speculative investment is different in that you actually know what you are betting on.  You still can be wrong (it might not be very valuable, or you overestimated its value), so that's why people can get confused.  Speculative investments should not be done with money you mind losing.  A speculative investment actually has a chance of paying off for everyone down the line by actually creating value.  A Ponzi scheme and Pyramid scheme collapses eventually because no value is created.

You shouldn't sink all of your retirement accounts into Bitcoin (unless you don't mind losing most of it!), but it may make a decent investment.  Do not base your decision only on what it's done in the last few months.  The past rate of growth is unsustainable for a long period of time (otherwise owning a Bitcoin would be worth all the wealth on Earth after enough time, and I don't think anyone thinks that will happen).  It might go up.  It might be overpriced now.  It might be fairly priced.  Do your homework, try to figure out what would actually make it valuable and how valuable it would be in those cases.  Figure out how likely each of those scenarios are to play out.  Figure out your risk tolerance (most people would not risk $100,000 for a .1% chance at becoming a billionaire, even though mathematics say it's a good deal).  Then invest.  Or start using them for something useful.  Buy goods where it is cheaper to buy them.  Take advantage of the semi-anonymous nature of it.  Buy something you can't otherwise purchase.  Build a business model that takes advantage of Bitcoins.

[eMansipater]

Thanks Dusty and and evoorhees!

[Iceredwing]

I like your approach to keep it simple and straight forward for the new guys. I can see this FAQ growing into much more robust hub of information about bitcoin making clear of it's facts and myths. Very nicely done. 

[brocktice]

Thanks for the good initial response to this apparently common perception of bitcoin. I've also added an explanation with a slightly different angle on my blog, here http://virtuallyshocking.com/2011/05/22/why-bitcoin-is-smart-and-not-a-scam/.

If it's ok with the OP I'd like to add a link to this thread as well.

[eMansipater]

If it's ok with the OP I'd like to add a link to this thread as well.

Go for it!

[brocktice]

If it's ok with the OP I'd like to add a link to this thread as well.

Go for it!

Done, thanks!

[RobCayman]

Hi, i'm completely new to BitCoin and am completely baffled by the concept, I'm also not 100% sure I'm asking these questions in the right place, but i will ask, and hopefully be pointed in the right direction.

1. is the 21 million bitcoins equal in value to the sum of global resources (including both physical, and  intellectual)?

2. according to what i've read, everything is transparent. Coupled with the fact that almost every country in the world considers it illegal not to pay tax on transactions, do i have any security from prosecution? or alternatively, why have governments not clamped down on bitcoins already?

3. Am i correct in saying that BitCoin is essentially a global unified on-line autonomous resource tracking system?

4. assuming that the answers to the previous questions are all positive, can BitCoins  be extended to function globally as a complete replacement for the current credit based economic system?

I hope that someone can either assist me or point me to someone who can

thanks

[FreeMoney]

Hi, i'm completely new to BitCoin and am completely baffled by the concept, I'm also not 100% sure I'm asking these questions in the right place, but i will ask, and hopefully be pointed in the right direction.

1. is the 21 million bitcoins equal in value to the sum of global resources (including both physical, and  intellectual)?

2. according to what i've read, everything is transparent. Coupled with the fact that almost every country in the world considers it illegal not to pay tax on transactions, do i have any security from prosecution? or alternatively, why have governments not clamped down on bitcoins already?

3. Am i correct in saying that BitCoin is essentially a global unified on-line autonomous resource tracking system?

4. assuming that the answers to the previous questions are all positive, can BitCoins  be extended to function globally as a complete replacement for the current credit based economic system?

I hope that someone can either assist me or point me to someone who can

thanks

1. Not yet, maybe people will value them that much someday

2. All transactions are recorded in the block chain which every node has. The transactions contain no information about you, so unless you give away the connection between 1fhdjHFS98DKJjdksDS9euDH44 and yourself then no one knows it was you who sent 3.3BTC to 1HE9hd9ejwQ3QnvJKSL4LKccn. I don't know of any countries where small gifts to friends are taxed. It's pretty wrong to say that all governments tax all transactions. Governments are slow as hell.

3. Sounds roughly correct.

4. I think so. The extensions required are mostly ease of use in a broad sense.

[eMansipater]

Hi, i'm completely new to BitCoin and am completely baffled by the concept, I'm also not 100% sure I'm asking these questions in the right place, but i will ask, and hopefully be pointed in the right direction.

Welcome here!  This is a perfectly good place to ask these kinds of questions.

1. is the 21 million bitcoins equal in value to the sum of global resources (including both physical, and  intellectual)?

Bitcoins vary in value according to supply and demand.  But if you mean will 21 million bitcoins be enough for global-level trade, then the answer is almost certainly yes.  As they currently stand bitcoins can be subdivided down to the eighth decimal place so that, as an example, even if the entire present-day U.S. economy ran solely on bitcoins, it would still be practical to buy small items with 0.00000001 btc.  Long before bitcoins would ever run into this problem, however, they could be easily "upgraded" to allow even smaller denominations.  So for all practical purposes bitcoins are infinitely divisible.  But it's unlikely that bitcoins will ever be the only currency or means of exchange on the planet.  Does this answer your question?

2. according to what i've read, everything is transparent. Coupled with the fact that almost every country in the world considers it illegal not to pay tax on transactions, do i have any security from prosecution? or alternatively, why have governments not clamped down on bitcoins already?

Are you saying that you plan not to pay taxes on bitcoin transactions or income?  Bitcoins are very much like cash:  even if your transactions aren't centrally stored somewhere, you are still expected to pay taxes.  Cash is used extensively to try and avoid taxes, so it's likely that bitcoins can be used for that as well.  But in both cases you're going to have to explain to the IRS agent where the money came from to buy your new yacht.  Trying to avoid taxes by using bitcoin is both illegal and ill-advised.

To answer your second question, governments have not clamped down on bitcoins already because they haven't needed to.  If bitcoins start to be used to fund illegal activities, launder money, evade taxes, etc. then they will simply pursue the people who do these things as they would if these things were being done with cash, gold, or expensive art.  It would be fairly impractical to shut down the BitCoin network itself, as it doesn't appear to be illegal in most countries, and has no central point where it could be blocked or turned off.  Consider the example of another peer to peer technology:  file-sharing.  P2P file-sharing has enabled activities that some governments have considered harmful, and so both civil and criminal prosecution has been used against companies or individuals participating in them.  But there's no way to shut down P2P file-sharing itself, and it would be ridiculous to make file-sharing technology illegal when it has so many legitimate uses.  Similarly, unless BitCoin devolves into some sort of black market crime tool, it won't get shut down.  But if people use it to break laws, you can be certain governments will prosecute them--both individuals and organisations.

3. Am i correct in saying that BitCoin is essentially a global unified on-line autonomous resource tracking system?

Yes, if I understand you correctly.

4. assuming that the answers to the previous questions are all positive, can BitCoins be extended to function globally as a complete replacement for the current credit based economic system?

In theory, yes.  In reality, however, people tend to use different tools for different things so that they can take advantage of contrasting features.  So it's highly likely that BitCoin will only ever be one of many tools for measuring and transferring value.  Just like many people use cash, credit cards, and PayPal, there will probably be many different products that offer different features and services.  It's conceivable that all of these could end up being built on BitCoin in a similar way to how many world currencies are based on the U.S. Dollar, but we're a long way off from that happening so that would be pure speculation.

I hope that someone can either assist me or point me to someone who can

thanks

You're very welcome.  I hope my answers were helpful--feel free to ask or explain more if you need to.

[RobCayman]

Thanks, what a wonderful answer.

I do not intend to use BitCoins to evade Tax. That would undermine a global system that at the moment has no recourse but taxes. I am South African, so not 100% familiar with the US taxation laws, but doubt very much they are different to our own.

The main reason I asked what I asked, is because I am currently writing about How to get to a world without a credit-based economic system. Bitcoin fits every requirement for acatalyst to Unified Global Autonomous Resource Based Economy, and the elimination of the trust factor is a stroke of genius.
Someone needs to write a layman's explanation of BitCoin and spread it into other systems. In that one stroke could come the end to many global inadequacies, from resource mis-management, to war, poverty hunger, health care and even education. for a summary of the work I am busy with, please see my blog pages under the pseudonym Rob Cayman : http://therantingsofrob.blogspot.com/2011/05/getting-to-a-better-world-without-money.html
and
http://therantingsofrob.blogspot.com/2011/05/getting-to-a-better-world-without-money.html

I promise that they are good reads even if my thinking is flawed.

I am definitely using and spreading the BitCoin concept!!! Awesome!!!

[eMansipater]

Fascinating stuff, Rob!  I'll have to read more of it when I get a chance.   I agree that with some careful implementation BitCoin could have incredibly powerful economic consequences.  But something tells me there's still a lot of hard work to be done to get there, so I'm diving in!

[hiakuryu]

I'm not worried about it being a Ponzi or a Pyramid scheme but...

Everyone is pontificating on the economics of it, but what is the crypto doing? The client source code is there, nice... I guess... But that is just going to tell you or me that it's a client to solve a crypto puzzle block. What is it that it's doing? We're running a distributed computing app that works on blocks of a cryptographic puzzle and we don't know what the puzzle is. What are we actually doing with our computer cycles? What is it that we're actually decrypting or encrypting? Until the server side source code is released I'm not touching this because of the commercial and national security implications.

It doesn't help that Satoshi himself is so wrapped in mystery. No one knows who he is or why he's done this. People talk about transparency, trust and decentralisation in the system, but without the server source released and no knowledge of satoshi's background there is a giant black hole with absolutely no transparency whatsoever and no trust for me at all with this guy. If it's all that he says it is then why doesn't he come up and tell us who he is? We're geeks and for the most part we're meritocrats. We'll put our hard earned real life money behind someone who can actually do something for real. We're not gonna dismiss someone for being a girl or a guy or a child or gay or even a furry. Unless there is more transparency throughout, including the motivations of the founder and some background I won't touch it and will strenuously tell people not to go near it either.

[brocktice]

... without the server source released and no knowledge of satoshi's background there is a giant black hole with absolutely no transparency whatsoever and no trust for me at all with this guy...

There is no server source. There's no server. It's peer to peer. Everything about bitcoin is in the published client source code. If you look around these forums you'll see the cryptography discussed in depth. It's also explained in Satoshi's paper.

[frog]

2. All transactions are recorded in the block chain which every node has. The transactions contain no information about you, so unless you give away the connection between 1fhdjHFS98DKJjdksDS9euDH44 and yourself then no one knows it was you who sent 3.3BTC to 1HE9hd9ejwQ3QnvJKSL4LKccn. I don't know of any countries where small gifts to friends are taxed. It's pretty wrong to say that all governments tax all transactions. Governments are slow as hell.

Isn't this a vulnerability? What if a Dull starts transacting 0.01 BTC to another Dull and back again, continously?
the chain will grow bigger than my harddrive is?!

[adrian33]

Satoshi is an encrypted identity, he might be helping out on the board or wherever, you just don't know. 

[barbarousrelic]

I'm not worried about it being a Ponzi or a Pyramid scheme but...

Everyone is pontificating on the economics of it, but what is the crypto doing? The client source code is there, nice... I guess... But that is just going to tell you or me that it's a client to solve a crypto puzzle block. What is it that it's doing? We're running a distributed computing app that works on blocks of a cryptographic puzzle and we don't know what the puzzle is. What are we actually doing with our computer cycles? What is it that we're actually decrypting or encrypting?

https://en.bitcoin.it/wiki/FAQ#What_is_mining?


And, as broctice has noted, all Bitcoin source code is open source. There is no trusted server, everyone running the Bitcoin client is also a server.

[Meni Rosenfeld]

@hiakuryu - what brocktice said, and:

but what is the crypto doing? ... What is it that it's doing? ... What are we actually doing with our computer cycles? What is it that we're actually decrypting or encrypting?

See protocol specification. And you're not encrypting or decrypting anything, you're hashing.

No one knows who he is or why he's done this.

That's kind of the point, we don't know and we don't care, because it's not about him. He doesn't have more power over Bitcoin than anyone else.

People talk about transparency, trust and decentralisation in the system

People talk about transparency, decentralisation and the fact that trust is not needed because the Bitcoin protocol relies on proof-of-work, not trust. (Compare to actually making trade with bitcoins, which requires some sort of trust, reputation or mediation).

2. All transactions are recorded in the block chain which every node has. The transactions contain no information about you, so unless you give away the connection between 1fhdjHFS98DKJjdksDS9euDH44 and yourself then no one knows it was you who sent 3.3BTC to 1HE9hd9ejwQ3QnvJKSL4LKccn. I don't know of any countries where small gifts to friends are taxed. It's pretty wrong to say that all governments tax all transactions. Governments are slow as hell.

Isn't this a vulnerability? What if a Dull starts transacting 0.01 BTC to another Dull and back again, continously?
the chain will grow bigger than my harddrive is?!

There are mechanisms in place to stop transaction spam.