Several readers of my most recent op-ed on cyber currencies, “Bitcoin is a Ponzi scheme, and it will collapse like one,” criticized my characterization of cyber currencies, and specifically bitcoin, as Ponzi schemes. I will explain why cyber currencies in fact are akin to a Ponzi scheme even if they are not criminal frauds.

Friday's unprecedented collapse of cyber currency prices reinforces my Ponzi scheme characterization of cyber currencies. Bitcoin, the dominate cyber currency, hit an all-time peak, slightly above $20,000 last Sunday morning before beginning a moderate price slide that accelerated in the early hours of Friday morning Eastern time.

ADVERTISEMENT

By late Friday morning, Bitcoin's price had dropped to $11,833, a 41-percent decline from Sunday's peak. Every other cyber currency reported on the coinmarketcap.com website showed similar, if not greater price declines. The decline in the market value of all cyber currencies exceeds $100 billion; bitcoin alone has lost almost $40 billion of market value.

The collapse of cyber currency prices over the last 24 hours powerfully reinforces my assertion that at their core, cyber currencies are Ponzi schemes, or certainly close Ponzi cousins. This price collapse also destroys any belief that cyber currencies represent a reliable store of value — anything but!

Ponzi schemes, such as the one Bernie Madoff operated for years, are fraudulent because they promise returns to investors that are totally illusory. Ponzi operators such as Madoff use cash received from recent investors to repay earlier investors, returning not only their original investment, but also a “profit” presumably earned by the operator while holding that “investment.” Ponzi operators also pocket a portion of what they collect from investors.

Since Ponzi schemes rarely invest in anything with a real or intrinsic value, such as stocks, bonds, property, businesses, etc., which generate real income, Ponzi schemes do not generate any real profits. The same is true for all cyber currencies — there is nothing real about them.

While cyber currencies do not have an operator, per se, “miners,” who produce and sell fresh “cryptocoins,” collectively are comparable to the operator of a Ponzi scheme. The coins that miners earn are the equivalent of what a Ponzi-scheme operator pockets from the funds he collects.

Put another way, cryptocoin mining generates a negative value-added — the mining activity consumes real resources, notably the electricity used by the miner’s computers, yet all this activity generates no real value, only a fictional asset that nonetheless can readily be bought and sold.

That cryptocoins have any market value — people willingly exchange dollars, euros, yen, etc., for cryptocoins like bitcoin — derives solely from the belief that the coins will continue to rise in value without end. As with Ponzi schemes, the greater fool theory is alive and well in the world of cyber currencies.

The greater liquidity — the ability to buy and sell large amounts of a cryptocoin without materially affecting its price — of bitcoin and other coins with large amounts in circulation does not constitute real value because the coins themselves have no substantive value. That is, being able to easily buy or sell large quantities of nothing hardly represents economic value.

Ponzi schemes inevitably crash when incoming cash from investors is no longer sufficient to cash out earlier investors and pay them a “profit,” too. Usually, the crash occurs when enough nervous investors suddenly try to cash in their investments, sucking out all of the operator’s cash. Once the operator begins to default on making payments upon demand or when promised, the game is over and that Ponzi scheme is no more.

The same phenomenon — the desire to quickly liquidate an investment before prices drop even more — will occur with cyber currencies as there will be far more sellers than buyers for a particular cryptocoin. That imbalance will quickly cause the price of that cryptocoin to plunge, as we saw so clearly on Friday. If investors bravely buying that cryptocoin as its price is dropping cannot arrest that price drop, then it will continue.

Since nothing of substance differentiates one cryptocoin from another, except possibly the rate at which they are mined or their perceived liquidity, contagion will quickly spread to other coins, as we saw Friday, much as a run on one bank can trigger runs on other banks. Unlike banks, though, there is no insurance comparable to bank deposit insurance to protect investors from a collapse in the market value of their cryptocoins.

Conceivably, futures contracts on specific cyber currencies or, eventually, cryptocoin shorting could help to cushion a plunge in cryptocoin prices, but given the infant stage of these futures contracts — they only recently became available for bitcoin — investors cannot place much confidence in hedging strategies to protect against a collapse in bitcoin’s price, much less cryptocoin prices generally. It will be interesting to see what impact today's price collapse will have on this futures market.

An additional threat to elevated cryptocoin prices is the proliferation of crypto currencies. As of noon Friday, Eastern time, coinmarketcap.com listed prices and current market capitalizations for 1,375 crypto currencies with a total valuation of $437 billion; bitcoin accounted for $205 billion, or 47.0 percent, of that valuation.

While bitcoin’s champions assert that the maximum supply of bitcoins will never exceed 21 million, in fact there is no legally enforceable guarantee that the supply of bitcoins could not be increased above 21 million.

Further, given that there is no substantive difference among cryptocoins — they all are equally illusionary and have no intrinsic value — no individual cryptocoin, not even bitcoin, will be immune to the price-depressing effects of a never-ending increase in the quantity of all cryptocoins.

Just as paper currency loses value when the printing press is cranked up and an economy is flooded with that currency (witness Venezuela today), so too will cryptocoins lose value when the quantity outstanding grows rapidly.

As cryptocoin investors wake up to this possibility, they will be much more inclined to sell rather than buy cryptocoins when coin prices begin a sustained decline. That certainly has been evident Friday, as many cryptocoin investors are rushing to sell their coins before prices drop further. That rush to sell must be especially intense among those who have leveraged their cryptocoin bets.

I will not venture a guess as to when or where the collapse in cryptocoin prices will finally bottom out, but if nothing else, this collapse should irreparably undermine the belief so many "investors" have had in cryptocurrencies. Viewing them as variants of a classic Ponzi scheme will help greatly to put cryptocurrencies in a proper perspective.

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking industry, monetary policy, the payments system and the growing federalization of credit risk.