Since crypto exchange FTX collapsed into bankruptcy and its Ponzi-like shell game with investor money was revealed, many commentators have doubled down on their criticism of cryptocurrencies as a type of Ponzi scheme.
For those who need a review, Ponzi schemes start with an initial investment from an early round of investors, and the money is then used (and spent) for the purposes of the general partners or issuers of the investment product. When the time comes that the original investors want to withdraw their funds, their investments are returned through funds invested by subsequent rounds of investors, giving the illusion of solvency and returns.
Similarly, FTX kept making funds available to earlier investors on its exchange using the deposits of subsequent investors – those earlier investments had been swept away to Alameda Research, an affiliated hedge fund.
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The FTX revelations have led a chorus of voices – including actor Ben McKenzie and Nobel Laureate economist Paul Krugman – to allege that cryptocurrencies in general are a Ponzi scheme.
Why crypto isn’t a Ponzi scheme
Let’s be clear: Though bad actors are using cryptocurrencies as a medium with which to conduct Ponzi-like schemes, crypto itself isn't a Ponzi scheme.
For one thing, tokens like bitcoin (BTC) and ether (ETH) do hold value, even in down markets and don't depend on inflows of new money to pay off investors. Rather, holders of these tokens can exchange them for other items of value, or fiat currency, any time they can find a counterparty willing to take their crypto.
There is no central entity giving these tokens the illusion of value, but instead, the investing public’s willingness to pay $17,000 or $21,000 or $68,000 for one bitcoin determines the ultimate market value of the token.
The most popular cryptocurrencies are able to deliver value in and of themselves without the manipulations of a Ponzi scheme operator.
What crypto tokens can do
And as a reminder to financial advisors, cryptocurrencies do have fundamentals and real-world use cases.
Here are a handful of functions that cryptocurrencies provide:
1. Medium of exchange
As 2022 comes to a close, cryptocurrencies can be used as a medium of exchange at hundreds of retailers, including AMC Theatres, Virgin Galactic and Cheap Air. Many of these retailers use BitPay, a service that for a small fee converts crypto into the currency of a vendor’s choice within the flow of a transaction.
Holders of bitcoin can also convert their coins into fiat cash at bitcoin ATMs or via a debit card prepaid with their tokens.
And while many people argue that the volatility of bitcoin and other popular cryptocurrencies makes them unfit as a medium of exchange, stablecoins that don't fluctuate in value are on the rise.
The reputation of stablecoins was tested this year with the collapse of some “algorithmic” stablecoins like Terra/UST. However, they still have the potential to overtake paper currency by accommodating fast, safe and precise digital payments. Central banks are taking this challenge seriously by working to develop digital currencies of their own.
2. Foreign exchange
Using tokens for cross-border remittances continues to be one of the more popular uses for cryptocurrencies.
While many critics have lambasted the volatility and uncertainty of cryptocurrencies compared with fiat currencies like the U.S. dollar, many other international currencies suffer from high volatility and inflationary pressures far beyond those felt by the dollar.
Tokens like bitcoin are still able to move across borders faster and cheaper than fiat currency.
3. Decentralized applications (dapps)
Blockchain technology and digital tokens are being applied to problems far beyond those involving investors, advisors, exchanges and digital broker-dealers.
The technology is being applied to issues in real estate, agriculture, healthcare, gaming and supply-chain management, among others.
Tokens, distributed through initial coin offerings, are programmable assets that use smart contracts to automatically execute transactions if certain conditions are met without the need of an intermediary. Many industries, not just financial, can benefit from smart contracts that eliminate the need for intermediaries.
In 2022, Ethereum, the blockchain represented by ether, the second-largest cryptocurrency by market capitalization, underwent a transformation from a proof-of-work blockchain to a proof-of-stake blockchain, offering holders of ether the opportunity to generate yield by “staking” transactions on the blockchain. As a result, it has become much easier for many crypto investors to take some income out of their holdings without selling a position.
But so-called “yield-farming” opportunities have existed for several years in decentralized finance (DeFi). While some of these opportunities are rife with risk and potential fraud, others offer investors the chance to receive more income more efficiently than they would via low-risk stocks and bonds – even in the current higher interest rate regime.
5. Investment diversification
Many investors are going to bet that blockchain will continue to proliferate and that the demand for cryptocurrencies will increase again, driving prices upward from their 2022 swoon. While these may often be pie-in-the-sky hopes for easy money, some credible analysts also expect that the value of major tokens like bitcoin and ether will eventually begin to rise, perhaps growing beyond the peaks reached over a year ago.
While advisors generally promote long-term investing over get-rich-quick speculation, for younger clients with high incomes or very high net worth, a little speculation on the potential growth of digital assets shouldn't seriously detract from their ability to reach long-term financial goals.