Bitcoins Are Not a Ponzi Scheme – sort of
I’ve been around the internet and stuff since, well, before the internet was really the internet. Over that time, I have seen more than a few things come and go, and more than a few get rich quick schemes come screaming through town, leaving in their wake a pile of people who lost a butt load of money on the next sure there. So when I heard about Bitcoin for the first time a couple of years back, I look at it very closely, and actively chose not to play the game.
The why was actually pretty clear even back then. The structure of bitcoin, the thing that makes it run, is the processing. People use their computers or dedicated machines to “mine” bitcoins, and in doing so provide the checking and the transaction services that make bitcoin possible. Now, the problem is that mining is not a constant thing. Rather, as it goes along it becomes harder and harder to solve the math required to complete the task at hand, which then pays out the same number of bitcoins as before. The complexity continues to go up, and the payout remains constant.
What many people and groups have done is build dedicated mining machines which are generally specialized PCs lots of graphics cards because they have the rights types of processors for the job. Then they moved onto mining with multiple machines, with racks of machines, and in some cases, even entire buildings filled with machines. What is funny however is that for all the complex calculations they have done to mine a bitcoin, they never have seemed to do the basic math that says the reward continues to shrink, as the effort goes up.
I was reading one of those Ted discussion things about how “Bitcoin is not a ponzi scheme“, which lead to the title of this post. In most technical of terms, Bitcoin is not a ponzi scheme, but like a ponzi scheme, it does depend on more and more people doing something for less and less chance of return. Even that isn’t the true fail point of Bitcoin. In my mind, the fail point is that in order for things to continue, you need people to process the transactons (by mining coins). At some point, the equipment and the electrical power required to do so will be higher than the price of the coins. The only way that this can work out is for the price of the coins to go up enough to make it worth processing. However, that rising price would be a relatively unnatural thing, considering all the pressure against it. That pressure is oddly created by the mining itself.
When you mine, you get bitcoins (or micro of whatever satchis). However, you pay for your equipment and power with real money. The only way to have the money is to sell the bitcoins that you make. In the beginning, when the cost / reward factor was heavily tilted towards reward, it was easy. You mined, you made a boat load of bitcoins, you sold a few of them to pay the bills, and you kept the rest. However, with the current tilt more towards the risk / cost side of things, real miners are forced to sell a high percentage of the coins that they mine just to stay in the game. As the calculations get harder and require more effort, the margin shrinks further, which forces more of the coins to be put on the market. That generally will lead to a supply versus demand issue, which drives the price down. That falling price in turn means that even more coins must be sold in order to pay for processing. AS you can see, it creates a downward spiral (type of the hat to Trent Reznor) where the lowered prices forces more sales to stay in the game, and those sales in turn force the price down.
Worse yet, bitcoin could find itself in a situation where it lacks processing. Bitcoin has an issue called the “51 attack“, where anyone gaining 51% of the total processing would be in a position to defeat the basic security of the system and basically destroy it. Already, there are issues where one or more of the mining pools may have just about reached that level. If the costs of mining exceed return, there is great potential that one or more groups may move to complete the 51% or more control and “cash out” on bitcoins, destroying it. In fact, the problem of decreasing returns makes this an almost inevitable result.
If bitcoin fails in this fashion, it will have in fact been a form of Ponzi scheme, but not in the money itself – rather in the simple math that says it will run out of processing the same way a ponzi scheme runs out of potential new members to fuel the system. When it happens, it won’t be pretty.