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I was asked whether Bitcoin is a Ponzi scheme as I was explaining Bitcoin. In support of the question I was presented with the following scenario. I didn't know what to answer.

Let's assume Bitcoin started today and had no transactions and no customers. Tomorrow, the first 10 people ever buy into Bitcoin. The price at that time for one bitcoin is $100. So, 10 people bought in at $100 thus there is $1000 in the Bitcoin economy.
The next day, the price of a Bitcoin doubles and goes to $200 per coin. Now again hypothetically, let's say ALL 10 of these people want to sell their Bitcoin and cash out. The math now says $2000 will have to be paid out.

How will this be handled as there was only $1000 in the system? I don't believe Bitcoin is a Ponzi scheme, but this particular equation does not add up. What am I missing here?

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    You can't count "money in the system" based on the total purchase price of the asset and expect it to remain unchanged. By this logic, every capital market is a Ponzi scheme. – Nate Eldredge May 4 '15 at 7:41
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    closely related: Is Bitcoin a scam? – Murch May 4 '15 at 9:17
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    It is part of the FAQ – Peter Mortensen May 4 '15 at 17:42
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    It's not a strict ponzi scheme, but it does appear slanted toward giving early adopters and easy way to make a ton of money at the expense of those buying in late. – Almo May 5 '15 at 1:35
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    @Almo Umm, that is true of all deflationary currencies. This only feels weird because for a hundred years, we've been using currencies that are only ever inflationary (by design!) - i.e. buying earlier means a net loss. And it's not really relevent to the question anyway, since that's not what a Ponzi scheme is, even in part. The investment return is just related to the risk - the initial adopters had much higher risks of wasting their investment than you have today - this is reflected in the demand going up while supply doesn't really change much -> increased real value. – Luaan May 5 '15 at 9:06
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The Scenario is confused, because it assumes that there is only one side to a trade.

The scenario assumes that the money goes "into the Bitcoin economy" when people buy bitcoins. This is confusing, because it sounds as if there were only one side to the trade. You will find that the scenario doesn’t imply Bitcoin to be a Ponzi scheme, once you take a closer look at how trades happen.

People own bitcoins:
When Alice pays Bob $100 to buy one bitcoin, Bob is the new owner of the $100 and Alice is the new owner of one bitcoin. The money didn’t "go into the Bitcoin economy" – it went to Bob.

What changed was the Total Dollar Value or Purchasing Power of Bitcoin: People see that someone was willing to pay $100 for one bitcoin.

So, in your scenario that should rather be: There are currently 10 bitcoins in the system, and the spot price is $100. This gives Bitcoin a Total Dollar Value, or Total Purchasing Power of $1000.

There is no problem the next day either: When the spot-price increases to $200 per bitcoin, that means that one person, say Alice, was willing to sell for $200, while another, say Carol, was willing to pay $200 for a bitcoin. Apparently, Carol thought that bitcoin was undervalued at $100 and was willing to go higher with her bid. And who would blame Alice for selling her coin for a 100% markup in one day?

Now as described in your scenario, the other nine owners of bitcoins offer their bitcoins as well for $200 each. The question then is, whether there are enough buyers to support the price at $200. This boils down to a balancing of supply and demand: Perhaps, Carol wanted only one bitcoin. Then there will be nine offers to sell a bitcoin each at $200, but no buyers. In order to cash out, the sellers have to find someone that wants to buy though. There is no "bitcoin economy" that stores the value and pays them out when they want to exit their positions.

Ponzi?

Ponzi schemes have an operator that manages a fund which pays off earlier investors with the money from later investors. To keep this pyramid scheme running, the operator must constantly attract more investors. In contrast, Bitcoin is like a commodity in that it is traded between individuals in relation to supply and demand. Bitcoin doesn’t pay any returns or dividends, nor does it make any such promises.

For a longer example how prices are found in the Bitcoin economy, you might also find my answer on How do buy and sell orders work? interesting.

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Bitcoins are no different from any other commodity in this regard. We say that the price of a car is $45,000, but that doesn't guarantee that you can sell one for $45,000 unless you can find someone willing to buy one for $45,000. When we say some particular number is the price, we mean that's basically the number that buyers and sellers both agree that it is worth. But it's not a guarantee that you'll be able to buy or sell at that price.

Bitcoin exchanges report the prices at which Bitcoins change hands when they do change hands. They also report the price at which people are willing to buy (typically slightly less) and the price at which people are willing to sell (typically slightly more). If you try to buy or sell a large quantity, this will change the price. For example, if the last trade was at $250 and someone is willing to buy 10 bitcoins for $240, and you sell them 10 bitcoins, the price would move to $240. And now there wouldn't be anyone left willing to buy at $240, so the new buy price might drop to $235.

I'm not sure why you would connect this to a Ponzi scheme. Ponzis don't work this way at all -- they pretend to be investing but actually a central operator pays out of a fixed pool. Bitcoins behave more like stock, they are bought and sold at some agreed value based on the value of the underlying assets. Bitcoins have underlying value because they can be securely exchanged, allowing them to function like a currency.

While some people buy Bitcoins hoping they can sell them at a higher price, other people buy them strictly as a means of exchange. They exchange the Bitcoins for goods and the recipient may exchange the Bitcoins back to some other currency. The Bitcoins provide value because they allow the exchange to take place in a neutral currency, with high security, and at high speed, something that might otherwise be impossible. This capability makes Bitcoins have value beyond speculation.

In an sense nobody sets the price and in a sense everybody does. Anyone who wants to buy a Bitcoin can set the price they're willing to pay however they please. Anyone who wants to sell a Bitcoin can set the price they're willing to take however they please. As a result of trades in a free market, discovering the value is not difficult. If the highest price buyers are willing to pay is $250, and the lowest price sellers are willing to take is $251, the fair value is right in-between. (Assuming a perfect market, which we don't quite have.)

This is how many markets, including stock markets, work.

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    Exchanges don't set prices, but report them. When a Bitcoin changes hands, the exchange reports the price it traded at. Say the last Bitcoin sold for $240. Clearly, there can't still be both someone willing to sell at $240 and someone willing to buy at $240, or they would already have traded. So either the only people willing to buy are offering less than $240 or the only people willing to sell want more than $240. If you want to buy now, you'll have to offer more than $240. (Coinbase is not an exchange. They're a buyer and seller of Bitcoins. They can set their prices however they want.) – David Schwartz May 4 '15 at 10:57
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    @Jayrok There is no money "in the system". There are just people willing to buy and people willing to sell. When they agree on a price, they make a trade. It's an open market, not a closed system. – David Schwartz May 4 '15 at 11:00
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    If the sell price is $250, that just means someone is willing to sell at least some fraction of a Bitcoin at $250 and nobody is willing to take less. If the buy price is $250, that means someone is willing to buy some fraction of a Bitcoin at $250 and nobody is willing to pay more. When the buy price and sell prices meet, a trade occurs and we have a new last price. The distance between the buy and sell prices is called the "spread". Better markets have smaller spreads. – David Schwartz May 4 '15 at 11:02
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    @Jayrok: I think I have covered this pretty well in my answer: In order to sell a bitcoin, you have to find someone that wants to buy it. A trade happens once a buyer and a seller agree on a price. That price then becomes the "current price of Bitcoin", until the next trade happens. – Murch May 4 '15 at 11:09
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    @Jayrok No, for two reasons: 1) People might value, for example, dollars at Bitstamp differently from dollars at Coinbase. 2) The market isn't perfectly liquid nor instantly equalizing. – David Schwartz May 4 '15 at 17:21
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A Ponzi scheme is characterised as follows (this is according to Wikipedia, rather than for example the US Department of Justice, which would focus more on the criminal culpability in its definition):

A Ponzi scheme is a fraudulent investment operation where the operator, an individual or organization, pays returns to its investors from new capital paid to the operators by new investors, rather than from profit earned by the operator.

If you sell your holding in Bitcoin (or any asset) to another investor, then you aren't being paid a return by the operator of the scheme at all, from new capital or otherwise. The concept is not applicable.

A Ponzi scheme is when the operator claims that they're holding people's money and using it to generate profit (that is, buying and selling something that generates profit, such that the operator has capital value to match or exceed investor's subscriptions). But actually the operator isn't holding anything, and has given away all the investor's subscriptions.

If Bitcoins paid interest/dividends in US dollars, meaning that you could keep your Bitcoins and take a return, and furthermore if the interest was paid using new subscriptions, then Bitcoin would be a Ponzi. But nothing like that happens at all.

Bitcoin isn't an investment scheme that holds your money for you. It is, as the other answers say, a tradable commodity. So, statements like "thus there is $1000 in the Bitcoin economy" doesn't mean that some hypothetical operator is holding $1000 in a US dollar-demonated bank account, and that it uses this money to pay anyone who wants to cash out. Nothing of the sort. If the price goes to $200 and those 10 people cash out, all that means is that 10 other people want to pay $200 each for bitcoin, and have bought them from the first 10 people. There isn't "$2000 in the system", the original owners have taken $2000 from the new owners. However, the value of the 10 bitcoins at the time of the trade is $2000, so the bitcoin system as a whole is described as "being worth $2000". Sometimes people say it "has $2000 in it", but this means it has $2000 worth of bitcoins in it, not that there are 2000 actual dollars in there. There is no guarantee as to what the value will be when the new owners sell, and there aren't $2000 "in it" any more than there are really $2000 "in" an old vase you fetch out of the attic and someone on Antiques Roadshow says it's worth two grand.

What Bitcoin (or any tradable asset) can be subject to is bubbles:

An economic bubble ... is "trade in high volumes at prices that are considerably at variance with intrinsic values". It could also be described as a situation in which asset prices appear to be based on implausible or inconsistent views about the future

Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, when a sudden drop in prices appears.

Since Bitcoin (like other currencies) is actually intended to be a marker of economic value with no other intrinsic value, one can argue that the US dollar and gold are also subject to extremely long-running bubbles, and Bitcoin should be no different. But at this point the argument becomes semantic, because what one actually cares about is not whether currency "is a bubble" in that sense, but under what circumstances and how badly it might crash.

Anyway, even if Bitcoin does eventually collapse, which is by no means certain, a bubble is not a Ponzi scheme. It does have one property in common, that the last person in before it collapses will lose most of their money.

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The next day, the price of a Bitcoin doubles and goes to $200 per coin. Now again hypothetically, let's say ALL 10 of these people want to sell their Bitcoin and cash out. The math now says $2000 will have to be paid out.

Why? If everyone's selling off their assets in a panic sell, the price naturally drops to whatever people are willing to pay to buy it (which seems to be nothing in your simplified scenario). Bitcoin does not purport to guarantee a specific "cash out" value.

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In addition to everything else already said, there is another false assumption here.

If Bitcoin started today, there would not be any bitcoins yet that you could buy. So the first ten users cannot possibly buy them for $100, or any price. They have to mine 10 bitcoins (either each user can mine one bitcoin, or the first user can mine 10, and then sell nine of them, or any other combination).

Let's say that the first user mines all 10 bitcoins. Let's also say that the first 10 users have $500 each sitting in the traditional bank account - $5000 total.

With your premise, users 2-10 would then pay the first $900 total. So User 1 would end up with $1400 in his bank account, and users 2-10 would end up with $400. It still adds up to $5000! Basically, contrary to your assumption, there is $0 in the "bitcoin economy".

Reading between the lines, it seems to me that you might be thinking of bitcoin as a "company" that you have to "pay". It's actually a marketplace.

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People seem pretty confused based on their answers but you're asking the billion dollar question aren't you

A Buyer gets matched up with a Seller through an online exchange. The buyer needs to "fund" their account with "$" to trade to the Seller for crypto.

So the buyer gives the online exchange real actual money from their credit card. All that money goes to the exchange and stays with the exchange (forever... yes. forever. sorry guys, keep reading for explanation). In return the exchange gives the buyer "simulated USD/EUR/etc. $" but it's actually a form of crypto that remains on the exchange to be traded with buyers. It's treated like it's real USD/EUR/etc. but it isn't and it actually has no value but people keep buying it to buy crypto with all the while money continues to pool in the basements of exchanges

We treat the value of simulated USD/EUR/etc. $ as though it were actual $ based on the confidence that any number of us at any given time could make a withdrawal on it as if the exchange platforms have been keeping it safe for us all this time in good faith.. as if the first commandment of bitcoin cult school isn't to trust online exchange only for as long as you absolutely have to

Bitcoin isn't a ponzi scheme, the online exchange platforms are. The illusion of liquidity they're providing is responsible for meteoric rise in speculated value. But no real money will ever leave the Exchange, if too much of an attempt is made the Exchange will Mt.Gox

Whoever asked you this question is on the right track... What does this really mean? Right now it doesn't matter at all how much crypto is valued or how much anyone owns. 99.9% of us will have massive returns on our crypto investments but none of those returns are ever going to be getting spent on anything...

  • your answer is slightly wrong (and mostly speculative). Exchanges facilitate the transfer of values between two partners (A and B), and keep a fee. So money goes from A to B, and B sends e.g. the bitcoins to A. Exchange gets the fee for this tx. Exchanges don't have all the money in the basement. They are not banks. But if all users withdraw at the same time, I can imagine another MtGox. As crypto currency exchanges are not always regulated (I hate this f...ing word), it is pure speculation, how exchanges react to mass withdrawals. – pebwindkraft Nov 22 '17 at 18:35
  • Saying online exchanges are a ponzi scheme is exactly like saying a bank is a ponzi sheme. They offer the same services, and may or may not run fractional reserves. This is the primary reason one should maintain their own wallet under their own control where no-one else has access to the private key. Use an exchange for the purpose it was designed, that is to exchange value between the fiat system and the cryptocurrency system. By the way, the same advice goes for "real" banks where you deposit your fiat currency. – Max Vernon Nov 23 '17 at 18:48

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