Have you ever wondered what you'd find if you upended your life for a few months and did a deep dive trying to understand what makes the crypto ecosystem work?
It just so happens that due to exogenous circumstances mostly beyond my control, that's exactly what I did starting a few months ago. I've spent over two months learning about crypto full-time as part of a research gig. This post is the first of what I hope will become a collection of stories from my work so far.
A new kind of Ponzi scheme
On October 31st, 2008, a pseudonymous user named Satoshi Nakamoto published a whitepaper on Bitcoin.org titled "Bitcoin: A Peer-to-Peer Electronic Cash System". The paper, and Satoshi's subsequent comments, are almost entirely focused on the technologies puzzle pieces necessary to allow for a peer-to-peer, anonymous, permissionless method of sending cash over the internet.
It turns out Satoshi was correct in the short term: the earliest users of Bitcoin were cryptography libertarians, followed by a wave of people using Bitcoin to buy and sell illicit goods and services over the internet. But Bitcoin did not become a trillion-dollar asset because it was better at facilitating online purchases of drugs. Bitcoin's real innovation was enabling a new kind of Ponzi scheme that is more stable than those that came before it. To understand Satoshi's innovation, I'm going to tell you the story of one of the earliest examples of a Ponzi scheme in the US.
The Ladies' Deposit Company
In the 1860s, a fortune teller named Sarah Howe moved to Boston. There isn't much information about what she was doing in Boston prior to the late 1870s, but in 1875 she seems to have discovered a taste for financial fraud. Howe took out several loans from different banks all secured by the same collateral and was subsequently arrested. Her conviction was overturned on appeal, freeing Howe to begin what would become her most famous business: The Ladies' Deposit Company.
In the 1870s, banking in the US was almost completely unregulated. Pretty much anyone could start a bank so long as they could convince enough other people to give them money. "Anyone" included the woman who had committed financial fraud a few years before.
Like any good startup, the Ladies' Deposit Company focused first on accruing power users with a particularly acute need not addressed by the existing industry players. In the 1870s, the best group of power users for a new bank were unmarried women: single women, divorcees, and widows were particularly poorly served by the existing banking system.
Sarah let it slip to a few of her female friends that she had attained backing from the reputable "Quaker Aid Society" to start a new bank that would pay its depositors 8% monthly interest. Such eye-popping interest rates would be enough to perk any naive investor's enthusiasm and any experienced investor's suspicions. However, Howe did not advertise these rates broadly, as one might naively expect.
In fact, Howe was very particular in her recruitment strategy and set strict conditions for new depositors. Listen to this account from 1892 describing how she convinced new depositors to join the bank.
Miss Susan Smith went to the Ladies’ Deposit with her two hundred dollars in her pocket, a little timorous, somewhat dubious, rather incredulous. To her surprise, she found that her patronage was by no means solicited, — was not even wished, unless she was exactly the right sort of woman and precisely met some four or five conditions.
In a few moments she began to burn with desire to enter the inclosure thus jealously guarded; and if she succeeded — as she generally did in the end — in persuading the person in charge to take her little all, she departed with a sense of deep gratitude that she had been permitted to become a depositor.
The same idea, a little varied, was beautifully carried out in the request, delicately but firmly made in almost every case, that the customer would not gossip about the Ladies’ Deposit. If, indeed, she had a particular female friend, who was excessively worthy and greatly in need, and who happened to have two hundred dollars or more, such a friend might, as a favor, be very quietly informed of the privileges of the establishment.
Howe also made a point to immediately return the deposits of any customer who questioned anything about the bank's operation or how it was able to generate such eye-popping returns.
There are a dozen little tricks like this which are described at length in this 1892 article from the Atlantic. Howe seems to have mastered the parlor manners of Bostonian upper-class women from the time. Some contemporaries described her as having a "maternal affect".
When The Boston Herald published the first article about the LDC, Howe seems to have retained the writing advice of a lawyer in drafting a reply, which the paper duly published the following week. The article, which was meant to cast doubt on the whole enterprise, ended up doing far more to spread news of the Ladies' Deposit Company to the broader Bostonian populace. When Howe's pool of deposits grew large enough, she bought a large house in the middle of downtown Boston and began opening new branches around the city.
Eventually, the scheme became unsustainable. Howe had not even bothered lending out the money given to her by depositors in any attempt to generate interest. Instead, she had kept most of it in a large chest of drawers in the back room of her house, then later on the upper floor of the bank's office building. As time went on, the imbalance between deposits and claims on deposits grew and grew and grew, until withdrawals by only a small fraction of the bank's depositors would be enough to clear out all of the bank's savings.
On September 25th, 1880, the Boston Globe published the first of a series of investigative articles into the LDC, alleging fraud. Within days, panicked depositors began withdrawing their money in mass, and by October 4th, Sarah Howe was forced to announce a suspension of withdrawals. In its three years of operation, The Ladies' Deposit Company had accrued at least $271,000 of deposits, amounting to about $8 million in today's money.
Howe served three years in prison for the scheme, though remarkably enough, the main charge brought against her was "raising money under false pretenses", a charge brought against her for the false claims she made that her bank was backed by the Quaker Aid Society.
When released from prison, Howe almost immediately started the exact same fraud all over again. She even named her new bank the "Women's Bank". She accrued another $1.5 million in inflation-adjusted deposits before the new fraud was exposed, at which point she fled the city to avoid prosecution.
Howe tried the scheme again in Chicago and several other cities before finally returning to fortune-telling in her later life. She died in 1892.
Normal Ponzi schemes all follow the same trajectory
If you squint, the story above follows a simple trajectory:
- Some money making scheme is proposed, whose details are often purposefully kept vague.
- Through a combination of dozens of clever tricks (which always change from one ponzi to another), an ever-expanding group of investors is parted from their money.
- Some event causes a sufficiently large group of depositors to withdraw their money all at the same time. The longer the Ponzi lasts and the higher the interest rate, the easier it is for such a run to cause insolvency.
- The Ponzi runs out of money and is forced to halt withdrawals. The fraud is revealed for all to see.
Historically, this general structure is shared by nearly all Ponzi schemes. However, there are a few notable exceptions, one of which was invented only recently.
Magic internet money: a new, more robust kind of Ponzi scheme
Bitcoin shares some, but not all of the characteristics of normal Ponzi schemes. Like a normal Ponzi, Bitcoin holders can only make money if more people buy into the money-making scheme. Like many old-school Ponzi schemes, Bitcoin does not produce any surplus; it is a fundamentally unproductive asset (in fact, Bitcoin produces negative value because proof of work consumes substantial hardware and energy). Like Sarah Howe's Ladies' Deposit Company, Bitcoin can only make some people rich at the expense of others.
But Bitcoin differs in one key way: there is no bank account that can run out of money. This is the key to understanding why Bernie Madoff's Ponzi collapsed at $50 billion while Bitcoin reached $1 trillion in value; there is no piggy bank to raid when FUD causes investors to lose their nerve. So Bitcoin can never truly be killed.
This is why Satoshi's invention actually matters; the peer-to-peer cash aspects of crypto are ultimately a side-show. The main event was a new, super-viral method for creating and spreading a more stable type of Ponzi scheme on the internet.
Bitcoin (and other cryptocurrencies), can still face crises of confidence, which can see the on-paper value of people's holdings drop by 80% or more. But so long as a single person on the earth is willing to buy Bitcoin, the price will never go to zero[1], and the potential for another even bigger bull run will remain.
- ^
Unless a fundamental, unfixable flaw is found in the foundations of cryptography like an algorithm to reduce NP problems to P problems. Even if proof of work is somehow broken, Bitcoin will just do a hard fork and switch to some other consensus mechanism.