Has crypto built anything useful?
Or is it just a myriad of Ponzi schemes with sophisticated grifters stealing money from hopeful newcomers?
Depending on who you ask, Crypto could be the financial coming-of-Jesus moment. Or it could be a “venereal disease… below contempt” in the words of Charlie Munger.
Part of the problem in assessing the crypto industry is we throw around certain terms without really understanding them, and without having a clear terminology around them. There are Ponzi schemes. But most projects aren’t Ponzi schemes. That doesn’t mean they’re necessarily good, but we need some more expressive ways to describe projects that are good and bad, living and dying, scams and not.
So here’s one attempt at a framework for judging crypto projects.
I’ve broken them out into two meta categories: living or dying.
Then within those categories, there are four subclasses: Pyramid, Ponzi, Tulips, and Spenders.
Put together, this gives us a useful framework for looking at new or existing projects and assessing if they have a future.
A living project is one where there are net spenders in the economy creating some amount of revenue for the business. People who are paying to use the service without getting paid to use it.
One example of this is AAVE on Ethereum. When you deposit your funds and borrow against them on AAVE, you have to pay a certain amount of fees to AAVE for their service. AAVE isn’t paying you any bonus tokens to borrow assets, so you are a net spender in the AAVE economy once you take out some debt.
If AAVE manages its costs, then it is a profitable business. It is living.
Uniswap is another good example of a Living project. They earn some trading fees on every transaction, and they don’t need to pay out UNI tokens to get you to use their platform. People just use it. A third example of a living crypto project is Yearn. People will happily pay Yearn their 20% management fee to do the auto compounding or risk management for them, without getting paid in some other tokens for using the platform. That's real.
Outside of crypto we have plenty of examples of living businesses. The taco food truck I get lunch from sometimes is a living business because I'm paying them for tacos, without getting paid some mysterious TACO coin (redeemable in the TACOVERSE??) for doing so. The taco truck has net spenders. It makes revenue. Maybe even profit. Weird concept, right?
Unfortunately many projects in crypto are not living, even if they seem like it. They’re slowly dying.
If a project is spending more on incentives and emissions than it’s earning from users, it’s dying.
Most projects that are doing this will say that token emissions are not “spend,” but they absolutely should be treated as such. No one would seriously argue that the TVL for a project would stay the same if the emissions were completely shut off. Crypto folks are always looking for free money machines, and unless you have a product they are actually using, they’ll rotate their funds elsewhere as soon as you turn the money printer off.
Terra's Anchor Protocol is the most poignant recent example. There were real spenders, people who were willing to pay to borrow money on the platform. But the amount Anchor had to spend on inflating the yield to attract capital far exceeded the revenue they were generating.
Unsustainable growth like this is not some special crypto thing. Uber is famous for this. The reason our Ubers are so expensive now is they stopped being subsidized by VC money. You could argue that the only reason Uber was able to displace cabs in some cities is because Uber was burning money to fuel their unsustainable growth. Now that the money has run out, cabs are getting more popular again.
Before the popularity of venture capital, most businesses started out as real sustainable businesses and slowly grew into global behemoths. Now they don't have to wait. They can burn a few billion dollars to skip the boring slow period, then figure out how to become a real sustainable business later. Hopefully. Or they can get an Apple TV series made about them as a concession prize.
“Dying” is perhaps a strong term, but it’s suggestive of the direction the business is going in. Unless they can turn things around where people are paying more to use their product than they’re paying out in incentives, they will die. Many businesses and projects start off in a dying phase, and being in the dying phase doesn’t mean it will die, so it shouldn’t be interpreted too strongly.
These are the two most important categories: if a project hasn’t figured out how to switch from dying to living, then it’s not a “real” business yet, at least in my mind. Very few crypto projects have successfully done this. Then to get more specific, there are four categories we can further break down Living or Dying projects into: Pyramid Schemes, Ponzis, Tulips, and Spenders.
A pyramid scheme is one in which the primary source of revenue is from people having to pay to enter the system. And where your primary source of revenue as a participant in the system is by getting other people to pay to enter, so you earn a share of their revenue. Thus the "pyramid" structure.
The people who are early and are able to recruit a ton of people make the most money. The later you join, the less money you're able to make as there are fewer people to recruit, and at some point the scheme tips over where the later people can't earn back their initial investments.
It's actually hard to find a good example of this in crypto. Many projects exist where early investors make more money than later investors, but that hardly makes something a pyramid scheme. The question is: where is there a product where you make money by convincing other people to buy into it? And where you make money directly from the people you convince to join?
Cardano might be a candidate. Their focus on convincing YouTube influencers to promote Cardano, and then get their followers to stake to their node so the influencer earns a share of all the yield generated on their stake definitely feels pyramidy.
Evan Armstrong argued that NFTs like Bored Apes are like an MLM, a less aggressive type of pyramid scheme, but they’re missing the crucial element of generating cash flows from later people you recruit. A Bored Ape holder doesn't get some share of the fees paid by people he convinces to buy an Ape. The only overlap is that early investors do better than later investors, which is true in pretty much everything. You wouldn't argue Facebook is a Ponzi just because their stock is down 80%, puting later investors in the red.
Ponzi is the hardest to claim. A Ponzi scheme is one in which there is no real underlying business that's generating revenue, and the funds of later contributors are just paying off the earlier contributors. It also typically needs some element of deliberate fraud, since that fraud is what distinguishes it from a normal unsustainable business.
Bernie Madoff's Ponzi scheme is perhaps the best known and strongest example. He was committing fraud by faking trades to explain the source of profits when in reality he was recirculating money from later investors to earlier ones. He was running an investment business, but some of the returns were fabricated.
Bitconnect is probably the most famous Ponzi scheme we've seen in crypto yet. They were promising 1% compounded returns per day, which turned out to be coming from other people putting money into the system.
As far as we know now, Anchor protocol's 20% interest rate on UST was not a Ponzi. They don't seem to have been committing fraud by implying the yield was coming from anywhere special. They said it was marketing spending by the Luna Foundation to drive the adoption of UST. It's not that different in practice from VCs subsidizing Uber rides. I'm not saying it's right or good, what happened with Luna is pretty fucked, but it's not clear to me right now that Anchor was acting criminally.
A Ponzi is a situation where some investment is paying out dividends that are funded by other investors. But a tulip is a situation where investment is getting more valuable because of the belief of other investors. And typically, a situation where the investment has very little utility besides being an investment or store of value.
Many things are tulips, and we only judge them differently based on their durability. Gold is a tulip. Art is a tulip. Any status symbol can be a tulip. Most NFTs are tulips, even if they promise membership in some community.
Calling something a tulip does not necessarily mean it’s inherently valueless. We can make gold into jewelry, sure, but the only reason we’re inclined to do that is because gold is valuable. The only reason we think it’s valuable is it’s sufficiently rare for other people to think it’s valuable. If we all stopped caring about gold, or if we figured out alchemy, no one would care about gold anymore.
Tulip in this context just means the value is based primarily on some intersubjective myth about the assets importance. It only has value so long as other people think it has value.
Finally, we have spending. This category is a little odd since you don’t have a “spending” the way you have a “pyramid scheme,” but it’s a sufficient umbrella to capture what distinguishes a real crypto project from the others.
Ponzis and Pyramid Schemes are both ways of generating the appearance of spending without having real spending. And while a Tulip can be very valuable, there is often very little spending in the business so it’s hard to call it really an investment vs. speculation.
Without real spending, a crypto project is either dying or pure speculation. Which makes this spending question one of the most important when evaluating the legitimacy of any project:
Who’s spending money
Is there a way for this spending to exceed the project’s expenses
And at least in the crypto realm, this typically means there needs to be some spending of tokens or assets that are not the native ones. This is a challenge many games can run into that I outlined in the One vs. Two Token article. If a game is making all of its money in their token, they then have to figure out how to dump their token on the market to actually collect that revenue. Spending something else like ETH or USDC is more legitimate.
Alright, now that we have the various categories laid out, let’s look at how they apply to different projects and might test our intuitions about what’s legitimate or not.
Dying Projects Where Early Investors Make Money
What if you have an unsustainable business where some people make money, and then it declines dramatically in value?
WeWork is a decent example of this. Benchmark initially invested $17m in WeWork, and later sold some of that investment for $315m. If WeWork was an unsustainable business, where the early investors were getting paid off by later investors, was it a Ponzi scheme?
While it feels close, it doesn't seem like it, since there was a real business being worked on that was trying to reach (and still is trying to reach) a point of sustainability. So an unsustainable business where early investors manage to make money isn't necessarily a Ponzi. There needs to be some element of a fabricated business or no attempt at a business.
This is true for many tech startups. They go out and raise money on some big goal they want to accomplish, and the early investors just need later investors to come in to buy them out. They don't actually need the business to succeed or become sustainable. So are all tech startups Ponzis? Or Tulips? They might be Tulips, but they definitely aren't Ponzis. Just Dying.
Now, what about crypto projects? There are tons of crypto projects that launch, get bought into by early investors, go through a hype cycle, then drop 80-90% or more and never recover their all-time highs. The investors who sell at the top can end up making tons of money thanks to the people who bought in later as it was running up.
Are those projects Ponzi schemes? Again I think we have to look at what the business is actually doing. Solana is down 85% from the all-time high, and some investors absolutely made a killing by buying it at $3 and selling it at the top. But that doesn’t mean it’s a Ponzi or pump and dump. Solana is building a real product with users who are spending SOL to use it, albeit currently much less SOL than is being emitted as staking rewards.
Bitcoin vs. Ethereum
Where do Bitcoin and Ethereum fall? Critics will sometimes call them Ponzi schemes, but that doesn't make sense. There's clearly no false business being operated to sway investors. Nor are there any cash flows you get from investing in either of them (yet).
Bitcoin is somewhere between a Tulip and an Dying Business. You can't do anything with Bitcoin besides trade it or hold it, but you do have some spending in the economy via transaction fees. The emissions from mining greatly outweigh the transaction fees though, so it's still heavily subsidized by the new bitcoins being printed. If the fees get high enough to justify continuing mining without the block rewards, then it would be a Living business, but we aren't there yet.
Ethereum is currently a Dying Business since you do have more things you can do with Ethereum by paying gas fees, but the emissions exceed the fees being paid. That said, it's possible that after the merge there will be more net spenders in the Ethereum ecosystem than new tokens being emitted, in which case the Ethereum network would become a Living, sustainable business. And it would be the first Proof of Stake chain to do so since all the competing L1s are massively unsustainable businesses.
But in both cases, there's no real Ponzi argument you can make. They're either Tulips or Dying.
Play 2 Earn Games
What about Play 2 Earn games with inflationary breeding loops like Axie Infinity or STEPN?
In my STEPN article, my biggest criticism was that their minting program would create runaway inflation eventually devaluing the sneakers and tokens. I also argued that their GMT token was massively overpriced and had no cash flows or revenue associated with it to justify the price.
So the game itself is definitely a dying business, but is it also a Ponzi? This one is weird since there's not really a business outside of the game itself, yet there is clearly some value to in-game work as we see from all the Web2 games that develop grey market economies. So saying "all of the value is imaginary in a game" isn't the same as saying it's not real. Sure there's something very different about a digital sneaker vs. a set of silverware, but the digital sneaker is still a thing people value to play the game.
But the game isn't exactly dying in the way I described it above, since they aren’t paying out a ton of extra free bonuses to incentivize activity. People bid up the prices because they wanted to play more. So it's kinda closer to the Tulip model, where the prices were driven up primarily by speculation on what you'd be able to do with your digital sneakers, more than any true underlying value. So maybe "Dying Tulip" is the best designation here.
Why isn't it a pyramid scheme? You don't benefit from recruiting people into the game, aside from the benefits that come from more people being in the ecosystem in general.
If by giving someone your activation code you earned 10% of their GST then it would definitely be a pyramid scheme, but no such mechanism exists. I’m sure some future game will add it though as a “growth hack.”
What’s the Point?
We could go through this exercise for any number of crypto projects, and it might seem a little pedantic, but I find it helpful as a way to analyze new and existing projects to see what their future might hold.
The first question has to be whether the project has real spending or not. Is there some way it’s generating cash flows from being used?
If not, where is the money coming from? Is it just a Tulip people are speculating on? Or is it some sort of Ponzi or Pyramid scheme?
And if there is real spending, is the project living or dying? Is it having to emit a huge amount of tokens to incentivize people to do that amount of spending? Or is that spending happening without incentives?
For me, this is how I’m looking at what projects might survive the bear market. Yearn’s token has had a brutal drawdown against ETH, but their business seems extremely solid. MakerDAO is another good example. Terrible token price, but the business itself is very healthy.
One big question will be which of the competing L1s can transition from dying to living. If the Ethereum Merge goes on as planned, and gas fees stay consistent, then it should become deflationary and be a business with solid cash flows. Can other L1s pull off something similar? It’s easy to pick on Solana’s seemingly impossible task of getting enough on-chain action to become sustainable at their current gas prices, but I think those criticisms underestimate the effects of a product like Solana Pay getting integrated into Shopify. Small fees are fine if you have enough of them.
In a bull market, everything looks amazing. But now that we’ve sobered up a bit, looking at projects through these lenses can help separate the wheat from the chaff.
Thank you Wikipedia for the photo of Charles Ponzi
Great read Nat! Given the ongoing tendency to label anything with unsustainable tokenomics as a ponzi, this article brings much needed granularity and precision to the conversation!
Hats off Nat. Love the perspective here and will apply it to a few projects.