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Busting Bitcoin's Bubble Bobbles

Published on December 7th, 2013 by george
By GEORGE ETTINGER - Dec. 7, 2013 [caption id="attachment_1690" align="alignright" width="400"]Critics say this diagram of the Bitcoin market suggests instability. Critics say this diagram of the Bitcoin market suggests instability.[/caption] Another day, another hundred-dollar fluctuation... give or take. Another day, another harsh economic comparison- a bubble, Ponzi scheme, pyramid scheme, pump and dump, tulip-mania, or sometimes all of them in the same conversation. The enthusiasts within all of us will wince and cry foul at every one of these mentions, if only because we know it is so far removed from all of them.  It's not a scam, it's not a scheme, it's not a mania, it's not a bubble... Er.  Um.  Well, actually that might not be entirely true. There are some things you need to know about scams, schemes, manias, and bubbles.

 

PART I:  The Pleasant Facts

Before confronting the worrisome realities of some of the biggest threats to Bitcoin, I should at least begin with some upbeat reassurances, however small they may be.  There are a lot of accusations against Bitcoin that DO come entirely out of misinformation or bad logic, and there is more than enough sense and wit out there to dispel them.

THE "PONZI SCHEME"

One of the easiest things to say with any certainty is that Bitcoin is not a Ponzi scheme.  Sometimes it seems like the most popular pejorative to throw at the blockchain, but it is almost never applied with the actual meaning in mind. [caption id="attachment_1655" align="alignright" width="196"]Authorities of his day called Charles Ponzi "the modern-day Bernie Madoff." Authorities of his day cryptically referred to Charles Ponzi as "the modern-day Bernie Madoff."[/caption] The Ponzi scheme, named for the 1920's fraudster Charles Ponzi, has much in common with Pyramid schemes- but more on those later.  In principle, a Ponzi scheme lures investors in with promises of regular returns on their initial investment.  Early investors will receive regular interest dividends that "prove" they are making that money back on the fly.  This obvious, immediate return will help encourage further investment and recruit more subsequent investors. The scam is that they aren't being paid any profits- the earliest victims just receive portions of the later victims' investments while the bulk of all funds goes straight to the operator himself. So, in a transparent Ponzi scheme, participants are all offered an opportunity to invest in some vague or unspecified new venture (hedge funds, horseless carriages, the word "productivity," et al)  and then pour their investment into a bucket.  The promise of regular disbursements of profit keeps up their faith, and helps them sell others on the merit of the scheme; e.g. "You know, Arthur, this horseless carriage hedge fund I'm into has really upscaled my productivity." What they don't know is that their "profits" are just whatever splashed out of the bucket when the guy after them poured his money in.  The "investments?"  Those are still in the bucket, which is getting heavier every time you recommend it to somebody.  And the bucket itself?  That bucket is staying at Bob Scammer's house, who in this case is the scammer and not just a man with a tragic surname. The point is that Bitcoin has very little in common with this methodology.  Most schemes we can discuss will center on a ringleader, and the closest thing anybody can point a finger at is generally Satoshi Nakamoto.  Whether fictional or not, the "Satoshi" character never solicited any actual money- he just created the object we're all apparently enamored by.  It was the rest of us that are creating a monetary value through our actions, and it is us still that are spending and receiving money.  There simply isn't a "Ponzi" to pin Bitcoin on. The increased returns by word-of-mouth recommendation has a lot in common with the networked nature of Bitcoin... but so does every other form of investment, media, or advertising.  It's not a unique concept for value to grow higher as a larger group takes interest.  For this to be a Ponzi scheme, it would have to be some kind of crowdsourced, psuedo-ponzi scheme in which all participants are simultaneously a Ponzi and victim until they cash out in one state or the other.  I wouldn't call that a Ponzi scheme so much as a "Schroedinger's Slush Fund."   [caption id="attachment_1656" align="aligncenter" width="300"]...or what everybody else on Earth calls it, a "casino." ...or what everybody else on Earth calls it, a "casino."[/caption]

THE "PYRAMID SCAM"

The other ill-fitting stab-du-jour Bitcoin receives often is Pyramid scheme.  Points for effort are due to anyone who calls in that, because at least it makes a slightly better case than Ponzi scheme.  That said, it still doesn't actually fit. Pyramid schemes, often discussed as "multi-level marketing solutions," have a similar basis to Ponzi schemes: one morally-deficient administrator reaping the rewards of a growing stable of hapless investors.  The reason it takes the tri-corner shape is because that stable of victims beneath the big cheese does the legwork in creating a new layer of victims beneath themselves. The old adage of "...and they'll tell two friends" comes out in full force here.  The downward growth is exponential; each layer is geometrically larger than the last, hence the flat triangle becomes a voluptuous pyramid.  To borrow liberally from Wikipedia:   [caption id="attachment_1671" align="aligncenter" width="400"]Traditional Pyramid Scheme model; often erroneously labeled "the Libertarian Airlines Seating Chart" Traditional Pyramid Scheme; often erroneously labeled "the Libertarian Airlines Seating Chart"[/caption]   Each upper layer will supposedly bow out of the payment scheme when the "bottom" group further down pays up.  The sales pitch is that, when you new guys reach your quota, you move up in the organization.  I.E. the blue "Captain" in the illustration gets his full payout by the three layers beneath him and them steps out of the chart.  The two "co-pilots" become their own "captains" and a new, even bigger layer moves in at bottom to keep paying up... and so on. The reasons this becomes an obvious scam are twofold.  First, the "founding" layers are often all the same person, placing themselves in multiple positions to receive nearly every portion of investment.  Even after the first layer is "fully" paid out, they usually are the second and third (or more) as well. They don't mind stepping out after just a few rounds of cash-grabbing because of the second problem: exponential growth like this becomes unsustainable incredibly fast.  That same "airplane" model would encompass over four thousand distinct people after a dozen layers, and that's growing at a modest 2x rate.  Typically a pyramid scheme would encourage members to recruit five or more new members each- if each member recruited six new members, the entire organization would surpass all human population by the dozenth new level.  It simply cannot keep growing past the first few suckers, so the pilot cashes out as soon as possible.   [caption id="attachment_1675" align="aligncenter" width="500"]"Now seating Row Four; if all passengers in Row Four could hand their wallets directly to the pilots and proceed to their seats, we will eject and have you crashed in Houston precisely on schedule." "Now seating Row Four; if all passengers in Row Four could hand their wallets directly to the pilots and proceed to their seats, we will eject and have you crashed in Houston precisely on schedule."[/caption]   The pyramid scam is built to fail from the beginning.  It's a classic model of unsustainability, and preys on the universal human desire to make a quick buck.  At its simplest this begins with the chain-letter asking you to mail five dollars to five people and then add your name to the list... at its largest it included massive-scale door-to-door sales operations that folded with its founders, interestingly, nowhere to be found.   This fails to fit the Bitcoin model yet again.  At the start, it suffers from the same problem as the Ponzi model- it assumes "Satoshi" is a calculating ringleader who recruited people directly for his plan.  While this isn't impossible, it simply doesn't make sense with what we've seen.  The Satoshi character largely disappeared from the entire scene well before Bitcoin hit the mainstream, and there is no financial connection between people who use Bitcoin and Satoshi's own funds. This connects to the second major fallacy.  Bitcoin completely fails to use the "pay it upward" model of a pyramid scheme.  There is no significant pay structure at all, because Bitcoin is a fabricated commodity.  It's a thing that exists in a vacuum until users opt to spend it for currency, goods, or services.  All the cash movement in and out of Bitcoin has been done by the users, not by the creator... and its to other users, not up through an illusory hierarchy.  It just doesn't make sense as a pyramid scam. Lastly, the inevitable collapse of a Pyramid due to unsustainable growth could be pinned on Bitcoin on paper... but fails to make sense in practice.  As I've discussed before, the oft-touted "market cap" of 22 million Bitcoins to share among the population fails to account for divisibility.  With pop culture saturated by the unit of "One Bitcoin," many are still ignorant to the fact that the blockchain consists of over two quadrillion satoshi units.  Nothing in the universe is "infinitely sustainable," but two quadrillion units of currency is enough to last a little while.

 

PART II: The Uglier Truths

The Pyramid scheme comparison, just like the Ponzi one before it, shows an ignorance of how Bitcoin actually works.  Bitcoin itself does not connect to anything but other Bitcoins; anything that brings existing money or value into the equation is done by the users, not by its creators.  Bitcoin by itself only exists to be traded to other users on the blockchain.  Anything else that happens to it is not a result of a Mister Ponzi or a ringleader, but by users themselves. Those are only two of the unfavorable comparisons I've brought up, however.  Some of the other scams, frauds, and market-horrors out there aren't so easily-dismissed.  Some of them are definitely worth thinking about- others may apply to Bitcoin outright.

THE "TULIP MANIA"

Tulip Mania is, without a doubt, the least-threatening-sounding economic bubble disaster in history.  As far as bubble crashes go, it's also one of the first on record.   [caption id="attachment_1680" align="aligncenter" width="500"]THE HORROR THE HORROR[/caption]   Tulips were a somewhat exotic bounty in the early 17th century.  Not native to the western Europe, the flower was altogether new and exciting for the Dutch, and its arrival around 1600 began a burgeoning reputation as a status symbol.  Within a few decades, the soaring Dutch economy latched onto the Tulip in full force. With their sluggish growth cycle of several years from bulb to flower, the mania began at a slow boil.  Speculation was picking up enough steam by 1610 that the government had to ban the short-sale of tulip bulbs.  By the 1630's tulips were among the top five exports of the Netherlands. By 1637, people wanted their tulips and they wanted them right now, damn it. What was it all for, though?  Were tulips serendipitously edible and delicious?  Were people such connoisseurs of pigment that the delicate colors of an exotic flower in their living room was worth any price?  Did the damn sprouts grant wishes or something?   [caption id="attachment_1681" align="aligncenter" width="400"]Was every Dutch citizen a dyslexic with a cartoon mortgage to pay?  No historian has denied it! Was every Dutch citizen a dyslexic with a cartoon mortgage to pay? No historian has denied it.[/caption]   There's no sense joking about it- it was the exact same driving force behind Pyramid and Ponzi scams, and the same force that has driven many people to Bitcoin since April.  People want money.  People want easy money.  People want all the money, all the time, for none of the effort.  Tulip mania was just that- a mania.  It was a psychologically-driven mass delusion: a consensus among a whole population that these flowery widgets had intrinsic value.  This notion of value was so widely-held that, at its height, the right species of Tulip were changing hands multiple times a day for prices beyond a skilled craftsman's annual wages.  People were speculating on tulip futures, paying premiums for "unbroken" tulip bulbs, creating elaborate tulip-farming operations... ...then, in 1637, it simply stopped.  The reasons were many; profiteers took their profits and quit, hoarders grew tired of the unpredictability and got out of the game, and massive numbers of new florists from years earlier were finally bringing a glut of bloomed tulips to market.  Whatever the individual causes, the sudden tip downward spiked a rush of sell-offs... which turned that dip into a nosedive.  By 1638 the tulip had become the useless plant-bauble we know and love today. The Dutch Tulip Madness is a seminal case study for sociologists, economists, psychologists, historians, and those people who like history-slash-science without having to make it a job.  As early as 1841 it was cited as a landmark case in Charles Mackay's social-psychology work, the aptly-titled Extraordinary Popular Delusions and the Madness of Crowds.  The takeaway is always the same; mass hysteria over a quick buck can build for years upon years, but when that feedback loop ends, it can end fast.  Tulip fortunes were made and lost in an instant. No matter how it feels to admit it, the Bitcoin market has plenty in common with the Tulip market.  The increasing momentum of mainstream-popularity has plenty of parallels in itself, but a deeper look reveals even more to be wary of.  Home-grown tulip gardens, bastions of a long-term investment, were a distant echo of today's ASIC sales and mining rigs.  The rampant speculation and day-trading of tulips then and Bitcoins now are nearly indistinguishable.  Both of these eruptions of value came from speculation, hoarding, and a psychological value over any intrinsic values.   [caption id="attachment_1692" align="aligncenter" width="640"]17th-century artist Jan Brueghul the Younger painted this image of shrieking monkeys in formalwear haggling over plants and titled it "Satire on Tulip Mania."  This is literally what you are looking at.  This painting is the South Park of 1600's Europe. 17th-century artist Jan Brueghul the Younger painted this image of well-dressed shrieking monkeys haggling over flowers and titled it "Satire on Tulip Mania."  I am not exaggerating; that is literally what you are looking at.  Replace the tulips with iPhones and you'd have an episode of South Park on oil & canvas.[/caption]   Let's not kid ourselves about speculation.  A majority of Bitcoins right now are being bought for speculative purposes and sold for fiat national currencies.  Despite the noble businessmen-and-women using it as currency in real goods-and-services transactions, Bitcoin is a hoarded commodity right now.  People see value in buying and selling it because everybody else sees value in buying and selling it.  If something were to strike a major blow to that perception of value, the damage could be swift and devastating.  Even at an individual level, a perishable tulip bulb isn't very different an easily-lost Bitcoin private key.  Bitcoin fortunes, through market moves or petty fumbles, are made and lost in minutes as well. Despite all the fearful symmetry, Bitcoin still has serious advantages over its agrarian predecessor.  Bitcoin was, since inception, meant as a medium of exchange.  It's been designed and streamlined to be a transferable unit between users on a global scale- something the tangible, living tulip could never compete with.  As much as tulips may have swapped hands as some sort of barter-currency, Bitcoins were made to be currency.  This ease-of-use, combined with its resistance to duplication, creates a certain minimum of intrinsic value as money. ...that value, however, can only be sustained when its used as money.  The degree to which people are hoarding and day-trading Bitcoin for cash -with foreign exchange margins bordering on arbitrage- is making Bitcoin a commodity and not a currency.  As a commodity, the intrinsic values of Bitcoin-the-currency go out the window.  Bitcoin is riding high on perception and information, not on utility.  Compared to Tulip Mania, this has even more in common with...

THE "PUMP & DUMP"

Just when you thought Tulip Mania was a tough act to follow, the Pump & Dump enters the ring for "hardest name to take seriously in investing." Mercifully abbreviated to "the P&D," this scam is much subtler than the blatantly-criminal Ponzi and Pyramid schemes.  P&D scamming amounts to little more than lying about a stock to drum up interest in it.  First, a manipulative scammer/entrepreneur buys up a hearty supply of a low-cost stock or commodity.  Then, they go about spreading false word that the goods in question are about to undergo a valuable shift. The P&D scam has many roots in word-of-mouth and business newsletters, where planting the right seeds can make a stock grow high and grow fast.  These days, we have the internet as the ultimate megaphone for terrible ideas.  Spam emails, facebook shares, and popup ads can trickle bad stock tips to millions in a single minute.  Misinformation doesn't need to be especially convincing to move markets; just one false tweet from the Associated Press was enough to shake up the S&P 500 for a day. Dishonest price manipulation isn't unfamiliar to Bitcoin at all.  In April, when Mt.Gox was the largest mover of Bitcoins in the world, DDOS attackers created a rash of panic sales as they brought the website crashing down- along with prices.  It's doubtless that somebody acquired plenty of cheap Bitcoins in the aftermath of the April crash.  Traditional commodities and futures are also highly susceptible to manipulated drops thanks to short-sales.  Selling at a high price, then manipulating prices down in order to fill that sale is basically a reverse Pump & Dump: the "Short & Distort."   [caption id="attachment_1687" align="aligncenter" width="615"]"Short & Distort" tactics are suspected by many as the cause of the Great Concentrated Orange Juice Crash of 1989. Many historians suspect "Short & Distort" tactics to be behind the Great Concentrated Orange Juice Crash of 1983.[/caption]   Of all the things I've discussed here, the Pump & Dump scam is, by far, the scheme with closest ties to Bitcoin.  It doesn't require the product or company's creator to be in on the scam; it just takes unscrupulous early adopters and a massive amount of hype- two things that are in excellent supply. It would be conspiratorial- maybe even paranoid- to suggest that Bitcoin's mainstream media attention is blossoming out of the bad seeds of a few manipulative masters.  Despite that, there are plenty of men and women out there who stand to gain plenty from all this hype.  Most are gaining plenty every day now.  They're counting on the explosive value of a collective delusion to bolster something beyond its intrinsic means.  Mixed metaphors be damned; so long as Bitcoin is a commodity first and a currency second, it's a Pumped-up Tulip waiting to be Dumped. No, I'm not insinuating there are malevolent puppetmasters in the shadows, priming the Bitcoin hype for a pocket-lining long-con.  There's no sinister Satoshi pulling the strings here.  Bitcoin administrates its hype the same way it administrates the blockchain; via crowdsourcing.  To wit: we are that crowd. [caption id="attachment_1696" align="alignright" width="238"]Similarly-poor judgement was also behind the "Pump & Dunk" crises of the 90's. Similarly-poor judgement led to the "Pump & Dunk" crisis of the 90's.[/caption] If there's any villain, it may as well be all of us.  We're all responsible, one way or another, for the speed of this hype train.  Nearly everyone involved in Bitcoin is out to make money- not that there's anything terribly wrong with that goal, but it can lead to shortsighted decisions.  In our scramble to get Bitcoin out there and get it accepted as currency, we're fanning the flames of speculation.  We are "pumping" Bitcoin, and every new person who gets into it in the hopes of turning a comfortable profit on investment is another mouth to spread the pumped-up word. What's going to happen to Bitcoin when a few speculators decide it's high enough and it's time to cash out?  What happens when its a few more than that?  How many people does it take to tip from "downswing" to "dump?" The "Pump & Dump" problem is a very real one- one that we aren't taking enough time to consider. It's a message that is rarely discussed, and usually muddled.  Some critics have called attention to the all the symptoms when decrying Bitcoin... only to shoot themselves in the foot by calling it all a "ponzi scheme."  Whether or not this surging market becomes a P&D depends entirely on us and the choices we make.  It's how we apply Bitcoin during and after this goldrush that will determine its staying power. It is that lasting, intrinsic value as a currency that can save us all from...  

PART III: The "B" Word

I'm just going to say it up front.  Bitcoin could be a bubble.  The band-aid is off.  Itch it a little, make that scrunched-face wince everybody makes, and then shake it off.  We need to keep our wits here.  No, you can't leave.  We're going to talk about this.  I've already locked the doors. Bitcoin, in its current state, has all the makings, trappings, and fixings of a bubble.  We're deluding ourselves if we claim otherwise.  The signs are in front of us.  Here are just a few:
  • Growing valuations beyond intrinsic values
  • Speculator hoarding
  • Sudden surge in public interest
  • New investors buying in even when prices are already at their highest
How many of us can honestly say we haven't encountered an unusual number of friends, family, and acquaintances suddenly asking us about "the bit-coins" in the last two weeks?  How many new users do you think Gox and Coinbase picked up the day Bitcoin hit $400?  When it hit $700?  $1000? Compare the typical stages in a bubble; stages_bubble to this year in Bitcoin; coinbasechart   We don't need to scare ourselves, but we do need to think about our role in where this is going.  Our own greed could cripple us.  As mentioned in the Pump & Dump scenario, we could be inadvertently setting ourselves up for a fall if values peak and exchanges suffer too heavy a sell-off.  Bitcoin may recover, or it may not.  There would be no guarantees. Far be it from me to criticize greed!  Greed and ambition can get a lot of things done!  They can also, however, drive incredibly stupid decisions... as we saw with the tulips.  It was greed that drove tulips to absurd heights, and the same burnout that let the flowers collapse could fall upon us. Fortunately for all of us, Bitcoin still has those innate strengths that protect it.  Plus, nobody has to forsake greed to enjoy them. The difference in all these scenarios is that Bitcoin is still a currency at heart.  Bitcoin is meant as a medium of exchange, purchase, and transaction- don't cash out your greed, just spend it.   As I've said time and again, the pillar holding Bitcoin out of harm's way has always been utility.  So long as we can spend it, it can survive.  So long as people will spend it, there's incentive to accept it.  So long as it circulates through an economy -rather than stagnating- it stays fresh, so to speak. In the end, we don't need to tremble in fear of the big bad bubble looming over us.  People suspect bubbles everywhere, in every market, all the time.  Most of the same overvaluation and "intrinsic value" arguments against Bitcoin make a strong case against the US dollar as well.  More than any of this, we have to remember that Bitcoin is only the blockchain; it is not the exchanges, it is not the perceptions we make of it.  It doesn't belong to a person, a Ponzi, or a government.  Bitcoin itself remains a flexible, independent entity. I don't need to lecture the Bitcoin users who have been at it all year- they already live, breathe, and eat Bitcoin.  Newcomers, however, need occasional reminders that Bitcoin isn't tulips, orange juice, or pork bellies.  It's money.  Using it for transactions, rather than cashing it out for the fiat, might not keep its dollar value soaring- but it will maintain the infrastructure that Bitcoin needs to stay resilient.  We need to temper greed with caution, and embrace Bitcoin not as a ticket to riches, but the riches itself.  If we face a massive sell-off all at once, Bitcoin will become a giant vestigial lump at the heart of every dead exchange, and the bubble will have finally popped.       Image credits (in order): Taito Corporation, Wikimedia Commons, Reno Tahoe, Wikimedia Commons, Matt Hurst, Alexandre Dulaunoy, WordShore, Wikimedia Commons, Paramount Pictures, Reebok, Hofstra University, Coinbase

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