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Ponzi schemes: The Danger of High Interest Savings Funds

The views expressed in this article are those of the author and do not necessarily reflect the position of Bitcoin Magazine

Over the past five months, the Bitcoin community has seen the emergence of savings funds offering interest rates far higher than any seen in the traditional economy. The most innocuous form of high-interest deposits, mining contracts, have been around for a long time, allowing anyone to financially participate in mining operations by buying shares and collecting a percentage of the profits in return, offering returns of up to 1.4% per week, or an annual percentage rate (APR) of 106%. Non-mining opportunities began to offer even higher returns than this. GLBSE assets like TYGRR-BANK return up to 2.2% per week, or 211% APR, and in mid-January a forum user known as “imsaguy” offered 6% per 2 weeks, or 357% APR, although at the cost of a somewhat long-term commitment. More recently, however, the interest rates seem to have lost all sanity. Looking at the “lending” and “securities” subforms at bitcointalk.org, we see headlines like “ShadowAlexey’s Deposits 12-18% per month“, “Savings Account, 4% Weekly“, and even “Hashking’s 6.75% Weekly Deposit Special” – a staggering 2921% APR.

The largest of these lenders, and likely the one that many of the other funds are at least partially themselves invested in, goes by the name “pirateat40″, or Pirate for short, and Pirate’s deposit operation is formally called “Bitcoin Savings & Trust”. Accounts in BST are heavily coveted, with Pirate enforcing limits on the number and size of deposits, and interest rates are very high: 4.2% for deposits of at least 100 BTC, 5.6% at 500 BTC and 7% (that’s 3313% APR) at 2000 BTC. Pirate has been unwilling to reveal much about how he is able to earn such high interest rates in the first place, although the reasons that he has given include market arbitrage and “private loans to network members”. Pirate boasts that his activities in such fields provide returns of 10.65% per week, and he pays out an average of 5.98%.

However, both of these methods of earning money are highly suspect. The prevailing interest rate on the lending forums is at about 1.5-8% per week depending on the duration and risk, and reasonably trustworthy individuals can get capital for free from the Islamic Bank of Bitcoin, so even assuming that money is shuffled from borrower to borrower at 100% efficiency with no defaults, earning 10.85% per month is impossible. Market arbitrage may sound more plausible at first glance, but the reason why it cannot explain Pirate’s earnings is that it simply does not scale. At low levels, if bitcoins are worth $4.95 on one exchange and $5.05 on another, and such a thing happens just as often in the other direction, it can indeed provide decent profits. However, the act of buying on one exchange and selling on the other itself helps bring the prices back together, so the process is ultimately self-defeating. Pirate claims that 300000 BTC passes through his accounts every month, but, at the time of this writing, selling even 50000 BTC on MtGox would push the price down to $4.99, and buying that much would push the price up to $5.38, negating any possible profits. Such a large sale on any other exchange would almost certainly send the prices there to either below the $1.992 low of November of above the $31.9 high of June. Furthermore, the idea that market trading activities are less lucrative than their most zealous proponents claim has some empirical evidence: although the activity in question was speculation and not arbitrage, the last time trading was used as a justification for extremely high returns on deposit accounts, Bitscalper, it turned out to be a scam.

The other problematic question with regard to Pirate’s deposit accounts is that of why he is willing to offer such high interest rates in the first place. Rather than offering loans within the Bitcoin community, he could have instead obtained private funding for his ventures. Even if he was unwilling to betray his proprietary financial strategies at all, plenty of lenders are willing to provide interest at rates lower than the average of 6% that he is paying no questions asked, and credit card debt bears an interest rate of less than 0.5% weekly. The response that Pirate gave when asked this question is this:

Ok lets say your business was in “pet rocks”.  Now, there’s a demand for them from an active but relatively small community (like Bitcoin) that believe these rocks are worth their weight in gold.  So you run to your bank and withdraw everything you can, hell you might even ask the banker for a loan.  You tell him it’s for some home remodeling and because he’s known you since grade school you get the loan.  With money in hand you run to the rock market and spend everything you got on certified “Pet Rocks”.

You get your business off the ground while paying off the loan but in the back of your mind you can’t shake the thought of “What happens if people find out these are just rocks or if the rock market is overtaken by nano pets?”.  You take the risk and keep building your business by reinvesting your profits back into buying more rocks.

You wake up one morning, roll over and look at your phone to see the current price of “pet rocks” to be worthless.  With a ill feeling creeping over your body you start to think about how many rocks you have in the warehouse and how much money you’ve actually creamed off the top.

Why didn’t I just borrow the rocks from the rock community and pay them a portion of my profits?  That way if something was to happen, I made good money doing it and my long time friend (the banker) still likes me.

Essentially, Pirate wishes to avoid having USD-denominated debt to secure himself against the risk of Bitcoin price fluctuations. However, this excuse does not stand up to close scrutiny for a simple reason: the possibility of shorting. Sites like Bitcoinica, and soon Kronos.io, offer the ability to deposit a small amount of bitcoins and then trade that for a large positive USD balance and a negative BTC balance, earning a profit if the Bitcoin price goes down. This would essentially give Pirate the ability to cancel out any positive USD exposure that he has with a sufficiently large and highly leveraged short. To see how this works, consider a simplified mathematical example.

In Pirate’s current setup, let us assume that he is borrowing $25000, in the form of 5000 BTC, from investors at 6% weekly and investing that 5000 BTC at 11%. His net exposure to USD is zero, and every week he has a revenue of 550 BTC and an expense of 300 BTC, for a net profit of 250 BTC, or $1250. What would happen if Pirate decided to borrow the money from a non-BTC source and short BTC to compensate? The interest rate that Pirate would have to pay would be much lower, so he might perhaps be able to secure that same $25000 loan at an interest of only 1% weekly (68% APR, still a very high rate for traditional investors). In order to short, Pirate would need to set aside, for example, $5000 of collateral balance, which he can then convert into $25000 USD and -4000 BTC (4x leverage). He can then convert the remaining $20000 into 4000 BTC and use that for his market activities. The positive $25000 USD balance in his margin trading account perfectly balances out his $25000 debt, once again giving him a net USD exposure of zero. As for his profits, however, he is earning 11% weekly on 4000 BTC, or a revenue of $2200 per week, but is paying only 1% weekly on $25000, or $250 per week. Net profit: $1950 per week.

Of course, Bitcoinica has been hacked, and Pirate would have lost $5000 this month had he done this exactly (although compensation is likely to come for Bitcoinica users in the future), but even still Bitcoinica has only shut down once in the 26 weeks since Pirate started lending, so this would only have reduced his weekly profits from $1950 to $1758. Alternatively, he could choose to avoid using Bitcoinica at all, and simply short bitcoins on his own by offering highly leveraged positive Bitcoin, negative USD accounts.

Finally, even if Pirate prefers to stay within the Bitcoin community, there is simply no reason to offer such high rates to investors. He is already forced to restrict supply for his high-interest deposit accounts, so he could easily have kept the rates at a much more reasonable 2.5% per week and gotten as much capital as he needs. Setting deliberately high interest rates to attract more depositors than one needs is a strategy that only makes sense for a Ponzi scheme.

If Pirate is indeed participating in a Ponzi scheme, something which he has repeatedly denied, there are three ways in which he could be doing it. First, he could be running the Ponzi himself. Second, he could be investing in a larger Ponzi scheme outside of Bitcoin – Sergey Mavrodi’s MMM is a likely possibility because of the heavy Russian presence in the Bitcoin community. Finally, he could be even further down the chain, investing in high-interest funds outside of the Bitcoin community which are themselves investing in a Ponzi scheme; in this case, perhaps Pirate does not even realize that he’s investing into a Ponzi scheme at all.

If the Bitcoin lending economy is indeed backed by a Ponzi, the situation is further complicated by the surprisingly large number of middlemen in the Bitcoin lending economy, which creates a complex pyramid of investors.

On the first level of the pyramid, MMM intermediaries invest in pyramids like MMM receive returns of 40-60% per month, and are offering BTC-denominated investment accounts to acquire more capital for these investments. However, because the supply in these accounts is artificially restricted, and the interest rate is kept above the level that the market requires, demand inevitably arises for some of these investors to re-lend, pocketing a portion of the profits for themselves. Pirate, a high-interest lender on the Bitcoin Forum, also encourages this by offering his highest interest rates to very high balance accounts, so the average small investor would get a better return through an intermediary than through Pirate himself.

Some of these re-lenders are actually funds, which invest partially in what are arguably more legitimate ventures, like mining contracts and Bitcoin startups, but decided to accept the risk of one of their investments turning out to be a Ponzi scheme and defaulting for greater returns. This complex web of intermediaries can often make it difficult for both individual investors and even funds to invest without accidentally exposing themselves. The re-lenders themselves, of which the openly admitting Pirate re-lenders are often called “Pirate Pass Through” (PPT) bonds, either allow customers to deposit in them directly or through the Global Bitcoin Stock Exchange (GLBSE), which itself takes a small fee for buying and selling. Each level takes a profit, but the interest rates at the end are nevertheless as high as 3-6% weekly.

However, the question that must be inevitably asked is: what happens when the pyramid collapses? The lower-level MMM investors can easily default on all their debts and disappear, having earned a substantial profit from the difference between their rates with MMM and the rates that they offer their depositors. As for the BTC lenders, if Pirate turns out to be an MMM investor and defaults explicit PPT bonds will be able to get away with a default as well, but the more diversified funds, especially those who do not realize that they are exposed to an MMM default, face a more complex situation. Some will attempt to take the losses and keep operating, while others will shut down and perhaps offer their investors partial payback for their losses, explaining that they did not realize that the funds that they were investing into were connected to MMM. The GLBSE will only benefit, because the brief period of uncertainty between rumor of a default and outright announcement may generate a large volume of panic sales, all generating the exchange fees. The investors, however, will bear the brunt of the losses, and some will likely lose thousands of dollars.

The chance exists that Pirate is engaged in legitimate activity, and if that is true the likely scenario is that interest rates will soon go down, since the Bitcoin economy cannot possibly be growing fast enough to continue to earn Pirate a 19545% APR return. Parts of the Bitcoin economy are indeed growing quickly behind the scenes, as Coinabul and BitInstant are both reporting massive growth over the past six months and BitPay is claiming a 3x growth in transaction volume processed every month, but such a rate be sustained. The high interest rates on the GLBSE and in the Bitcoin community as a whole were also justified by the currency risk, as the value of a bitcoin itself might go up or down by a factor of 2 in the space of a month, however as much of this risk, especially in the downward direction, has faded away in the past four months, forces of supply and demand will likely push interest rates down as time passes.

On the other hand, if Pirate is running, or indirectly investing in, a Ponzi scheme, a default will likely have a serious impact on the Bitcoin economy because of the sheer number and size of the deposits involved, although legitimate businesses like MtGox, BitInstant and BitPay will survive unscathed. Whatever the outcome of the present lending bubble may be, since Bitscalper and now Bitcoinica have failed to return user investments in a reasonable amount of time, there is growing awareness that anonymous investment funds are a dangerous tool, and the result of this latest round of investment opportunities will likely determine what the community’s attitude toward such practices will be for years to come.

Vitalik Buterin is the main writer for Bitcoin Magazine and a passionate advocate of safe Bitcoin investments

 

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Vitalik Buterin is a co-founder of Bitcoin Magazine who has been involved in the Bitcoin community since 2011, and has contributed to Bitcoin both as a writer and the developer of a fork of bitcoinjs-lib, pybitcointools and multisig.info, as well as one of the developers behind Egora. Now, Vitalik's primary job is as the main developer of Ethereum, a project which intends to create a next-generation smart contract and decentralized application platform that allows people to create any kind of decentralized application on top of a blockchain that can be imagined.

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