COLUMN: When will the bitcoin bubble burst?

An old chart showing 17th Century tulip prices in Amsterdam

Someone like me would make an ideal bitcoin enthusiast – libertarian by political persuasion, open source enthusiast, early adopter of all kinds of technologies, hater of big government and possessor of what my wife calls a ‘mildly paranoid personality’. 

Yet, try as I might, I just can’t see bitcoin as anything other than the most successful ponzi scheme of recent times.

A ponzi scheme is defined as a scheme in which the capital invested by people who join later constitutes the profit earned by those who invested before them.

In other words, a ponzi scheme is an investment scheme in which people invest money in the expectation that they will get outsized returns, but these returns are entirely dependent on more and more people investing as time goes by.

Once new investors stop coming in, the earlier investors can no longer get the return/profit that they expected, and the whole thing collapses.

Now, there are people who may ask if gold too is not such a ponzi scheme.

There are two differences between gold and a typical ponzi scheme. One — the person investing in gold is primarily looking at capital preservation, rather than the generation of extraordinary returns.

Even if gold does not give a return — but only helps you protect your wealth against inflationary tendencies — people will, and do, invest in it.

In other words, people still invest in gold even if its price increases only by 5% or 7% a year. But can you imagine if the value of bitcoin or other cryptocurrencies rose only by 5% or 7% a year? How many people would invest in it? Would these ‘assets’ have any takers?

Another key similarity between a ponzi scheme or a pyramid marketing scheme and bitcoin is the absolute need to win more and more converts. A pyramid scheme needs more and more people/members to join if it is to deliver returns. Therefore, it is the duty of those who join to persuade as many new people as possible and bring them into the network.

This can also be seen in the evangelical zeal of bitcoin investors: They are always trying to ‘convert’ and bring in more and more people into the network by talking about the huge returns they have made and so on.

Of course, bitcoin enthusiasts may argue that this is not a fair comparison to make, as bitcoin is not as useless as a membership of a typical ponzi or pyramid scheme. They may say it is a full-blown currency and can be used to pay for goods and services.

Yet, the fact is that bitcoin has not been able to fulfill its initial promise of emerging as a mode of payment. Several problems stand in the way. First is the high transaction fee, which makes the network extremely inefficient and unsuitable for most transactions.

The average transaction fees on the bitcoin network is $2-$4, or around Rs 150-300 rupees. Would you pay for a 10 rupee tea if you had to shell out Rs 200 as a transaction fee? In fact, would you pay Rs 1,000 for a shoe if you had to pay Rs 200 as the transaction charge?

The second limitation that stands in the way of using bitcoin as a means of payment is transaction time. While payment methods such as UPI, credit card etc are nearly instantaneous, a bitcoin payment can take anywhere from 10 minutes to 1 hour to go through. Can you imagine hanging around at a tea-shop for 10 or 20 minutes to check if the payment went through?

These are problems that were not anticipated at the time bitcoin was conceived, but are big enough to hamper its adoption as a method of payment.

Yet, despite bitcoin failing in its primary promise of enabling a truly decentralized, reliable and cheap payment platform, people still continue to value the platform as if its original promise can still be fulfilled.

We can understand the situation using the following, fictitious example of ‘peerphones’


Suppose a company brings out a new kind of cellphone, Peerphone, that doesn’t require a traditional cellular network, or even a provider. 

It works by connecting to your neighbor’s Peerphone, which in turn connects to that of his neighbor’s and so on — creating a decentralized, mesh network. But due to technological reasons, only 22 million of them can be created.

Of course, the Peernetwork doesn’t work right now, but it will when enough people purchase such phones and switch them on at some time in the future.

After an initial period of skepticism, people are enthralled, and more and more people start buying these phones. 

The price of Peerphones go from $100 to $2000 in five years, as they are considered the future of communication, and they will help free people from the tyranny of cellphone companies. 

Of course, there are only 22 million handsets that can be part of the network, so that adds to the frenzy and FOMO.

Fast forward another 5 years, and the Peerphone maker has long since stopped production of the handsets, having made all 22 million possible, but the phones are still being furiously bought and sold in the market. 

Each phone is now worth $10,000, and there are special marketplaces where such phones are sold. 

As is the nature of market-traded commodities, sometimes the price of the phone goes up, sometimes, down. 

Many people have become millionaires from trading such phones, while some have lost their life’s savings. But the overall trend has been on the up, and the bulls believe the peerphone will soon touch $100,000 or even $1 million.

In all this hullabaloo, nobody has bothered to use their phones to actually make calls, because the phones have become so valuable that they cannot — need not — be used to make calls. Their economic value is now far more than their value as a medium of communication. They have become an appreciating asset that must be preserved in pristine condition.

Nobody cares whether the original promise of enabling carrierless communication — the prospect that kicked off all this frenzy — can realistically be achieved or not. 

Indeed, in some countries such as El Salvador, people have tried to use the phone to create peer networks, but it has hardly been as successful or revolutionary as envisioned. 

Such experiments have brought to light unexpected hiccups, such as dropped calls due to someone in the network switching off while a call was being routed and so on.

But nobody cares, because these days, nobody sells these phones on the promise of delivering carrierless communications. Now, the whole pitch is around ‘peerphone to the moon’ — how, given the current trends, peerphone will soon touch $100,000 and eventually breach the $1 million mark.


The second major problem with bitcoin is the sheer unfairness of the way in which it was distributed.

We can understand this using the example of a fictitious currency called Libernotes.

Suppose a person invents a new currency called Libernotes. He has designed it in such a way that only 22 million of these can ever be printed and in circulation.

Suppose the person spent 220,000 dollars to invent and print these 22 million notes, which means each note cost around 1 cent to produce.

Now, suppose this person offered to sell 100 of these libernotes to you for 1 dollar each. The person says this is the currency of the future, because it contains very advanced technology that makes it impossible to counterfeit. He argues that because of the superior technology, people will stop using traditional bank notes and move to libernotes. Because of this, the value of each libernote will also go up, and you will make a tidy profit in the future.

Suppose he manages to convince 100 of his friends about the superiority of the new currency, and they together purchase 1 million out of the 22 million notes he had originally printed. 

Thus, the inventor has now generated $1 million by selling 1 million libernotes. This means he is already sitting on a profit of $778,000.

Now, these friends of the inventor approach others with the same marketing pitch of how these currencies are more superior and they will replace ordinary cash and so on, and offer to sell these notes at $5 each.

Some of them manage to convince others, while others don’t. But enough of them manage to do so, so that the ‘price’ of the libernotes has jumped to $5 each.

This also means that the 21 million notes that the inventor still has left in his garage is now worth $105 million.

Of course, some of his friends who were not very good at marketing and sales are also now thrilled to find out that the ‘price’ of their notes has gone up five fold due to the marketing efforts of others.

This keeps going on and on.

For example, people who got hold of the notes for $5 each now go to others with the same marketing pitch, about how libernotes are going to be the future of payments, how they will totally outshine current currencies because of their superior convenience and anti-counterfeit measures and so on.

They offer to sell the notes at $10 each.

This goes on for five years, and now each note is worth $30,000. 

Meanwhile, the inventor has liquidated most of his notes in between, partly to keep the market liquid and partly to cash in on the price increases.

Now the inventor has only 7 million notes left, having sold the remaining 15 million notes at an average price of around $10,000. Thus, on his initial investment of $220,000, he has already earned a profit of almost $2.2 billion. 

Some of his friends and friends of friends are also millionaires now, even though they did not do much way of marketing or evangelization.

Eventually, libernotes — which were supposed to be a superior method of carrying out transactions — have instead become a prized commodity and is traded on public exchanges.

The price of these libernotes keeps changing every day, and because of that, nobody uses these notes for making payments.

For example, if you put up your house, worth $300,000, for sale for 10 libernotes on Monday, you might end up getting only $50,000 dollars when you manage to sell it after two weeks and reconvert the notes into dollars.

Because of this risk, nobody uses libernotes to set a price for anything, and the price of everything continues to be designated in terms of traditional currencies.

Another problem is that even when people are willing to take payment in libernotes, they demand extra money in the form of transaction charges — claiming that they have to go to the bank and convert these notes into regular currency later.

In other words, the key USP of the notes — of replacing traditional bank notes — has come undone, but surprisingly, no one seems to have noticed! 

Nobody seems to care that libernotes are not, and perhaps can never be, used in place of regular currencies, but people have forgotten this simple fact in all the excitement.

There are also those who support bitcoin for ideological reason — because of what they see as the unfairness of fiat currency. They point out that it is unfair and unnatural that any single organization — such as the US Federal Reserve — should have the right to create currency.

Yet, the alternative that they push for has been created by an individual who continues to hoard a large quantity of the currency for himself, and who distributed it at cheaper rates to those around him, leaving large parts of humanity — especially in poorer countries — to buy this currency at astronomical valuations.

While bitcoin may have started as a genuine libertarian experiment at developing a truly decentralized currency, it has been taken over by people who believe that their investments will continue to increase in value as newer converts come in.

The question is, what happens when you run out of new converts, and when will this happen?