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“I landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me.”
— Charles Ponzi 
The True Ponzis of Finance
When naysayers accuse digital assets of being a Ponzi, we crypto enthusiasts typically respond with the sophisticated retort, “it takes one to know one.”
It’s childish, but effective: By constantly declaring everything a Ponzi — stocks, bonds, real estate, the dollar, life itself — the label begins to lose meaning.
And the less meaning it has, the less damaging it is to crypto.
There is, of course, not a lot of space for nuance in this age of Twitter hot takes. So, “it takes one to know one” may well be the most effective defense of crypto.
But the truth is, crypto is not a Ponzi. And nor are any of those other things.
What makes an investment a Ponzi is when money from new investors is paid out to existing investors in order to create the appearance that the investment is earning returns.
No one thinks bitcoin is out in the world earning returns.
Bitcoin doesn’t even pay a yield. You can’t be a Ponzi without paying a yield!!!!!!!
Lots of cryptos do pay yields, however. The most notorious of which are the OHM forks (R.I.P.).
But these were not Ponzis, either.
When some dummy (like myself) paid $1,000 for one OHM token, the OHM protocol would then issue 1,000 new tokens to stakers.
Those rewards were often confused with yield, but it was clearly stated in the documentation that these were newly issued tokens being distributed, not earnings.
Olympus DAO was not pretending to be earning 8,000% returns: They were just printing new OHM and handing them out, like they said they would.
They did label that return an “APY,” however, which was misleading.
I think OHM and its forks were a worthwhile experiment and may still prove to be a first step in the development of a sustainable stablecoin pegged to crypto-native assets.
But I’ll concede there was a large element of Ponzinomics involved. And that the eye-popping “APYs” made crypto more susceptible to the Ponzi accusations.
To find a true Ponzi, however, we have to leave crypto and return to traditional finance.
Because there is one — and I believe only one — legally sanctioned Ponzi scheme: closed-end mutual funds.
Charles Would Approve
Cornerstone Strategic Value (ticker: CLM) is a $1.7 billion closed-end mutual fund that has earned a coveted four-star rating from Morningstar.
The fund is so popular with retail investors that it trades at a 51% premium to its net asset value. 51%!
Investors are willing to pay that lofty premium because, even at 51% above NAV, the fund still distributes an annualized “yield” of 15%.
With 10-year yields at 2%, 15% is hard to resist.
You, eagle-eyed reader, may have noticed the quotation marks above.
I put quotes around yield because what holders of CLM (or any other closed-end fund) are being paid is not, in fact, a yield. It’s a “distribution.”
It’s a distribution because what holders are receiving is not entirely earnings. If you hold CLM, most of the 15% that is being distributed is your own money being returned to you.
If you put $1,000 into a closed-end-fund, the fund can immediately return $150 of your own money to you and say it’s paying a “distribution” of 15%.
Except that no investor ever hears “distribution.” We all hear “yield.”
Paying a distribution that looks exactly like a yield gives investors the impression that their investments are earning a return…which is the very definition of a Ponzi.
And, yes, this is entirely legal.
In the case of CLM, 62% of the distribution for 2020 was investors’ own money. In 2019, it was 75%.
The directors of CLM will tell you they do this in order to smooth returns: At the start of each year, they set a target return so that investors know what to expect.
If the fund’s earnings fall short of that target, they make up the difference with a “return of capital” (i.e., by paying you with your own money).
But CLM has been missing its distribution targets and smoothing returns since at least 2015.
That fig leaf of a rationale (smoothing returns) gives closed-end-funds legal cover.
But it seems to me that these funds are cynically exploiting the insatiable demand for predictable yield among retail investors.
This is the same reason why Bernie Madoff remained in business for so long.
Madoff’s fund continued onboarding new investors a full seven years after a Baron’s article first raised doubts about his impossibly consistent returns.
Investors, in fact, never actually lost faith: The fund was going strong right up until the day Madoff was perp-walked out of his office in handcuffs.
Madoff’s believers stuck with him for so long because the draw of predictable returns is so powerful that perfectly intelligent people unwittingly delude themselves about how it’s being generated.
Some closed-end-funds are exploiting that universal truth of behavioral finance in the same way that Bernie Madoff did.
Greater Fools
All the non-stop Ponzi accusations and counter-accusations have so successfully muddied the waters that the definition of the word has effectively changed: anything that gets bought at one price and sold at another now qualifies.
“Ponzi” has become synonymous with the “greater fool” thesis.
Bitcoin and its successors do, in fact, fall into the greater fool category: To make money in crypto, you are dependent on someone deciding to pay you more for it than you decided to pay someone else.
But that is also the case with gold, the US dollar, real estate and a lot of other perfectly sensible investments.
Writing off the entire investment universe because “everything’s a Ponzi” will not help you achieve that early retirement you are counting on.
The trick is simply to have a solid thesis on why you will be able to sell for more than you bought.
Figuring out why someone will pay you more for your crypto in the future is trickier than figuring out why someone may pay you more for your house.
But it’s not impossible.
So, be sure to avoid the tiny few examples of true Ponzis that are out there (mostly in TradFi!)
And spend your time and energy instead on identifying what the many greater fools will be paying up for in the future. Find this email helpful? Tweet it!
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Written by @bgilliam1982 and @aaronhasapen.
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