The world of cryptocurrencies has seen a rise in Ponzi schemes since 2016, when the market gained mainstream prominence. Many shady investment programs are designed to take advantage of the hype behind cryptocurrency booms to seduce impressionable investors.
Ponzi schemes have become rampant in the industry primarily due to the decentralized nature of blockchain technology that allows fraudsters to bypass centralized monetary authorities that would otherwise flag or freeze suspicious transactions.
The immutable nature of blockchain systems that makes fund transfers irreversible also works in favor of scammers by making it difficult for Ponzi victims to get their money back.
Speaking to Cointelegraph earlier this week, Johnny Lyu, CEO of crypto exchange KuCoin, said that the sector was fertile ground for these kinds of schemes for one main reason:
“The industry is full of users eager to invest their money, and there is virtually no regulation preventing projects from hiding their malicious intent.”
“Until clear and internationally approved financial regulation of the crypto industry is established, it will continue to witness the rise and fall of Ponzi schemes,” he added.
How Ponzi Schemes Work
The Ponzi scheme phrase originated in 1920 when a con artist named Charles Ponzi marketed a high-yield program to investors that allegedly leveraged postal reply coupons for impressive profits.
He promised investors returns of up to 50% in 45 days or 100% interest in 90 days. True to his word, the first group of investors got the returns they claimed, but unbeknownst to them, the money they received actually came from later investors. The cycle was designed to attract new investors and allowed Ponzi to steal more than $20 million.
While he wasn’t the first to use such a scheme to scam people, he was the first to use it on such a scale. Therefore, the technique is named after him.
Simply put, a Ponzi scheme is a bogus investment program that promises astronomical returns to clients but uses money raised from new investors to pay off early investors. This helps the scammers behind such operations maintain some semblance of legitimacy and attract new investors.
That said, Ponzi schemes require a constant flow of cash to be sustainable. The ruse usually ends when the number of new recruits falls or when investors decide to withdraw their money en masse.
How to Spot a Crypto Ponzi Scheme
There has been a sharp increase in the number of Ponzi schemes in recent years along with the uptrend of the crypto market. As such, it is important to know how to spot a Ponzi scheme.
The following are some of the things to consider when considering whether a crypto project is a Ponzi scheme.
Promised ridiculously high returns
Many crypto Ponzi schemes aim to reward investors with high profits with little risk. This, however, contradicts how investing works in the real world. Actually, every investment comes with a certain amount of risk.
Typical crypto investments fluctuate according to prevailing market conditions, so such claims should be seen as a red flag. In many cases, investors who join such networks never get any return on their money.
Khaleelulla Baig, founder and CEO of KoinBasket, a crypto index trading platform, told Cointelegraph that transparency should be the most important factor to consider before investing money in a crypto project:
“What really matters is transparency about the details of the project. Most founders build their business on hope and optimistic projections. Check the past history of the founding team’s delivery history against commitment.”
He also advised investors to stay away from projects with shady fundamentals that rely on outside influences.
Unregistered investment projects
It is important to confirm if a cryptocurrency company is registered with regulatory organizations like the United States Securities and Exchange Commission before investing any money. Registered crypto companies are usually required to submit details about their revenue models to their respective regulatory authorities to avoid penalties. As such, they are unlikely to participate in Ponzi schemes.
Projects registered in jurisdictions with lax crypto regulations that additionally have Ponzi-like features should be avoided.
Some jurisdictions, such as the European Union, have already come up with elaborate crypto regulations designed to protect crypto investors against these types of scams. According to a recent proposal approved by the European Council, crypto companies will soon be required to comply with the Markets in Crypto Assets (MiCA) rules and will need to have a license to operate in the region.
Putting crypto businesses under MiCA will force them to reveal their revenue models, and this will temper the rise of crypto businesses relying on Ponzi-like schemes on the block.
Use of sophisticated investment strategies.
Ponzi schemes usually allude to complex trading strategies as part of the reason why they can earn high returns with minimal risk. Many of their outlined growth strategies are often difficult to understand, but this is usually done on purpose to avoid scrutiny.
The Bitconnect Ponzi scheme that was revealed in 2016 is an example of a Ponzi scheme that used this tactic to mislead investors. Its operators encouraged investors to buy BCC coins and lock them on the platform to allow its “sophisticated” lending software to exchange the funds. The platform claimed to provide monthly returns of up to 120% per year.
Ethereum co-founder Vitalik Buterin was one of the first notable figures to raise the alarm about the project. The scheme was brought down by US and UK authorities, who declared it a Ponzi scheme. Its closure in 2018 caused a drop in the price of BCC that generated losses of billions of dollars.
High level of centralization
Ponzi schemes are usually run on centralized platforms. One crypto Ponzi that relied on a highly centralized network is the OneCoin Ponzi scheme. The pyramid scheme, which ran from 2014 to 2019, swindled investors out of about $5 billion. The project relied on its own internal servers to run the scheme and lacked a blockchain system.
Subsequently, OneCoin could only be traded on the OneCoin Exchange, its native marketplace. Tokens can be exchanged for cash, and fund transfers are done via wire.
The OneCoin marketplace also had daily withdrawal limits that prevented investors from withdrawing all of their funds at once.
The scheme fell apart in 2019 after the arrest of some key members of the operation. However, there is an outstanding federal arrest warrant for OneCoin founder Ruja Ignatova, who is still at large.
KuCoin’s Lyu pointed out that the ominous red flags hadn’t changed much over the years and that MLM was still at the heart of many Ponzi schemes:
“Complex earnings schemes involving multiple levels of users, referral programs, percentages, sliding scales, and other tricks are signs of a Ponzi scheme that feeds higher levels using the funds injected by lower levels without doing any business.”
Multi-level marketing is a controversial marketing technique that requires participants to generate income by marketing certain products and services and recruiting others to join the network. Commissions earned by new recruits are shared with upline members.
One Ponzi scheme that recently made headlines for making use of this hierarchical system is GainBitcoin. The pyramid scheme headed by Amit Bhardwaj had seven main recruiters based in India and on different continents of the world. Each of them had the task of recruiting investors in the network.
The scheme guaranteed users a 10% monthly return on their Bitcoin (BTC) deposits for 18 months.
The scheme is alleged to have raised between 385,000 and 600,000 BTC from investors.
Fraudsters have used Ponzi schemes for over a hundred years. However, they have been able to thrive in the crypto industry due to a lack of elaborate regulations governing the sector.
Because the world of cryptocurrencies is susceptible to these types of schemes, it is important to exercise caution before investing in any new project.