The guest commentary below was from Ryan Maestro’s piece on Swan.com. This piece does not necessarily reflect the opinion of Hedgeye.
Why Do So Many Crypto Tokens Exist?
Here’s a bold statement: of the 19,000 crypto projects listed on CoinMarketCap.com, 99% of them are scams to enrich the person who created them. There are even token-generating websites out there that can create one for you for only $40.
Of the remaining 1% that are not technically scam projects because they actually provide some service or have some utility to other crypto projects, often the project’s token itself is useless to an investor. This is because revenue the protocol generates doesn’t accrue to the token holder (a few do, of course). These tokens exist, again, to compensate the team’s developers and early venture capitalists unloading onto the retail “Coinbase crowd.”
Ponzinomics: When Supply Meets Demand
The most blatant scam tokens rely on “Ponzinomics.” Advertised with a high APY in like kind, but with no revenue generated from the project itself where your return depends solely on a continuous flow of newly minted tokens. In other words, the token is constantly inflated. At some point, to collect one’s winnings, one has to take their original tokens plus the newly minted ones back to the exchange to sell them to the next buyer. Now imagine that scenario happening by the thousands. It can work for a while, but eventually the inflation catches up if token printing is its only feature.
It becomes a classic exercise every student learns the first week of Economics 101: supply and demand. If there are too many tokens that overwhelm buyers, the price will decrease. If the project has a good marketing or a shilling campaign, they can increase demand with a steady stream of buyers ready to lap up these excess tokens for a while. Eventually though, the token will run out of fresh buyers and the end result is always the same: the token goes to zero and the last set of buyers are left holding the bag.
Not Technically Ponzi Schemes
The crafty thing about these new Ponzi projects is that they don’t legally qualify as technical Ponzi schemes as specified by the SEC because new investor money isn’t directly flowing to another investor with a 3rd party asset, such as the US dollar, as it was with, say, Bernie Madoff.
Instead, these Ponzi tokens are created out of thin air, then sold to the masses, and the only thing that changes is the story behind it. With the now infamous Bitconnect, returns were supposedly backed by a trading bot. OneCoin was marketed as an alternative to Bitcoin and token packages came with educational trading materials. With Wonderland and the Ohm forks, they were marketed as centralized bank reserve assets where one exchanged a valuable asset for a token that supposedly earned 89,000% APY. And with Hex, it is marketed as a ‘certificate of deposit’ that earns 38% a year.
Hex is a great example of a Ponzi project that hasn’t gone to zero yet and I’ve written extensively about its underlying mechanics in detail on my website. What follows are the distilled major points that have led to a longer shelf life for it than most.
The founder, Richard Heart, is a very colorful person. He’s a master marketer (prior to crypto he was in the spamming business) who uses various social media platforms to market Hex and his eternally delayed subsequent project, the PulseChain Ethereum fork.
You’ll see him wearing outlandish outfits with top hats and sitting on a throne surrounded by Louis Vuitton automatic watch winding cases filled to the brim with Rolexes while he debates crypto influencers on why Hex is not a scam. You’ll see videos of him driving around in his Ferrari and a mini documentary showcasing the crafting of his ruby enshrined Hex ensemble that cost who knows how many hundreds of thousands of dollars to procure. You’ll also see the 555 carat black diamond that he recently bought at auction. Of course most seem to miss the point that all those luxury goods that Richard shows off and attracts viewers with weren’t obtained from investing in Hex, but from selling Hex to others.
It’s hard to find a better example of a person who seeks as much validation from total internet strangers as he does, but it seems to work and his followers worship him and will buy whatever he’s selling — twice.
In fact, he came up with the concept of a “sacrifice” where it says right on the website that when you donate your crypto to an address he controls, that you are to expect nothing in return. He has done this twice now and thousands of people gleefully dumped their Ethereum and other crypto assets into his wallet. In reality, donors are scheduled to get more worthless tokens on the new forked chain, but he is at least being honest about their value!
His social media strategy developed over many years before he came up with Hex, so he already had tens of thousands of followers ready to buy it when launched. These early entrants knew that their bags would fill faster if they were to “onboard” new users into it after them, so therefore the Hex launch came with its very own shilling army. It’s hard to come across a cryptocurrency topic on social media without one of these foot soldiers shilling it into the conversation about how great it has been for them whether it has or not.
The earliest entrants who got in on the ground floor became part of the marketing effort and proudly submitted pictures of their lambos and other luxury goods purportedly paid for with Hex winnings.
The Key Hex Feature
Usually, Ponzi projects don’t last more than a few years, but Richard Heart put a lot of thought into Hex’s design. He realized that selling is the enemy of a Ponzi project because when supply overwhelms demand and the price plummets, buyer interest fizzles out and the token never recovers. Crypto speculators want the token that “moons” and there is no shortage of speculators ready to jump on the next project headed to the sky. Therefore if he could figure out a way to reign in those pesky sellers, the project could have more longevity.
His solution was to market his project as a “certificate of deposit” where to get the rewards in the form of additional tokens, one has to lock up their funds for a period of time. Of course, the longer the lockup period one chooses, the more yield one receives. If they unlock early, they are heavily penalized and can lose much of what they put in. With the maximum lockup period being over 15 years, he’s probably just hoping you’ll just forget about your tokens entirely, but likely the project will be a distant memory well before then anyway and it won’t even matter.
He has bamboozled thousands into thinking that they can have a lifestyle similar to his with buzzwords that Hex can create “generational wealth” through “delayed gratification.” The only generational wealth being created here is for Richard Heart who managed to convince thousands of people to buy a digital token created from nothing. It’s hard to find that elusive product with a 100% profit margin, but Richard Heart managed to figure out a way to sell air and it doesn’t have the legal strings attached to it like his spamming business did.
Even though he received tens of millions of dollars in Ethereum selling Hex through the rolling year-long initial coin offering, he still decided to use a loophole engineered only for himself, to take those same assets used in the purchase and turn around and buy millions of Hex tokens for himself. He did so much of this that today he holds almost 90% of the entire supply of Hex. Instead of denying it, he plays a lateral that Satoshi Nakamoto also owned a large portion of Bitcoin in the beginning and that it, therefore, makes Hex similar to Bitcoin in some roundabout, non sequitur way.
The 38% “Interest Rate”
All those superfluous tokens that Richard Heart owns is key for keeping the purported interest rate at 38%. If you click around on the website you will see that it is mentioned that the inflation rate of the Hex supply is only 3.69%, so how does a 3.69% inflation rate translate to 38% APY?
It’s a sleight of hand because only tokens locked up get to earn interest. So, by keeping his 90% stash unlocked, all the inflation interest that would accrue to him instead flows to all the other holders. He could have doubled his token stash and then doubled the purported interest rate, it’s not magic. As a result, the circulating supply controlled by the retail investors is growing by the same 38% (delayed until the time lock ends), which is a lot of newly minted tokens for the market to absorb.
The Hex Ponzi Is Already Fizzling Out
The problem with Ponzis is that usually by the time they come to your attention, even if you wanted to jump in and jump out before it collapses, it’s usually too late and you are one of the last buyers.
Hex is already down 90% from its peak price back in September with no signs of slowing down so anyone who decided to jump in since then likely lost money in providing exit liquidity to earlier entrants. It could still pump up from here if the marketing engine revs up, but with the retail supply growing 38% (on average) each year, more and more participants are necessary to be brought into the scheme to even keep the price level.
And with the Pulsechain fork set to launch sometime soon, the count of the Hex tokens will double again, which will further negatively affect the price as Ponzi partcipants decide between the Ethereum or Pulsechain version.
The key takeaway from this is that if a token’s only utility is generating more tokens to compensate investors who’ve bought in, it’s a Ponzi and you’ll likely lose money in the end.
Ryan Maestro is an investment strategist at WantFI.com and writes about using traditional investing and the new cryptocurrency frontier to achieve financial independence. He holds a bachelor’s degree in mathematics, a master’s degree in economics, and a master’s degree in computational finance and has worked in the financial services industry for over a decade.