Are Cryptocurrencies and NFTs digital pyramid schemes based off of Greater fool theory?

In a 2021 interview with Bloomberg, Bill Gates, one of the most successful entrepreneurs of our time, said that cryptocurrencies and NFTs are “100% based on greater fool theory.” This statement sparked a debate among experts in the financial and technology industries, raising concerns about the sustainability of these digital assets and their underlying value. In this article, we will explore the idea that cryptocurrencies and NFTs are digital pyramid schemes based on the greater fool theory and examine the evidence supporting this claim. We will also discuss the potential risks and drawbacks of investing in these types of digital assets and whether or not Bill Gates’ statement holds water.

Cryptocurrency and NFT: A Brief Overview

A cryptocurrency (Bitcoin and Alt-coins) is a digital currency that uses cryptography for security. It is decentralized and operates independently of a central bank. There are thousands of cryptocurrencies in the market, and Bitcoin, Ethereum, Litecoin, and Ripple are some of the most well-known currencies.

An NFT, or non-fungible token, is a unique digital asset that represents ownership of a specific item, such as a digital artwork or collectible. NFTs are often built on blockchain technology, which is the same technology that powers many cryptocurrencies. This means that NFTs can be bought, sold, and traded like physical assets, but they exist only in the digital world.

NFT on Blockchain
“Blockchain Crypto Ape NFT” (CC0) via Pixabay

Understanding the Greater Fool Theory and Pyramid Schemes

Greater fool theory is an investment concept that suggests that it is possible to make money by buying assets that are overvalued or in a bubble, as long as you are able to sell them to someone else before the bubble bursts. Greater fool theory works by assuming that the value of an asset is driven not by its underlying fundamentals (such as revenue, earnings, or intrinsic value) but by the expectation of future price increases. In other words, people are willing to buy an asset, even if it is overvalued, because they believe that they may be able to sell it to someone else at an even higher price. The theory states that, as long as there is a “greater fool” willing to buy the asset at a higher price, the current owner can make a profit by selling it. This creates a self-fulfilling cycle of buying and selling, where the price of the asset keeps going up, even though it is not based on any real value. However, when the market is saturated with buyers, and there is no greater fool to buy the asset, the bubble bursts, and the price of the asset plummets. This causes investors who bought in at the peak of the bubble to lose a significant amount of money.

Pyramid schemes are a type of financial scam based on the greater fool theory. A classic pyramid scheme works by recruiting investors to buy into the scheme with the promise of high returns on their investment. Existing investors receive a commission for each new investor they recruit, and there are many tiers of investors who receives varying degree of commissions base on the level they are on the pyramid, as shown in the image below.

Pyramid Scheme
“Pyramid scheme diagram” By Security and Exchange commission, U.S. Federal Govt. (Public Domain) via Commons Wikimedia

As the scheme grows, each new level of investors generates returns for the level above them. However, as the scheme reaches its limits, it becomes increasingly difficult to recruit new investors, and eventually, the pyramid collapses, leaving most investors with significant losses.

In a pyramid scheme, investors believe that they will be able to sell this investment opportunity to a “greater fool” at a higher price. These schemes form financial bubbles driven by speculation and not by any real underlying value, and they are not sustainable. Financial bubbles are a relatively common phenomenon in financial markets. Throughout history, there have been many examples of financial bubbles. The dot-com bubble of the late 1990s and early 2000s and the real estate bubble of the mid-2000s are two examples of recent bubbles that caused heavy losses to many investors.

  • Dot-com Bubble: This bubble occurred in the late 1990s and early 2000s and was characterized by a rapid and dramatic increase in the value of technology companies, particularly those related to the internet. Many of these companies had little or no revenue and were valued based on their potential growth. When the bubble burst, many technology companies lost much of their value, while investors lost significant amounts of money.
  • Housing market bubble: This bubble occurred in the mid-2000s. It was characterized by a rapid and dramatic increase in the value of housing prices. The bubble was fueled by easy access to credit, lax lending standards, and speculation. The bubble burst in 2008, leading to a global financial crisis and leaving many homeowners with mortgages worth more than their homes.

How Do Cryptocurrencies and NFTs Fit the Mold of Pyramid Schemes?

As explained above, the greater fool theory is the root driver that form pyramid type financial bubbles. Identifying a financial bubble can be difficult, especially in real-time, since they are often characterized by a combination of factors and can take time to develop. Nevertheless, most bubbles have some common signs, such as soaring prices, speculation, overvaluation, and market euphoria. Interestingly enough, some of these signs can also be observed in cryptocurrencies and non-fungible tokens.

Intrinsic Value of Cryptocurrencies and NFTs

Since cryptocurrencies are decentralized digital currencies, they have no physical form. The value of a cryptocurrency is not based on any underlying assets or cash flow but rather on supply and demand and the belief that it can be used as a means of payment or store of value. This is why economic experts like Peter Schiff claim that cryptocurrencies are overvalued assets. The intrinsic value of an NFT is also a topic of debate, as it is not a physical asset, and it doesn’t generate any income or cash flow. Some argue that the value of an NFT comes from the rarity and uniqueness of the digital asset it represents, while others argue that the value is purely speculative and driven by hype and the expectation of future price increases.

It’s also interesting to note that investors can only make money from cryptocurrencies and NFTs only once. That is, once they sell the assets they own, and only if someone is willing to pay more than what the investors paid for it. As long as they remain the owners of these assets, the assets only have a perceived value, not a true monetary value. Based on this logic, what investors of cryptocurrencies and NFTs truly own is a string of digital numbers, nothing else. They can only make profits from these digital assets if they find a ‘greater fool’ willing to buy them at a higher price.

NFT
“NFT Non-Fungible Token Typography” (CC0) via Pixabay

The Role of Speculation and Volatility in the Value of Cryptocurrencies and NFTs

A rapid and dramatic increase in asset prices is one of the most obvious signs of a financial bubble. Both NFTs and cryptocurrency markets are highly volatile, as prices can fluctuate rapidly and unpredictably. They are relatively new and not well-established markets (compared to other assets like stocks or gold), and their prices can fluctuate due to factors such as lack of regulation, high degree of speculation, and sentiments of the investors.

The values in the cryptocurrency market can change dramatically with minor incidents. For example, in December 2020, Elon Musk tweeted about Bitcoin, causing its price to rise by nearly 20% within 24 hours. Similarly, a bankruptcy of a major crypto exchange like FTX can bring down the prices of the whole cryptocurrency market.

Speculation also plays a major role in the value of digital assets like cryptocurrencies and NFTs. Many investors buy and sell crypto (BitCoin and Alt-coins) and NFTs based on speculation, expecting that their value will increase in the future rather than any real use case or underlying value. This speculation can drive their prices to artificially high levels, creating a bubble. But, when these bubbles burst, the prices may decrease significantly, causing huge losses to many parties involved.

Bitcoin Price
“Bitcoin Price Chart Coin” (CC0) via Pixabay

Euphoria toward Cryptocurrencies and NFTs

Cryptocurrency has certainly generated a lot of excitement and interest among investors and the general public. The rapid price appreciation of some cryptocurrencies, such as Bitcoin and Ethereum, has led to significant media attention and hype. In fact, in November 2021, the price of Bitcoin reached an all-time high of $60,000, which resulted in a surge of new investors and traders entering the market, eager to get in on the action and potentially make a quick profit.

This enthusiasm and hype can be seen as similar to the euphoria stage in a bubble. In a bubble, asset prices rise rapidly as more and more people buy in, driven by the belief that prices will continue to rise. This can lead to a vicious cycle where rising prices attract even more buyers, driving prices higher. However, bubbles are often followed by a crash as prices eventually become unsustainable and reality sets in. Since its peak in November 2021, the value of Bitcoins has fallen by more than half. In January 2023 (at the time of writing this article), the price of a bitcoin is at $21,230.52.

The Dangers of Investing in Cryptocurrencies and NFTs

Although cryptocurrencies and non-fungible tokens have become increasingly popular in recent years, there are many dangers associated with investing in these digital assets. One of the biggest risks associated with investing in cryptocurrencies and NFTs is the volatility of their value. As we explained above, the value of these assets can fluctuate rapidly, sometimes losing or gaining substantial value overnight. This volatility can lead to significant losses for investors, especially those who invest a large portion of their savings. To protect yourself from the volatility of the cryptocurrency and NFT markets, make sure to only invest what you can afford to lose and to diversify your investments across different assets. Additionally, it’s important to keep an eye on the news and market trends, as well as to have a clear exit strategy in place in case the value of your investment starts to drop.

Another major risk associated with investing in cryptocurrencies and NFTs is the lack of regulation in the market. Cryptocurrencies and NFTs are not backed by any government or institution, and there are no legal protections for investors in the event of financial loss. Moreover, the market for these digital assets is largely unregulated, which can make it more susceptible to fraud and manipulation. This lack of oversight also makes it difficult to trace and hold individuals accountable in the event of illegal activities. To protect yourself from fraud and manipulation in the cryptocurrency and NFT markets, it’s important to do your own research and invest only in reputable projects. Additionally, it’s always recommended to invest in well-established cryptocurrencies like Bitcoin and NFTs (Clock) that have a track record of success.

Investing in crypto and NFTs also poses security risks, as they are stored in digital wallets that can be vulnerable to hacking and other types of cybercrime. If your digital wallet is hacked, you can lose your entire investment in an instant. Using a hardware wallet to store your cryptocurrencies and NFTs is one way to keep your investment safe. These wallets are offline and are much more secure than software wallets. Moreover, you should always make sure to use strong and unique passwords for your digital wallets and to keep your recovery phrase in a secure location.

Another challenge of investing in this asset class is the lack of liquidity. These assets can be difficult to convert into cash, which can make it difficult to liquidate your investments quickly. This can be a major problem if you need to access your money quickly, such as in an emergency. In addition, these assets are not yet widely accepted as a form of payment (legal tender), which can limit their utility and value.

Conclusion

While cryptocurrencies and NFTs have the potential to be valuable investments, they are also susceptible to the same type of manipulation and speculation that has historically plagued pyramid schemes. The “greater fool theory” is often at play in the cryptocurrency and NFT markets, as investors always hope to sell their assets at a higher price, regardless of the underlying value. Furthermore, the lack of regulation and oversight in the cryptocurrency and NFT markets can make it difficult for individuals to protect themselves from fraud.

It’s true that the technology behind cryptocurrencies and NFTs is innovative, but the market for these assets is still largely unregulated and susceptible to manipulation. Therefore, it’s crucial for investors to be aware of the potential risks and to approach these investments with a healthy dose of skepticism.

If you enjoyed this article then you may also like to read our post on Cryptocurrency-Related Rug Pulls and How to Spot Them.

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