The Strange Case of Nakamoto’s Bitcoin – Part 1

The Strange Case of Nakamoto's Bitcoin - Part 1

“There's an old saying in Tennessee—I know it's in Texas, probably in Tennessee—that says, 'Fool me once, shame on… shame on you. Fool me—you can't get fooled again."

George W. Bush, Nashville, Tennessee, September 17, 2002.

Shams, Shakedowns, & Swindles

When I read through the list of confidence tricks on Wikipedia I’m struck by the boundless creativity that humans posses. I imagine the millions of variations of scams and schemes that must have existed over the lifetimes of 100 billion people, and marvel at our ingenuity when it’s applied to making a quick buck.

From papyrus to protocols, the undiscovered country of criminality lies along the frontiers of new technology. Ethical borders are easily crossed, and moral compasses ignored, when opportunity is plentiful and law is scarce. Outright theft has always been relatively straightforward, but risky. Why take by force what the gullible and guileless will volunteer? Patience is a virtue, and the long con is where the big money is at.

Fraud’s foundations lie in the marriage of dishonesty and exploitation. Beyond this, its taxonomy is arbitrary. Many choose to assign fraud to a category based on the specific goal or mechanism used, while some experts suggest classification which first considers group or individual targeting. Whatever our system, the limits of categorization quickly become apparent. Some schemes target groups and individuals simultaneously. Many scams borrow generously, their methods and mechanisms bleeding into one another, making them hard to pin down. Categorizing fraud is an attempt to define the scope and range of all possible human behavior which uses deceit to exploit others for personal gain. As a result, fraud’s internal boundaries can be unfocused.

While sometimes difficult, general categorization does help to provide clarity, specific instances of fraud are carefully examined and grouped based on their modus operandi. Occasionally new groups are discovered and given names like Payroll Spoof or ‘Ransomware. It is by dissecting specific species of fraud that new genera are discovered in the wild.

Using this approach, we can think of the Madoff investment scam as a specific species of fraud which belongs to the genus Ponzi Scheme. The Ponzi genus belongs to the family of Investment Fraud, which also contains the genus Pyramid Scheme. Members of the same family are distinct, but often share similar characteristics and mechanisms. We could say that the Madoff and Amway schemes are related, as their genera are both members of the Investment Fraud family.

As Bitcoin, and cryptocurrencies in general, claim to be investments, yet have no underlying sources of revenue, many have viewed them with suspicion. Some argue that Bitcoin is a Ponzi, while others counter that the comparison is erroneous as it shares traits with a pyramid scheme. Surprisingly, despite intense scrutiny, Bitcoin has defied precise categorization as a specific form of investment fraud, leading some proponents to suggest that, as a result, it should be cleared of all charges, “If it looks like a duck, but honks like a goose, then it can’t be either”.

In actuality, categorizing the mother of all crypto as Ponzi or pyramid is an attempt to fit a square peg into a round hole. Bitcoin is neither, it belongs to a new genus of fraud. It has several specific qualities that make it unique, and many others that it shares with known forms of investment fraud, notably Ponzi and pyramid schemes. By carefully examining Bitcoin’s construction and observing its relations with other forms of investment fraud, we can better understand the inner workings of the Nakamoto scheme.

Odd Duck

Like a Ponzi, Bitcoin doesn’t specifically promote a need for liquidity or sales. Like a pyramid, Bitcoin promotes, proselytizes, and preaches as realizing returns is dependent on new converts.

Like a Ponzi, Bitcoin doesn’t sell the rights to acquire new members or sell products. Like a pyramid, the right to sell something can be purchased, the ‘investment’ made during the mining process bestows Miners with the the right to sell the bitcoin they acquire.

Like a Ponzi, a Bitcoin investor’s returns don’t depend on their direct recruitment efforts. Like a pyramid, a Bitcoin investors ability to realize returns depends on transactions with counter-parties recruited into the scheme.

Like a Ponzi, Bitcoin guarantees returns to investors. Like a pyramid, Bitcoin investors entirely depend on recruitment to realize returns.

Bitcoin is a strange amalgam, and can best be described as an extensible sub-fiat distributed virtual investment fraud hybrid, more easily referred to as a type of Nakamoto Scheme.

It is extensible because Bitcoin is a digital network and can be used as a scaffolding onto which other forms of investment fraud can be grafted (Ponzi, Pyramid, Pump and Dump). It is sub-fiat, in that the initial investment in the scheme is not made with dollars, but with a commodity, as electricity is wasted during the mining process, giving the scheme a naturally occurring fiat on-ramp and valuation mechanism. It is distributed, as the mining process creates a level playing field, a fair market, where a stake in the scheme can be purchased. It is virtual, in that the scheme provides virtual returns which can only be realized via fraud which enables additional fiat on-ramps. It is an investment fraud hybrid, in that it shares many of the same characteristics and mechanisms that are found in related investment frauds.

We’ve known for some time that Bitcoin resembles other types of investment scams, so let’s take a look at what qualifies the Nakamoto scheme as a novel form of fraud.

Growing the Flock

Up until 2009, fraud could be conducted over digital networks, but Bitcoin is the world’s first case of investment fraud which is a digital network. Because participants and software can interact with the network, new systems can be created which allow the extension of further schemes.

Centralized exchanges can be built which enable more traditional forms of financial schemes. Exchanges can leverage insider information, or wash trade to manipulate prices, or can front run clients to liquidate leveraged positions. It is even possible conduct unregulated fractional reserve crypto-banking by selling synthetic bitcoin to customers.

Typically con-artists prefer to keep their schemes to themselves, but allowing others to build on top of Bitcoin helps to legitimize the scheme and attract liquidity from a wider audience.

Taking Wing

The most important, and most novel mechanism in the Nakamoto scheme is the way in which Proof-of-work (PoW) is leveraged and combined with mining rewards. Originally, Hashcash’s PoW was proposed as a way to discourage e-mail spam or denial of service attacks by forcing senders to expend CPU time, and hence electricity. Electricity costs money, and while the cost is small, it will scale with the number of emails sent, or connection attempts made. This method of using PoW explicitly ties it to some type of utility being provided. In contrast to the ethical ethos of hyper-financialization found in crypto, this method was preferred to email micropayments as it avoided the administrative and moral issues related to charging for e-mail.

In it’s original form, PoW expends electricity, but the value of that wasted electricity is a cost required to provide utility. Because the goal of this system is to provide some good or service (resource), a price ceiling is established based on the subjective value of being able to send an email.

Nakamoto’s genius lay in realizing they could hijack proof-of-work to kill four birds with one bitcoin.

Bird 1 - The Investment Vehicle

Firstly, Nakamoto inverted Hashcash’s PoW. Instead of being used to provide utility, the electricity expended by PoW could be tethered to the value of a digital token by a reward mechanism.  In Nakamoto’s incarnation, participants have a chance to receive a reward in the form of bitcoin by conducting PoW calculations. This process is referred to as mining, and it transforms the expenditure demanded by PoW from a cost into an ‘investment’ in the mind of the Miner. To participants, the bitcoin they mine has intrinsic value equal to the amount of money spent to mine it (electricity + capital + other operating costs). This gives the token a concrete value for everyone who participates in the mining scheme, and creates the foundations for a market by providing a universal valuation mechanism.

As it does not concern itself with providing utility, Bitcoin’s only goal is value. A price floor is created based on the amount of electricity used to generate a bitcoin. To realize returns, Miners must exchange the tokens for a greater amount of value than the cost of electricity used to generate them. Instead of PoW being used to provide a good or service, what we might call a resource, it’s purpose is inverted to transform a cost into an investment. To those who have been lured into mining, the ‘value’ of this investment is equal to the cost of electricity that they have used to generate the token.

Real economic exchanges involve the transfer of value for the utility of a resource, we give the baker money and in exchange receive our daily bread. Real investments are expenditures, where we exchange value for something that will possibly return a greater amount of value to us in the future. With investments we are purchasing the utility of possible future returns. Real Investments can be considered assets because they have mechanisms which can generate positive economic output, these mechanisms exist within a legal framework which defines them and enforces rules about their operation. If you remove the legal framework and all mechanisms for generating positive economic output, then what you are left with is not an asset. If value is exchanged in an economic transaction, but no good or service (resource) is returned, then no utility can be derived as there is no resource to consume.

Figure 2. In Hashcash value is exchanged for the utility provided by a resource. Cost a and b are acceptable, but the subjective value of email is less than the cost of c, as a result a price ceiling is formed and value c will not be spent. In Bitcoin PoW there is no ceiling or natural limit as these are exchanges of value for value. Because the cost associated with PoW is re-framed as an investment, a price/investment floor will be established. The utility which is provided in this implementation is not an end, but a means by which investors convert virtual returns into real returns.

All investment frauds attempt to change the nature of economic interactions from ones that trade value for the utility provided by resources, to ones that trade value for value. Traditional schemes will seek to camouflage this subversion of utility and removal of revenue generation by hiding the fact that there are no underlying mechanisms that generate positive economic output. We see this in the case of Ponzi and pyramid schemes.

For Bitcoin, external camouflage is unnecessary as its inversion of resources (provided utility) for value in proof-of-work means the system is premised on the exchange of value for value. However, from the perspective of those participating in the scheme, Bitcoin is a logically consistent economic system as participants believe that the act of wasting electricity is a resource which provides utility, this resource is then exchanged for value by way of mining rewards. Within the belief structure of the system Miners are like a business whose ‘investments’ fund the production of resources. The protocol then exchanges value (bitcoin) to the Miners for the resource they produce.

Miners view what they produce as a resource which they exchange for value, however, because Bitcoin’s PoW is inverted, in the real world, Miners produce an externality, wasted electricity which amounts to an economic and environmental cost, just as it does in the Hashcash implementation.

In a Ponzi scheme, the more you invest, the greater your potential returns, investors are limited by the amount of money they have to contribute. In a pyramid scheme, the more you work to recruit, the greater your potential returns, investors are limited by the amount of work they can do. The Nakamoto scheme is unique in that its PoW implementation produces a blend of psychological elements from both schemes. Potential returns are only limited by the amount of money Miners put to work, the scheme can appeal to their greed, as well as depend on a sense of entitlement to their returns as they have ‘worked’ for them. The Nakamoto Scheme achieves the best of both worlds, it produces the psychological buy-in we see from pyramid schemes and creates a ponzi like investment structure that is less constrained as it benefits from indirect recruitment.

By creating an automated system that tethers a representation of value (bitcoin) to the value of electricity expended through PoW, the foundations of a fraudulent investment scheme are born.

Bird 2 - Stake Ownership Distribution

Secondly, Nakamoto combined bitcoin rewards with PoW to create a distributed scheme. Running a distributed confidence game has many benefits but it also poses problems. Sharing profits in the scheme helps to legitimize it and produce a network effect. This greatly increases the reach of the scheme, which results in greater total liquidity invested into it, and as a consequence leads to greater returns extracted by co-operators. Trust is an issue though, and the creator of the scheme needs a way to place themselves on even footing with potential co-operators. Understandably, potential participants are less likely to trust in the scheme if up front demands for money are made.

Please note that I have settled on the usage of the word stake instead of ownership because, bizarrely, Bitcoin does not actually have a concept of ownership as we typically understand it. Miners gain initial custodial ownership of a bitcoin, but the only right that is granted by this ‘ownership’ is the right of sale. All other rights typically afforded to owners are missing.

Instead of investing by giving money to a centralized authority, interested parties are asked to waste resources as a proxy for investment. By requiring the consumption of a commodity to buy in on the ground floor and acquire stake in the scheme, Bitcoin is able to create a fair playing field as the PoW mechanism does not favour a particular participant. This is an ‘honest’ way of determining stake in an open investment fraud. As no central operator is taking the money invested, the stake acquisition process is more trustworthy and attractive to potential co-operators.

If I wanted to distribute stake in the analog world it would be much more difficult to provide a level playing field. I could provide a way to certify that co-operators set fire to fiat currency, and then match their ‘investment’ by compensating them with an unforgeable coin equal in value to the amount of fiat burned. However, this system has major drawbacks, as I could collude with investors to fake the fiat destruction, or some participants might attempt to use counterfeit currency. Moreover, the process scales poorly, limiting the pool of potential participants.

When compared to an analog equivalent, Bitcoin’s Proof-of-Work and coin rewards are an obviously superior method for creating an open distributed investment fraud, a key requirement for the Nakamoto Scheme.

Bird 3 - Guaranteed Returns

Thirdly, Nakamoto needed a way to guarantee returns to investors. The scheme had an investment vehicle, a way to value the investment, a mechanism to distribute stake, and a fair playing field that could serve as the foundation of a market, but it was missing a hook, the incentive that encourages participation. In Bitcoin, it is the halving schedule for mining rewards which not only promises returns to investors, but actually delivers on them.

Bitcoin has a planned total money supply of 21,000,000 bitcoins and approximately 19 million are currently in circulation. Nakamoto tied coin rewards to the PoW system whose supposed primary purpose is to select a Miner who can write data to a shared ledger. The Bitcoin protocol adjusts its hashing difficulty so that a cryptographically hashed block of data can be written to the ledger every 10 minutes. These blocks of data contain bitcoin transactions.

The Miner who guesses a hash that meets the difficulty requirements is able to write a block of data to the ledger. All other work is discarded by Miners who failed to guess the correct hash. As part of this process, the successful Miner includes an additional transaction where they are awarded a number of bitcoins. This reward acts as an incentive for Miners to conduct the work necessary to maintain the Bitcoin system. In 2009 Miners were rewarded with 50 bitcoin for writing a block to the ledger, however, every 210,000 blocks (around every 4 years) this reward halves, and in 2022, after 13 years, the current mining reward is 6.25 bitcoin.

Proof-of-work creates the investment vehicle, but it is the halving schedule which guarantees virtual investor returns. A Miner who generates 50 bitcoin by using $50 of electricity will value their bitcoin at $1. However, due to the halving schedule, in 4 years, to acquire another 50 bitcoins, the Miner will need to invest $100. As they are fungible, any bitcoin mined before the halving date is mined at a discount. After the halving date passes, the Miner must invest $2 per bitcoin in order to mine them. The Miner has doubled their money in 4 years, equivalent to approximately 19% APY.

After halving a Miner must make twice the investment to earn the same rewards, the existing bitcoin have, effectively, doubled in value. The Bitcoin protocol guarantees these returns. Amazingly, within the context of the Bitcoin system, these returns are real, however, as a non-participant we would refer to these returns as virtual (and fraudulent), as they exist in the native digital token and not as fiat currency.

Moreover, because other Miners have started participating over those 4 years, the hash rate and hence difficulty of finding the correct hash has increased. This means that overtime it has become more expensive to earn a bitcoin, meaning that it is possible that your investment has more than doubled after halving. The halving doubles the value of a bitcoin at the time the halving occurs.  Referencing our earlier example, if the Miner had invested $1 per bitcoin mined, but just before halving it took $4 of electricity to mine a bitcoin, post halving, the value of a bitcoin would be $8. The Miner is up 8x on their initial investment.

It should be noted that the combination of PoW, bitcoin rewards, and the halving schedule produce information asymmetries that lead to arbitrage opportunities. Some Miners may be more efficient in their production of bitcoin, leading to slightly different valuations. Moreover, some Miners and speculators may be more savvy in regards to Bitcoin’s true nature and fundamental mechanisms, leading them to acquire bitcoin in anticipation of greater virtual returns.

These guaranteed returns offer an extremely strong incentive to participate in the system as early as possible. However, virtual returns come with a catch. Investors can only realize the returns in fiat currency if they recruit others into the system. This is effectively a halfway point between a Ponzi and a pyramid scheme and is a staggeringly brilliant innovation in deception. Virtual returns that can only be realized if fiat liquidity is recruited into the fraud. The Nakamoto scheme is a masterpiece, and its creator a gifted idiot savant, or the Einstein of con artists.

Bird 4 - Realizing Virtual Returns

Fourthly, Nakamoto realized that PoW could be used to provide the utility of irreversible bitcoin ownership transfers, allowing participants to realize virtual returns either by trading bitcoin for goods and services, or for fiat currency. Bitcoin’s distributed append-only ledger allowed Miners to trade their bitcoin to one another, or to speculators, and no double spending meant a fair playing field to realize returns through fraud. This created a speculative marketplace where outside liquidity could be on-boarded into the scheme, the value of a mined bitcoin would not be constrained by the amount of electricity used to produce it. This is the mechanism that enables the ponzi and pyramid like aspects that we are familiar with in Bitcoin and the reason why the scheme is dependent on disinformation, propaganda, and indoctrination, as recruitment is necessary to realize returns.

Have you ever wondered why Bitcoin makes such a poor payment network? Why Nakamoto ignored or sidestepped questions on the transactional performance of Bitcoin and instead would focus on bandwidth? What about the transactional profile of Bitcoin being far closer to something used to register real estate transactions, rather than a global payment network? The answer is clear, transactions in Bitcoin are not meant to facilitate payments in the typical sense, they are useful insofar as they allow Miners and speculators to realize returns on their investments.

A speculative and deflationary ‘asset’ makes for a poor currency, people are disincentivized from using it today, as it might be worth considerably more tomorrow. This very criticism was leveled against Bitcoin on the BitcoinTalk forums in February 2010, as the design of coin rewards combined with the halving schedule rendered the protocol useless as a currency. Few would spend something whose value appreciated 19% every year. Nakamoto participated in this very forum thread and was well aware of the criticism, but shrewdly chose not to address the issue directly, ever careful to misdirect, lest too much attention be paid to Bitcoin’s fatal flaws.

By creating the narrative that these ownership transfers were entirely for payments, that Bitcoin was intended to be a form of electronic cash, Nakamoto was able to internally camouflage the true purpose of PoW and Bitcoin, the creation of a new form of investment fraud driven by speculation, and dependent on outside transfers of value in the form of fiat liquidity to realize virtual returns.

Quoth the Raven

Bitcoin is not a form of electronic cash. Bitcoin is not a store of value. Bitcoin is not a hedge against inflation. Nor is it digital gold, the future of finance, or an investment. Bitcoin is a type of Nakamoto scheme, a form of investment fraud which leverages an unsound economic premise to enable transactions where no utility is exchanged. The scheme is characterized by several unique properties:

  • The tethering of a speculative digital token to a cost in order to create the illusion of an investment.

  • The creation of a mechanism which can distribute stake in the scheme so that there are multiple co-operators instead of a single operator, i.e. a distributed open investment fraud.

  • Virtual investment rewards are delivered to co-operators, these returns are not fraudulent to participants operating within the system’s context (to an outside observer they are fraudulent returns).

  • As the scheme provides no underlying mechanisms to generate revenue, virtual returns can only be converted into real returns if participants become co-operators in subsequent investment frauds which enable the inflow of fiat liquidity. A built in mechanism which allows the transfer of the digital token is used to convert virtual returns into goods and services or fiat currency.

These properties can be used to distinguish the scheme from more traditional forms of investment fraud like Ponzi and pyramid schemes.


Bitcoin inverts resources for value with proof-of-work to enable a new form of investment fraud; however, proof-of-stake (PoS) also enables value for value exchanges. Although PoS systems are not sub-fiat and provide a less robust fair playing field to distribute stake, they are a more efficient, though less deceptive, form of Nakamoto scheme. PoS allows a scheme to more effectively provide access to fiat liquidity, not only can we do away with an expensive stake distribution process, but there is no need to wait for the organic growth of subsequent investment schemes which provide exit liquidity for co-operators.

‘Investors’ provide seed money to an organization in exchange for tokens which guarantee virtual investment returns (fraudulent returns) by way of a staking mechanism. This organization is then delegated with certain responsibilities. It is tasked with creating promotional materials, such as a whitepaper, purchasing advertising, handling media relations, and creating some amount of demonstrable functionality. Although the system will provide some form of functionality, due to the performance limitations of distributed append-only ledgers, this functionality will never be able to compete with existing in-market solutions, and hence there will never be a source of significant revenue which can compensate investors for their initial allocation of funds. No resources, and hence no provided utility, are being exchanged for investor value.

The true purpose of this organization is not to create a product, but to promote their scheme to potential victims and work with existing scams like cryto exchanges, in order to provide exit liquidity for their investors. As these centralized entities are doing a great deal of the heavy lifting to provide exit liquidity, we would expect that they would take a greater percentage of the profits and, as a result, we would expect to see more centralization in terms of token distribution (higher gini coefficient) in proof-of-stake systems vs. proof-of-work systems like Bitcoin or Ethereum.

Proof-of-Stake crypto systems are a type of Nakamoto scheme as they fulfill all of our criteria, with slight modifications in that they provide a less robust but more efficient stake distribution mechanism, and centralize the development of subsequent investment frauds to enable inflows of fiat liquidity.

Crash Landing

The Nakamoto scheme is substantively different than a Ponzi or pyramid scheme and far more deceptive. It leverages digital technology to create a form of economic disinformation which weaponizes investment fraud. Tethering cost to a speculative digital token, which guarantees virtual returns but does not provide utility, is a fraudulent act that should be banned. All systems which enable value for value transactions, where no underlying utility is provided in the exchange, drink from a poison chalice.

The most dangerous lies are the ones that we want to believe, and from alchemy to airdrops, the fantasy of getting something from nothing to get rich quick is commonly pressed into the service of exploitation. This lie is so powerful that when a stranger holds it up to us as a promise of freedom, we are willingly deceived, careful to avoid peering too closely at what lay beyond the curtain of our own self-interest. Instead we coat and varnish the ugly truth until it gleams, its dark heart hidden even from ourselves. The cryptocurrency industry is rotten at its core; based on a carefully orchestrated deception, it cannot serve as the basis for rational economic exchanges.

Freedom is only possible where rights have space to exist, and for a technology that brands itself as the personification of liberty, Bitcoin is devoid of substance. This absence does not stem from a lack of regulation, it is that Bitcoin does not contain anything that can be regulated. There is nothing here and no room for freedoms, except the right to sell a bitcoin. Hot air and hype cannot serve as the foundation for an economic system, and the creation of rules within the context of an investment fraud is madness.

Bitcoin uses a corrupted implementation of proof-of-work to recruit co-operators into an investment fraud and distribute its function. It creates an investment vehicle in the form of a speculative digital token which guarantee returns. The delivery of these virtual returns incentivize recruitment of fiat liquidity into the scheme, as the only way to realize profits is to find a greater fool. These mechanisms align the self-interest of participants, and this alignment serves as a powerful force that ensures all co-operators act in concert to increase the value of a bitcoin by as much as is possible and extend the fraud to the furthest reaches of our civilization.

Using cryptographic hashing techniques to create an append only ledger is not in and of itself exploitative. However, creating a mechanism that enables economic transactions where value is exchanged for value can only serve as a vehicle for fraud. Bitcoin and all cryptocurrency systems as they exist in their present form are examples of harmful technology. They are dangerous and should not be allowed to exist. Value must be tied to the utility provided by a resource, and not to deception or an externality. By defining the unique characteristics of the Nakamoto scheme, we are better positioned to identify them so that we may act accordingly when they are encountered.

As it turns out, “If it looks like a duck, but honks like a goose, then it’s probably related to both”.

To be continued in The Strange Case Of Nakamoto’s Bitcoin – Part2
An examination of the common properties observed in the Investment Fraud family.

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