By now, the crypto space is no stranger to scams and Ponzi schemes. But what exactly makes something a Ponzi? And what makes a business genuinely valuable and useful?
To understand this, let’s take the example of Axie Infinity, a play-to-earn game in the crypto space that works by new players purchasing “Axies,” i.e., tokens from other players, breeding new tokens (which is essentially what the game is about — breeding Axies) and then selling them off to other incoming players. Packy McCormick describes it as, “… a Pokémon-like game built on the Ethereum blockchain in which people buy digital pets, called Axies, as NFTs, and breed, battle, and trade them.”
The game generates revenue by taking a 4.25% fee when players buy and sell Axie NFTs in its marketplace, and by charging fees for breeding Axies to create new ones in the form of tokens.
And as of 1 August, daily active users on the platform stood at 260,246 gamers. This was a far cry from its all-time high of 2,718,810 active users recorded on 15 November 2021. The stock price has also plummeted from an all-time high of ~$166 in November 2021 to ~$18 today.
So, what went wrong?
Here’s the problem.
The only way Axie can keep generating revenue is via its existing players adding other players to the game who buy three of these tokens to sign up.
Now, this creates a problem: as soon as the market saturates and there are no more new users to sign up, the newly minted tokens have no takers. This creates a scenario where there is huge supply and little demand, leading to prices of the tokens collapsing.
In Axie’s case, there was an overload of Smooth Love Potion (SLP), Axie’s in-game token, which was issued with no means to burn or destroy the tokens. As a result, Axie suffered from inflation as its SLPs depreciated in value and failed to incentivize players.
Mark Cuban puts this in a better way in this podcast clip:
“So play-to-earn typically is subsidized. With Axie, they were smart, they were first, and they had a huge subsidy sponsor base where they went out there and got groups to sponsor people left and right and it just blew up. And why wouldn't it blow up? It's free money!
It’s going back to the old silicon valley way for software:
“We'll subsidize the cost for you — the cost of bandwidth or storage whatever it is to get you to use it and view it as a marketing cost.”
But it's still a traditional ecosystem where either you subsidize it or you generate revenues to buy the tokens that are being created. And if you don't generate revenues to buy the the tokens, either you have to have new subsidies continually coming in or you have to have new players coming in to subsidize the existing players. And the minute the musical chairs stop, it collapses.
Unless you have an ecosystem there, an economy there, that can continue to buy the the tokens to make it worthwhile for people to play if they're playing for some reason other than the fact they just love the game.”
With conventional games, players buy the game upfront for $40–$60 because they derive value from playing the game and the entertainment it offers. But in the case of Axie and the play-to-earn model in general, the real incentive for players joining the game is to sell their tokens for a price higher than what they bought it for and make a profit. It isn’t about loving the game as much as it is about making money from it. The game only has to be interesting enough to keep the marketplace going. But the real incentive for someone to join the game is always to sell tokens to newer entrants and earn a profit that way.
In other words — it’s a classic multi-level marketing (MLM) scheme.
MLMs are direct-sales companies that rely on salespeople selling directly to consumers to make all their product sales — usually clothing, makeup, healthy food and supplements, etc.
1. MLMs require their salespeople to buy starter kits to begin selling their product. Axie requires you to buy 3 Axies to begin playing.
2. MLMs reward their salespeople for signing up new salespeople a through a reward-sharing program and many early adopters earn a majority of their income from revenue sharing from their "downline" recruits. Axie has this as well in the form of sponsorships where an early adopter can passively earn revenue on their teams' work.
3. Many MLMs make a majority of their money on people signing up to sell the product, not on product sales themselves. It’s the same with Axie. People are excited by the opportunity to earn, so they are signing up and buying-in, but the number of people they will be selling to — the ones who wish to play the game for fun — is still very low.
But why are MLM schemes so bad, you might ask. And for that, we need to understand how real wealth and value is created in an economy.
MLM schemes violate the first-principle of any economy:
You get paid to bring utility to the world.
What do we mean by utility?
Let’s the simple example of a food delivery business like Zomato. In a world without Zomato, to get food at home, you would have to get dressed, go out, travel to the restaurant, place your order, wait there till the food was being prepared and packaged, take the parcel and travel back home. It would be a lot of energy and time expenditure that one would find not much value in.
In fact, one would be happy if it were someone else’s headache. So much so that they would be willing to pay a small premium for it.
This is the utility Zomato and Swiggy offer you. They essentially abstract and take away a lot of operational complexity you would otherwise have to deal with in their absence. And they charge an appropriate value for reducing that headache.
If you think about it, any business, essentially, is a simplified and abstracted layer between point A and B. Point A is where you are right now and point B is where you wish to be.
You have a block of iron right now. You can’t do much with it. Perhaps, it would be more valuable if you could turn that block of iron into a bunch of nails, or utensils, or a tool like a hammer. But how do you do that?
To do that, someone with enough process knowledge and skill has to go through the effort of melting that block of iron in a furnace and then fashioning it into a more useful form.
In fact, this is a great mental model to quickly understand where the economic value lies in any activity:
Think about what kind of headaches the business is taking care of, for you.
If you want to be even more physics-brained about it, any business is a mechanism to increase order and reduce entropy. Because order is valuable.
Coal, as it exists in its default form, isn’t very useful. But make a steam engine and now you have suddenly found a way to extract real utility out of that black piece of decomposed organic matter.
(We will discuss entropy and wealth-creation in-depth in a future essay. For now, you can ignore this. Let’s move on.)
Coming back to the problem of utility — in the case of MLMs — the utility you’re being paid for is not for the product you’re selling, but the fact that you were able to sell it to someone else, and that someone will then have to sell it to some other person, till the last person is left holding the bag — the product — which in itself might be totally worthless and lacking any real utility.
Leave businesses aside for a moment. You can even think about yourself as an individual employee who got hired just because they had the necessary skills and know-how to abstract away a crucial part of the business.
When someone hires you, they are indirectly telling you,
“Hey, this isn’t my headache anymore. I trust you to take care of <insert job description and headache-inducing activity> you’re hired for.”
Typically, a person works towards the real economy and gets paid for their work to provide utility to someone else.
For example, one would work in a restaurant as a waiter and serve food so that other users have utility such as being able to drink coffee, eat snacks. By having a waiter, the restaurant owner now doesn’t have to worry about serving food or remembering who ordered what. And in return, the waiter is able to charge a wage for it.
Even in the case of conventional games, users either 1) pay to play upfront to play the game or 2) play the game for free but get monetized in another way — via ads or giving up their user data. The idea is that one enjoys the utility of the game to their lives (de-stressing, novelty-seeking, or just killing boredom) and pays for that utility directly or indirectly. The game studio has to invest upfront, and hopefully earn their risk-adjusted cost of capital over the lifecycle of monetizing the game.
In the Axie model, the player is getting paid to play, but where is that money coming from? It isn’t coming from creating any real world utility for anyone else. It is simply coming from persuading other players to buy tokens at increasingly higher prices and promising them that they will be able to earn a profit on this investment by selling these tokens to someone else. The game itself isn’t interesting enough or valuable enough like other conventional games for players to buy tokens just for the sake of playing the game and having fun.
So, to circle back to our first question in this essay:
What exactly makes something a Ponzi?
A Ponzi is when no real complexity or disorder is being abstracted away for the user. The thing being sold in a Ponzi scheme doesn’t need to have any value in itself and derives all its value from its possessor’s ability to sell it to someone else.
There is no headache being removed from a certain operation — like CRED does, by saving you from using your bank’s shitty net-banking interface and abstracts away the complexity of paying your credit card bills or getting a loan. Or like Stoa does — by abstracting away and bringing structure to the complex and unstructured task of finding a business role that’s perfect for you.
So, the next time you think about a business and what value it generates, think about the headache it’s taking care of for its customers and you will know where its real utility lies.