Lex Sokolin: Weed Out the Ponzi Scheme Eating Ethereum

Lex Sokolin, a CoinDesk columnist, is Global Fintech co-head at ConsenSys, a Brooklyn, N.Y.-based blockchain software company. The following is adapted from his Fintech Blueprint newsletter.

We have a beautiful Ethereum garden. In it we grow cash equivalents called stablecoins powering applications that run on open-source, programmable blockchains. It promises to be the new economy – free, permissionless and global. It saw more than $50 billion in transaction volume in June 2020 alone.

But there is a hungry weed growing underneath. In our beautiful public garden, there spreads corruption. Can we root out this plant? Can we turn the soil?

The weed is called a pyramid scheme, and it always takes advantage of those who feed it. Take a look at the diagram below (from the U.S. Securities and Exchange Commission). After four levels of targets, the scheme needs just 7,000 people to be profitable to the swindlers. After the 10th level, it needs 60 million people. By the 13th level, you must consume 13 billion participants. There is never enough for the weed.

The weed can work on any technology, as long as it touches a human mind. You can spread it with words, on paper, by fax or in code. Here is how the weed looks when it’s implemented in software: This academic paper, published in January 2020, traces 184 software implementations of pyramid schemes operating on permissionless networks. There are more now.

Maybe you don’t understand how bad this is for the garden. Maybe you think letting this grow and overtake our mutual work is freedom. The strongest survive, the weakest die.

See also: JP Koning – The $10B Stablecoin Industry Has a Fraud Problem It’s Not Addressing

With that mindset, we would have no delicate flowers or cultivated beauty. All we would have is a desert of dandelions and horseradish. In the world of money and cryptocurrency, there would be no real economic activity, no central bank digital currency, no crypto-native businesses, no new financial infrastructure and no technology platform shifts to blockchain. Just a loud grind of theft guzzling gas fees, crowding out productive activity from Ethereum forever.

Let me introduce you to MMM, a pyramid scheme with roots in the former Soviet Union, which stole from nearly 10 million people during the 1990s. While decentralized finance and digital asset companies bend over backwards to be customer-centric and reform financial services (each in their own way), MMM is a pretender. It is a pretender that has stolen the language of the crypto economy to create a cancer in its body. It hides in the Paxos project and uses Ethereum for its 21st century machinations.

A personal aside: Growing up in the crumbling Soviet Union of the late-1980s, a series of TV commercials are etched into my memory.

You have to sympathize a little bit, and imagine a country that had no functioning economic system and a massive black market. As the Berlin Wall collapsed, so did the economic hallucination that was the centrally planned economy. The Chicago School of Economics group advised then-President Mikhail Gorbachev on a “shock therapy” approach to transition, leading to an unprecedented distribution of state assets (e.g., factories, buildings, natural resources) to people who could not tell the difference between a stock certificate and a stamp. Let’s just say China did better with the gradual approach.

Into this context came the ads. They feature a Russian man, Lenya Golubkov, who “invests” his money with a “securities cooperative” called MMM. His fortunes soon improve. He is able to buy boots, then a coat for his wife, eventually touring America with his brother and starting a successful business. The securities he buys look like stock certificates, promising returns of 100% per month and more.

You must understand that everything on TV carried authority in those times. Like movies from the U.S. that hinted at Western opulence and the promise of new wealth associated with liberalization, MMM was sold as a dream to regular people in a language they understood. I imagine in many poorer, less-educated parts of the world, such storytelling still works. As does this image of a voucher for a share in a pyramid scheme.

The man behind the scheme, Sergei Mavrodi, is a cartoon villain, dead at the age of 62 from a heart attack (who knows what that means in Russia now). He spent his life openly gaslighting regulators and politicians, briefly even becoming one to get immunity from prosecution. The people he was defrauding voted him in, but he ended up jailed anyway. Seemingly a brilliant mathematician and deeply cynical, Mavrodi wrapped the popular sentiments on the ground into a misleading trap for the unwary consumer. 

It feels like a long time since the 1990s. But in terms of human nature it has been barely a blink. After Mavrodi got out of jail, MMM resurfaced in 2011, made its way to the internet and has now implanted itself into the body of cryptocurrency. Mavrodi is dead, but his scheme is the decentralized autonomous organization that nobody wanted, living on in the code forever. Like a tapeworm, it eats 10% of Ethereum’s transactions and is responsible for 50% of the transfers for stablecoin Paxos, according to Coin Metrics.

The weed is not alone, it inspires others. Another pyramid called Forsage is eating up 25% of Ethereum’s bandwidth, beating MMM at its parasitic game. Forsage is the decentralized app with the most users and volume, outperforming legitimate DeFi pioneers like Compound and Kyber Network. Other software versions of this same thing will proliferate and evolve as the smart contracts ecosystem of Ethereum matures. They prey on how easy it is to fool people and sell them a lie, and to undermine the infrastructure on which they grow.

Regulators in the Philippines have attempted to go after the pyramid scheme, but of course to no avail. It has no reach over Lado Okhotnikov, the developer of the code. And we are in the Pirate Bay age of money: There is nothing to shut down, many will argue. This is permissionless.

There is hard work ahead. Instead of yield farming arbitrage, the crypto community must root out these weeds. If we ever want broad adoption, it is unrealistic to say “caveat emptor.” Most people are not able to probability-weigh payoffs and parse financial products for what is real and what is false.

Think for a moment of computer viruses. Just because computers can become infected and send your data and passwords to maleficent third parties doesn’t mean that is likely to happen. Various shields, defenders and open software protect users from those seeking to troll and harm us. In the early-1990s, there were just 5,000 viruses transferred between computers. In 2020, research shows, there are now nearly a billion infections per year, across millions of websites designed to trap and mislead people.

We still use computers. We still use the internet. It is safe to do so because the tools to protect people have been created and are as widely available as their adversaries.

In 30 years, I hope to say we still use Ethereum. If black hat hackers can band together to exploit well-meaning decentralized finance projects for their own gain, white hat hackers should come together to protect their users against naked pyramid schemes. If we don’t, there may never be real money in the system. Or worse yet, there will be no real decentralized system at all.