The Lex Newsletter: Ponzi screen shows other failings in crypto and VC

Dear reader,

One statement I hear a lot at the moment is: “This is just a Ponzi scheme.” Critics sometimes apply it to cryptocurrencies. Also to circular financings in the venture capital and buyout industries.

The reason for the current popularity of the P phrase is that Ponzi schemes are prone to falling apart when asset values crash. The investment empire of New York financier Bernard Madoff was exposed as fraudulent in 2008, for example.

People with long memories are saying: “Maybe many similar busts will occur now?” The terraUSD token has already collapsed. This week, South Korean prosecutors slapped no-fly bans on some employees of Terraform Labs, creator of the not very stablecoin. Fraud is alleged, though denied by company founder Do Kwon.

Cryptos resemble some historic investment scams in appealing to people of modest means who may feel shut out of conventional investment, for example in stocks or housing equity.

Vincent Mortier, chief investment officer of Amundi, which is doing very nicely in conventional asset management, has used a related P phrase — “pyramid scheme”. He was referring to aspects of circular buyout deals, cleverly anatomised this week by FT writers Helen Thomas and Kaye Wiggins. Here, private equity groups may sell stakes in companies to one another. Or a fund may sell a holding to another fund run by the same buyout group.

Successive private transactions that pump up valuations without the reality check of public market price formation also feature in tech venture capital. Lex thinks a down round by UK fintech SumUp reflected market realities better than the up round that doubled the notional value of US crypto platform FalconX to $8bn

But we should stop slinging P phrases around. Lex is sceptical about cryptos and circular trading by private capital groups. But they are not pyramid selling scams or Ponzi schemes, fun though it may be to label them as such.

Charles Ponzi was a small, dapper conman. His modus operandi was as follows. Promise stellar returns from market investments. As apparent proof of concept, pay equivalent amounts to smaller, older tiers of subscribers. Finance these payments with the subscriptions of larger cohorts of dupes. Keep going until you run out of recruits and the scam implodes.

Flagship crypto bitcoin does not function in this way — unless some clever, furtive computerised stuff is going on that only Satoshi Nakamoto knows about.

You may quibble that, as with circular trades in private assets, early purchasers benefit hugely from the recruitment of new buyers. But transfers of value between these groups is via the asset price, as with a traditional security. And bitcoin and private capital groups do not promise huge returns from conventional investments.

Intention is the other issue. Ponzi and pyramid selling schemes are deliberate scams. As Lex noted, prosecutors may struggle to establish fraudulent intent when cryptos and their promoters collapse. Private capital businesses employ smart lawyers who keep them on the right side of the law — most of the time.

Fossil fail

Charles Ponzi depended on his plausible manner. Bitcoin depends on the copious energy needed to “mine” tokens via cryptographic calculations. Its price stabilised this week at $21,000, about a third above its estimated production cost.

Real miners are also vastly polluting, particularly if they produce coal. Carbon emissions are therefore heading in exactly the wrong direction for zero-pledging governments and businesses. The world is burning more cheap coal as the cost of oil and gas rockets. Chinese electric vehicles would conk out halfway to their destinations if they hadn’t been built using cheap electricity generated from coal.

Germany is firing up mothballed coal-fired generation. A partial gas-to-coal switch would increase carbon emissions by 10mn tonnes, 6 per cent above previous forecasts. Extending the life of nuclear plants would make more sense. But do not expect that from a political class as bungling as any in Europe.

The appetite for cheap coal energy is good news for Glencore, a standout winner from the energy shortage. The UK-listed miner and commodities trader should generate half its market value in free cash flow in less than three years. Steelmakers are paying more for coking coal, but less for iron ore from the likes of Rio Tinto and BHP.

Economic confidence is crumbling as a result of rising prices for consumer products such as petrol. Joe Biden has been heckling US refiners such as Exxon and Chevron from the presidential box. There has been a big widening in the “crack spread” — the difference between the raw material cost of oil and the traded price of petrol. But this largely reflects a retreat from the underinvested refining business that has raised transport costs.

Debt bets

Higher interest rates and slowing economies are making life difficult for debt investors. Things could get very messy in Italy. Yields on the nation’s bonds have been ballooning. This is embarrassing for EU politicians and central bankers. It suggests that the eurozone might not be economically cohesive. Who knew?

The European Central Bank may now have to start buying up Italian sovereign bonds. It would have to pretend it was not engaging in self-defeating quantitative easing, even as it raises interest rates.

UniCredit can meanwhile congratulate itself on rebuffing last year’s attempt by the Italian government to lumber it with a struggling rival. Monte dei Paschi, which ranks among Italy’s oldest and worst lenders, this week announced a €2.5bn capital raise covered predominantly by Italian taxpayers. Its turnround plan depends on bad loans remaining low. What could possibly go wrong?

US collateralised loan obligations look exposed to a downturn as well. Interest payouts rise in relation to a spread over Libor, Sofr or some other benchmark. But investors can only revel in this inflation protection if the corporate issuer does not go bust.

Family-owned companies such as Mars, which the FT revealed is bigger than Coca-Cola, generally eschew such risky leverage. They will ride out the downturn in correspondingly better shape.

Economic drivers

We hope you have been enjoying Lex’s newsletters. Please let us know how we are doing at lexfeedback@ft.com, or delegate the task to an appropriate subordinate.

I make the latter suggestion apropos of a £1.6bn bid approach for Euromoney. Many readers will know this best from the hefty monthly magazine on international capital markets and its numerous spin-offs. The publication dashingly chronicled the growth of London’s Euromarkets of the 1980s, though data and events are now more important businesses.

Launch editor Christopher Fildes once recalled the moment when a copy of the first edition of Euromoney was reverently handed to backer Viscount Rothermere.

He passed the magazine to his chauffeur.

“Read that, Henderson,” Lord Rothermere said. “It will improve your mind.”

Enjoy your weekend,

Jonathan Guthrie
Head of Lex