What are crypto’s No Loss Lotteries?

We look at the new concept of crypto’s No Loss Lotteries and whether they’ve discovered digital alchemy or are just Prize Linked Savings reinvented.

If there was ever a product that promised a risk-free return, then crypto’s new breed of No Loss Lottery – promising the chance of winning prizes without taking any risk – certainly sounds like it fits the bill. But rather than discovering the Holy Grain of a genuine free lunch, No Loss Lotteries simply leverage blockchain technology to put a new spin on a century-old savings mechanism and tap into our preference for lottery-style prize jackpots over guaranteed, yet meagre interest.

Win by saving. $29,000 in weekly prizes 

www.pooltogether.com

PoolTogether, an example of a blockchain-based No Loss Lottery, has a main marketing message that is a tour-de-force of cognitive dissonance. It combines winning with saving, two ideas that are diametrically opposed. 

Winning infers participation in some skilled-based or random process – in other words taking some risk to obtain a return – whereas saving is a risk-averse tactic for preserving wealth. So what gives? 

The idea that you might be rewarded for being prudent is incredibly seductive, but [check’s the url] given there’s no such thing as a free lunch, we’re duty-bound to dig a bit deeper and figure out what’s going on behind the Wizard’s curtain.

Crypto power, 19th-century engine

“PoolTogether is a crypto-powered savings protocol based on Premium Bonds. Save money and have a chance to win every day.”

www.pooltogether.com

PoolTogether’s crypto power is DEFI – decentralised finance – a growing ecosystem of yield-generating applications powered by blockchains like Ethereum that function outside traditional banking.

There are no sign-up forms, credit-scoring or KYC. You just click a button to connect the digital wallet that stores your crypto to a DEFI application, a kind of banking robot. 

Rather than being bound by terms and conditions required by financial regulation, you digitally sign an agreement with a Smart Contract, where the agreement is defined in code and executed by the underlying blockchain, such as Ethereum. Code is law.

In the case of PoolTogether, the Smart Contract takes deposits from players in USDC (a synthetic version of the US dollar known as a Stablecoin) and invests them in DEFI services like Compound, which automatically pays interest on funds held there. PoolTogether aggregates those yields from all player deposits (savings) into a prize pool. 

Players earn ‘tickets’ to win that prize pool in proportion to the amount deposited, with their chances of winning based on the average deposited amount over the prize period.

Randomised prize draws take place weekly using a Verifiable Random Function (VRF), crypto’s attempt to create a provably fair digital equivalent of pulling a ball out of a machine.

DEFI protocols like Compound are “fully liquid“, meaning players can withdraw their full deposit anytime without requiring approval. 

PoolTogether doesn’t even take a cut for facilitating the operation – unlike a state or private lottery. So there you have it, folks, a No Loss Lottery. A free shot at winning a prize with no downside. Well, not entirely; the devil, as ever, is in the detail.

How No Loss Lotteries work

Though it’s tempting to believe PoolTogether has discovered a crypto-powered form of financial alchemy offering generous returns with no risk, the truth is far more analogue.

PoolTogether openly describes itself as based on Premium Bonds, which date back to the mid-19th century and a concept called Prize Linked Savings.

Prize Linked Savings (PLS) are used worldwide to encourage people to save. Savers forego regular, modest, guaranteed interest on their funds in exchange for a very small chance of winning a really big prize and progressively better odds of winning much more modest prizes – with no risk to their capital.

You can see the similarities between PLS and No Loss Lotteries, something that PoolTogether acknowledge on their website. Despite No Loss Lotteries leveraging new technology, they can’t defy financial gravity, so what’s the catch?

No Loss Lotteries – What’s the catch?

At the time of writing, the odds of winning the main prize at Pool Together are around 1/25 (or 4% chance). Unlike a traditional lottery, PoolTogether isn’t charging a margin, so the draws reflect the fair odds of winning, and depositors can withdraw their funds at any time, which isn’t the case with traditional PLS like Premium Bonds that enforce lock-in periods. 

PoolTogether also ensures the projected prize APR is higher than it is for the yield sources; otherwise, there’d be no logical incentive to participate. The inflated APR is achieved by taking a percentage of every prize – the Reserve – and re-depositing it into every prize pool, along with Sponsorship, where funds are deposited that aren’t eligible to win as a way of bootstrapping pool liquidity. 

Given you get your deposit back, this seems to fit the bill of a No Loss Lottery, but we know PoolTogether hasn’t discovered a new form of crypto alchemy because there is no such thing as a free lunch – duh. So what’s the catch?

Inflation

All prize pools and deposits are denominated in USDC, a dollar-pegged Stablecoin. Buying USDC exposes you to any inflation specific to its supply, which, if you believe its reserve auditing (which has been questioned) is backed by actual dollars. This means USDC is no different from holding a real Greenback, which is experiencing official inflation at more than double the predicted return – 9.1% as of June, 2022 – almost double the return on offer.

Fees

There may not be an explicit cost for purchasing tickets or an in-built margin skimmed by PoolTogether, but you have to pay a transaction fee (often described as GAS) to the network you use to transfer funds to the PoolTogether protocol. Four options (Ethereum, Arbitrum, Polygon & Avalanche) are available with varying GAS fees payable for each transaction in and out, which amount to an indirect entry fee. 

If you don’t already own USDC on any of those networks, you’ll also have to pay conversion or trading commission on exchanges to get hold of it and the same if you want to convert your USDC back to fiat money.

Opportunity Cost

There are, of course, other yield opportunities available inside and outside crypto. DEFI exists on a risk spectrum, with Compound chosen because of its credibility rather than the size of the return. You must compare the 4% to returns available elsewhere, albeit under different conditions.

Protocol Risk

The prize function might be risk-free, but the underlying systems on which PoolTogether runs undoubtedly aren’t, while crypto provides no form of deposit insurance against the numerous counterparty risks:

• PoolTogether’s Smart Contract could be hacked, and the funds drained, or its code updated with inadvertent logical flaws to the detriment of depositors
• PoolTogether could simply fold and disappear, doing what the crypto community describe as a rug pull
• The blockchain you use to move funds to PoolTogether could be hacked, or do a rug pull
• USDC may lose its peg rendering it worthless; the Terra/UST collapse in May 2022 shows how quickly that can happen albeit with a different Stablecoin design
• The ability of PoolTogether to boost returns using Reserves and/or Sponsorship is finite, which will eventually bring down the average prize yield
• The Governance structure controlling PoolTogether might vote to change the payouts to a less favourable rate.

So if you add up the transaction and conversion fees, account for inflation, opportunity cost and the inherent risks of blockchain protocols, PoolTogether isn’t risk-free. 

As ever, we have to ask why it has proved popular, given this information is available on their website, if not splashed across their home page. The success of PLS is predicated on our behavioural biases and, in particular, the possibility and certainty effect.

The allure of the Jackpot

PLS prizes are favoured over the steady drip of guaranteed interest because the way people perceive changes in the chance of winning isn’t linear.

In general, people overvalue a very small chance of winning a big prize compared to the chance of winning a more modest prize. In sports betting, this is known as the Favourite Long-Shot bias, where punters prefer to back longshots, even though they offer poorer expected value than lower-priced options.

The same thing is happening in PLS. Savers get drawn in by the chance of a big jackpot win but fail to calculate whether this is a rational choice when accounting for all the factors. This chasing on short-term gain can be linked to changes in people’s time preferences.

So from a player perspective, PoolTogether doesn’t quite live up to the No Loss Lottery label, but one question left unanswered is what the provider gains if they aren’t skimming a fee for providing the service. Here’s how they describe their purpose:

• Enabling people to have a chance for large returns without needing to risk their money
• Encouraging saving money by offering prizes
• Directing money away from wealth-destroying lotteries

As much as their intentions sound altruistic there is a profit motive. PoolTogether is partially backed by Venture Capitalists who’ll understandably want a return on their money.

What’s in it for PoolTogether?

Though PoolTogether is run in a quasi-cooperative way, the intention is to generate value in what is known as its Governance Token – $Pool. 

A Governance token can be likened to a share in a traditional company; it represents the value of the IP and technology behind PoolTogether and confers the right to vote on how the system operates in proportion to the amount held.

The magic of crypto means that 10,000,000 of these tokens were created at launch, roughly half held back as a treasury and the remainder distributed among founders, early users and investors.

20% of Pool tokens are currently in circulation at a price of around $0.90, down 99% from an All-Time High of $70 in November 2021. That insane drawdown is inherent in crypto, driven by sentiment rather than fundamentals.

As the vesting period for investors ended in February 2022, when the token was at $2.80, that huge upside was missed, but it explains why they would take the risk and why the project was created in the first place. 

It is a broader question as to what the Pool token’s actual value is. The ongoing lawsuit that PoolTogether is currently fighting in New York for allegedly running an unlicensed lottery illustrates that risks can come in many forms.

The laws of financial gravity remain

Human nature is precisely the same as in the 1950s when Britain was transfixed by the most famous PLS scheme, Premium Bonds and the idea that they could win a life-changing prize.

The attraction of a big jackpot prize, no matter the inferior expected value, will always suck people in, while the promise of new technology equally skews the perceptions of investors. The allure of a free lunch still tempts us.

Blockchain technology may have enabled a completely innovative way of delivering a seventy-year-old format, but cannot change the law of financial gravity. Though they sound attractive, No Loss Lotteries cannot conjure value out of thin air for players or investors.

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