Cryptocurrency projects with referral rewards are not equivalent to pyramid schemes or fraud: it depends on where the money comes from

If a virtual currency project exhibits certain pattern characteristics, and in combination with the current domestic policy direction of severely cracking down on coin trading speculation, there is a significant criminal risk that it may be characterized as the crime of organizing and leading pyramid (fraud) schemes.

In the earlier article “Virtual Currency Pyramid Schemes Get Cracked: These Four Types of Involved Projects Are Usually Featured,” Attorney Shao has already reviewed the typical patterns of virtual currency projects involved in pyramid schemes and their variations.

However, the Web3 concept is iterating rapidly, and new patterns keep emerging. In judicial practice as well, there are cases where judicial authorities—due to unfamiliarity with Web3 project models—mistake certain Web3 projects that have genuine commercial logic for pyramid-scheme crimes.

This article aims to discuss: what kinds of Web3 project models should not be recognized as pyramid-scheme crimes? Where exactly is the space for legal defense? This article will analyze the issue in combination with specific cases.

First, take a look at a case

Machael and others set up a virtual-currency platform, issued X virtual currency, and the project model is as follows: each time a downstream member trades X tokens, the platform charges a certain percentage of service fees, and at the same time awards 20% of the service fees to the upstream person who developed that downstream member, as a referral reward.

In this situation, do Machael and others constitute the crime of organizing and leading pyramid (fraud) schemes?

From a purely formal perspective, since the platform pays referral rewards to upstream members based on the downstream members’ trading activity, it seems to satisfy the formal element of “remuneration based on the number of persons developed,” and it appears there is little dispute about recognizing it as a pyramid-scheme crime.

But this conclusion is clearly too hasty.

Distinguish pyramid-scheme crimes from unlawful administrative “team compensation”: the key is where the upstream profits come from

According to the 2013 “Opinions of the Supreme People’s Court, the Supreme People’s Procuratorate, and the Ministry of Public Security on Several Issues Concerning the Application of Law in Handling Criminal Cases of Organizing and Leading Pyramid Schemes,” pyramid-scheme activities in the form of “team compensation,” which are aimed at selling goods and use sales performance as the basis for compensation, are not handled as crimes.

This provision establishes the core practical criterion for distinguishing pyramid-scheme crimes from administrative violations: the source of the upstream’s profits—whether it is the downstream’s principal, or the platform’s genuine operating income.

If the source is the downstream’s principal—then in substance it is “robbing Peter to pay Paul.” Using money from later entrants to fill the earlier participants’ returns is a typical Ponzi structure, which is suspected of pyramid-scheme criminality. But if the source is profits generated by the platform through genuine business operations—then it can be argued as an unlawful administrative violation in the form of team compensation, which does not constitute a crime.

Therefore, the starting point for lawyers handling cases like this is to determine, in the specific project model at issue, where the funds used for upstream rewards actually come from and what their nature is.

For virtual-currency projects involved in pyramid schemes: how to determine whether the platform has genuine operating income

Returning to Machael’s case at the beginning. To argue that the platform does not constitute a pyramid-scheme crime, it is necessary to combine the project’s specific circumstances, find a coherent commercial logic—i.e., prove that the reward funds paid to upstream members are earned by the platform itself, not taken from the downstream side. This requires looking at two situations.

Test 1: Besides reselling, what else can the token do?

If the only use of the token on the platform is to resell it to the next participant, or if it can be exchanged for USDT in the project party’s self-built “fake DEX” (and that USDT is in fact the principal of the later entrants), then the token has no independent value of its own. In that case, the project party has no genuine operating income, and the funds for upstream rewards can only come from the principal of new users—making the Ponzi structure difficult to deny.

Conversely, if the token can be used within the application to purchase goods or services that have independent value—such as NFT equipment, membership rights, data services, game items, etc.—and the consumption payments can be traced into the project party’s treasury, then the project party has a factual basis to claim “genuine operating income.”

Test 2: Without buying the coin, can a person still participate?

This is the key to assessing whether the act of purchasing coins constitutes an “entry fee” for pyramid-scheme participation. In Web3 platforms, users often need to first exchange RMB for USDT, and then exchange USDT for platform tokens. Whether this coin purchase counts as an entry fee mainly depends on this:

If without buying the coin, the user cannot even activate an account, and referral links cannot be generated, and the purchase of coins is forcibly tied to participation eligibility, then there is a risk of being recognized as an entry fee.

On the other hand, if users can register for free and obtain initial tokens by completing tasks, and they simply earn more slowly without purchasing the coin, then the compulsory nature of buying coins is insufficient, and it is not appropriate to recognize it as an entry fee.

Taking Move-to-Earn projects as an example: three possible legal characterizations

Taking “earn by running” (Move-to-Earn) projects as an example, combined with the two tests above, the same type of project may fall into three completely different categories in terms of legal characterization.

First category: does not constitute any pyramid-scheme-related unlawful act

Users can use basic functions for free. Purchasing NFT running shoes is only an optional value-added choice, rather than a mandatory entry threshold. Referral rewards are based on the actual consumption amount of the person being referred (e.g., NFT royalty revenue sharing), rather than on recruiting “headcount.” Tokens can be used for consumption within the application, for purchasing items, and for paying for services, with real use scenarios. The project party has genuine operating income such as NFT royalties and advertising cooperation, and the source of the upstream rewards is this income, rather than the principal of new users.

— In this kind of model, there is neither a mandatory entry fee nor a tiered rebate structure, and it does not constitute any form of pyramid-scheme-related unlawful act.

Second category: constitutes an administrative unlawful act of team compensation, but is not recognized as a crime

There is a tiered rebate structure: upstream members can obtain rewards from downstream members’ consumption and purchase activities. However, the basis for calculating the rebates is the downstreams’ sales performance (the amount or quantity of NFTs purchased), rather than the number of persons developed. The project is aimed at selling NFTs/tokens and has genuine circulation of goods. There is no subjective intent to obtain property by deception.

— It satisfies Article 7, item (3) of the Regulations Prohibiting Pyramid Schemes, and is deemed team compensation pyramid-type conduct, which is not recognized as a crime.

Third category: constitutes a pyramid-scheme crime

There is a mandatory purchase of high-priced NFTs/tokens as an entry threshold. The rebates are directly calculated based on the number of downstream persons developed, and are unrelated to consumption behavior. There are promises of high-interest static returns, and the funds come from the principal of later entrants. The tokens have no real consumption scenarios and are used only as a bookkeeping tool for pyramid schemes. There is subjective intent to defraud.

— At the same time, it satisfies all four elements of “entry fee + tiered rebates + recruiting for headcount-based compensation + defrauding property,” thus constituting the crime of organizing and leading pyramid (fraud) schemes.

One more supplemental point: if the project party has no real consumption scenario, what does that mean?

This is the key issue in most virtual-currency pyramid-scheme cases.

If the platform’s tokens are only resold internally to the next participant, with absolutely no real consumption scenario—meaning the user’s only purpose in buying coins is to wait for appreciation or to obtain static income—

— then the project party has no genuine operating income whatsoever, and the funds for upstream rewards can only come from the principal of new users.

No matter how the reward rules within the platform are designed, the underlying structure is a Ponzi scheme of “robbing Peter to pay Paul,” making it very difficult to change the fundamental characterization of the project as a pyramid-scheme crime.

Defense points: the following four items must all be supported by evidence

If the project party intends to argue that it does not constitute a pyramid-scheme crime, or that it only constitutes an administrative violation, the following four points must all be supported by evidence at the same time:

1. The token has genuine consumption scenarios, and can be used to purchase goods or services with independent value within the application;

2. The consumption payments do in fact enter the project party’s treasury, and the on-chain fund flows can be traced;

3. The upstream rewards come from the project party’s income, not from directly deducting from downstream principal;

4. The trigger point for the rewards is when consumption is completed, rather than at the time of purchasing or staking the tokens.

If any of the above evidentiary links is missing or broken, the risk of characterizing the conduct as a pyramid-scheme crime will increase significantly.

Conclusion

In cases like this, examinations such as the project party’s token-economy design, the traceability of on-chain fund flows, and the authenticity of consumption scenarios—if the judicial authorities are unfamiliar with Web3 business models—may lead to biased case characterizations.

In addition, the Web3 field itself iterates extremely fast. When each new model emerges, the corresponding judicial understanding is often still a blank.

But this also means that these kinds of cases have significant room for defense. As defense counsel, it is necessary to be familiar with the commercial model and operating logic of such projects in order to find effective entry points.