Ponzi scheme

1910 police mugshot of Charles Ponzi.

A Ponzi scheme is a particular kind of fraud. It is a peculiar money-raising operation presented as a legitimate investment. It offers returns that are actually paid by the people investing themselves, or by other people investing, and not from the real profits made, if any. More specifically, the money put in by latest investors is actually used to pay the earlier investors, until the scheme finally collapses.

Ponzi schemes offer returns that are usually much higher than those offered by legal forms of investment. It is so because they need to find new people who invest. Keeping the returns going that a Ponzi scheme advertises and pays requires an increasing flow of money from investors.

Finally, the system will always collapse because people have to pay more than they earn, if they earn anything at all. In some cases, the system itself does not collapse, but the authorities find it. In that case, they will stop the system, and start charging people, because running such systems is illegal in many countries. As more and more investors become involved, the likelihood of the scheme coming to the attention of authorities increases.

The scheme was named after Charles Ponzi, who became notorious for using the technique after emigrating from Italy to the United States in 1903. Ponzi did not invent the scheme (Charles Dickens' 1857 novel Little Dorrit described such a scheme decades before Ponzi was born, for example), but his operation took in so much money that it was the first to become known throughout the United States. His original scheme was in theory based on arbitraging international reply coupons for postage stamps, but soon diverted investors' money to support payments to earlier investors and Ponzi's personal wealth.

Nowadays, several Ponzi schemes are run online as HYIPs (High Yield Investment Program).

Example

People advertising Ponzi schemes often use words or phrases very appealing but, at the same time, quite vague and actually uninformative. Typical examples are:

• Hedge Futures Trading
• High-yield investment programs
• Offshore Investment

The people promoting the scheme will take advantage of the fact that the investors do often not know much about economics. The Madoff scandal of 2008 showed that investors presumed to be sophisticated, such as hedge fund managers and international bankers, can also be tricked into joining a Ponzi scheme by a promoter with a well-established (if spurious) reputation for financial skill. Sometimes people also claim that they have their own investment strategy and that this strategy can only work if it is kept secret.

Bernard Madoff, for example, only permitted one accounting firm, run by his brother-in-law, to perform audits on his hedge fund, claiming the need to keep his strategy secret.

Without the benefit of precedent or objective prior information about the investment, only a few investors are tempted, usually for small sums. Thirty days later, the investor receives the original capital plus the 20 percent return. At this point, the investor will have more incentive to put in additional money and, as word begins to spread, other investors grab the "opportunity" to participate, leading to a cascade effect deriving from the promise of extraordinary returns. However, the "return" to the initial investors is being paid out of the investments of new entrants, not from real profits.

One reason that the scheme initially works so well is that early investors – those who actually got paid the large returns – commonly reinvest their money in the scheme (it does, after all, pay out much better than any alternative investment). Thus, those running the scheme do not actually have to pay out very much (net) – they simply have to send statements to investors showing them how much they earned by keeping the money, in order to maintain the deception that the scheme is a fund with high returns.

Promoters also try to minimize withdrawals by offering new plans to investors, often where money is frozen for a longer period of time, in exchange for higher returns. The promoter sees new cash flows as investors are told they could not transfer money from the first plan to the second. If a few investors do wish to withdraw their money in accordance with the terms allowed, the requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent.

The catch is that at some point one of three things will happen:

1. The promoter will vanish, taking all the remaining investment money (minus the payouts to investors) with him.
2. The scheme will collapse under its own weight as investment slows and the promoter starts having problems paying out the promised returns (the higher the returns, the greater the chance of the Ponzi scheme collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run.
3. The scheme is exposed because the promoter fails to validate the claims when asked to do so by legal authorities.

What is not a Ponzi scheme

• A multilevel pyramid scheme is a form of fraud similar in some ways to a Ponzi scheme, relying as it does on a mistaken belief in financial reality, including the hope of an extremely high rate of return. However, several characteristics distinguish these schemes from Ponzi schemes:
  • In a Ponzi scheme, the schemer acts as a "hub" for the victims, interacting with all of them directly. In a multilevel scheme, those who recruit additional participants benefit directly. (In fact, failure to recruit typically means no investment return.)
  • A Ponzi scheme claims to rely on some esoteric investment approach (insider connections, etc.) and often attracts well-to-do investors; whereas multilevel schemes explicitly claim that new money will be the source of payout for the initial investments.
  • A multilevel scheme is bound to collapse much faster because it requires exponential increases in participants to sustain it. By contrast, Ponzi schemes can survive simply by persuading most existing participants to "reinvest" their money, with a relatively small number of new participants.

• A bubble: A bubble relies on the willing suspension of disbelief and an unrealistic expectation of large profits, but it is not the same as a Ponzi scheme. A bubble involves ever-rising (and unsustainable) prices in an open market (be that shares of a stock, housing prices, the price of tulip bulbs, or anything else). As long as buyers are willing to pay ever-increasing prices, sellers can get out with a profit, and there does not need to be a schemer behind a bubble. (In fact, a bubble can arise without any fraud at all - for example, housing prices in a local market that rise sharply but eventually drop sharply because of overbuilding.) Bubbles are often said to be based on the "greater fool" theory. Although, according to the Austrian Business Cycle Theory, bubbles are caused by expanding the money supply beyond what genuine capital investment supports, and in this case would qualify as a Ponzi scheme, with expanded credit taking the place of an expanded pool of investors.

• "Robbing Peter to pay Paul": When debts are due and the money to pay them is lacking, whether because of bad luck or deliberate theft, debtors often make their payments by borrowing or stealing from other investors they have. It does not follow that this is a Ponzi scheme, because from the basic facts set out there is no indication that the lenders were promised unrealistically high rates of return via claims of unusual financial investments. Nor (from these basic facts) is there any indication that the borrower (banker) is progressively increasing the amount of borrowing ("investing") to cover payments to initial investors.

• Multi-level marketing: Multi-level marketing (MLM), a marketing strategy that compensates promoters of direct selling companies not only for product sales they personally generate, but also for the sales of others they introduced to the company, is sometimes difficult to distinguish from illegal pyramid or Ponzi schemes, although legal and reputable MLMs exist.

Other pages

• White-collar crime

Further reading

• Dunn, Donald (2004). Ponzi: The Incredible True Story of the King of Financial Cons (Library of Larceny) (Paperback). New York: Broadway. ISBN 0767914996.

• Zuckoff, Mitchell (2005). Ponzi’s Scheme: The True Story of a Financial Legend. New York: Random House. ISBN 1400060397.

Other websites

• Ponzi scheme definition with distinctions, history, and other information