A Ponzi scheme (//; also a Ponzi game) is a form of fraud in which a purported businessman lures investors and pays profits to earlier investors using funds obtained from newer investors. Investors may be led to believe that the profits are coming from product sales, or other means, and remain unaware that other investors are the source of apparent profits. A Ponzi scheme is able to maintain the illusion of a sustainable business as long as most of the investors do not demand full repayment and are willing to believe in the non-existent assets that they are purported to own, and there continue to be new investors willing to contribute new funds.
The scheme is named after Charles Ponzi, who became notorious for using the technique in the 1920s. The idea had already been carried out by Sarah Howe in Boston in the 1880s through the "Ladies Deposit". Howe offered a solely female clientele an 8% monthly interest rate, and then stole the money that the women had invested. Howe was eventually discovered and served three years in prison. The Ponzi scheme was also previously described in novels (for example, Charles Dickens' 1844 novel Martin Chuzzlewit and 1857 novel Little Dorrit each feature such a scheme), was carried out in real life by Ponzi, and became well known throughout the United States because of the huge amount of money he took in. Ponzi's original scheme was based on the legitimate arbitrage of international reply coupons for postage stamps, but he soon began diverting new investors' money to make payments to earlier investors and himself.
The basic premise of a Ponzi scheme is "To rob Peter to pay Paul". Typically, Ponzi schemes require an initial investment and promise well-above-average returns. They use vague verbal guises such as "hedge futures trading", "high-yield investment programs", or "offshore investment" to describe their income strategy. It is common for the operator to take advantage of a lack of investor knowledge or competence, or sometimes claim to use a proprietary, secret investment strategy in order to avoid giving information about the scheme.
Initially, the operator will pay high returns to attract investors and entice current investors to invest more money. When other investors begin to participate, a cascade effect begins. The "return" to the initial investors is paid by the investments of new participants, rather than from profits of the product.
Often, high returns encourage investors to leave their money within the scheme, so the operator does not actually have to pay very much to investors. The operator will simply send statements showing how much they have earned, which maintains the deception that the scheme is an investment with high returns. Investors within a Ponzi scheme may even face difficulties when trying to get their money out of the investment.
Operators also try to minimize withdrawals by offering new plans to investors where money cannot be withdrawn for a certain period of time in exchange for higher returns. The operator sees new cash flows as investors cannot transfer money. If a few investors do wish to withdraw their money in accordance with the terms allowed, their requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent, or financially sound.
Ponzi schemes sometimes commence operations as legitimate investment vehicles, such as hedge funds. Hedge funds can easily degenerate into a Ponzi-type scheme if they unexpectedly lose money or fail to legitimately earn the returns expected. If the operators fabricate false returns or produce fraudulent audit reports instead of admitting their failure to meet expectations, the operation is then considered a Ponzi scheme.
A wide variety of investment vehicles or strategies, typically legitimate, have become the basis of Ponzi schemes. For instance, Allen Stanford used bank certificates of deposit to defraud tens of thousands of people. Certificates of deposit are usually low-risk and insured instruments, but the Stanford CDs were fraudulent.
High investment returns with little or no risk. Every investment carries some degree of risk, and investments yielding higher returns typically involve more risk. Be highly suspicious of any "guaranteed" investment opportunity.
Overly consistent returns. Investment values tend to go up and down over time, especially those offering potentially high returns. Be suspect of an investment that continues to generate regular, positive returns regardless of overall market conditions.
Unregistered investments. Ponzi schemes typically involve investments that have not been registered with the SEC or with state regulators. Registration is important because it provides investors with access to key information about the company's management, products, services, and finances.
Unlicensed sellers. Federal and state securities laws require investment professionals and their firms to be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.
Secretive and/or complex strategies. Avoiding investments you do not understand, or for which you cannot get complete information, is a good rule of thumb.
Issues with paperwork. Do not accept excuses regarding why you cannot review information about an investment in writing. Also, account statement errors and inconsistencies may be signs that funds are not being invested as promised.
Difficulty receiving payments. Be suspicious if you do not receive a payment or have difficulty cashing out your investment. Keep in mind that Ponzi scheme promoters routinely encourage participants to "roll over" investments and sometimes promise returns offering even higher returns on the amount rolled over.
If a Ponzi scheme is not stopped by authorities, it usually falls apart quickly for one of the following reasons:
A pyramid scheme is a form of fraud similar in some ways to a Ponzi scheme, relying as it does on a mistaken belief in a nonexistent financial reality, including the hope of an extremely high rate of return. However, several characteristics distinguish these schemes from Ponzi schemes:
Cryptocurrencies have been employed by scammers attempting a new generation of Ponzi schemes. For example, misuse of initial coin offerings, or "ICOs," on the Ethereum blockchain platform have been one such method. (per the Financial Times, "smart Ponzis"). The novelty of ICOs means that there is currently a lack of regulatory clarity on the classification of these financial devices, allowing scammers wide leeway to develop Ponzi schemes using these assets.
Economic bubbles are also similar to a Ponzi scheme in that one participant gets paid by contributions from a subsequent participant (until inevitable collapse). A bubble involves ever-rising prices in an open market (for example stock, housing, cryptocurrency, or tulip bulbs) where prices rise because buyers bid more, and buyers bid more because prices are rising. Bubbles are often said to be based on the "greater fool" theory. As with the Ponzi scheme, the price exceeds the intrinsic value of the item, but unlike the Ponzi scheme:
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