What is a Ponzi scheme?
A Ponzi scheme is a fraudulent investment scam promising high rates of return with little risk to investors. A Ponzi scheme is a fraudulent investment scam that generates returns for previous investors with money taken from subsequent investors. This is similar to a pyramid scheme in that both are based on using funds from new investors to pay previous backers.
Ponzi schemes and pyramid schemes eventually hit rock bottom when the flow of new investors dries up and there isn’t enough money to go around. At that point, the schemes fall apart.
Key points to remember
- The Ponzi scheme generates returns for older investors by acquiring new investors, who are promised a large profit with little or no risk.
- The fraudulent investment scheme is based on using funds from new investors to pay off previous backers.
- Companies that engage in a Ponzi scheme focus their energy on attracting new customers to invest, otherwise their scheme will become illiquid.
- The SEC has issued guidance on what to look for in potential Ponzi schemes, including guaranteed returns or investment vehicles not registered with the SEC.
- The biggest Ponzi scheme was carried out by Bernie Madoff, defrauding thousands of investors out of billions of dollars.
Understanding Ponzi Schemes
A Ponzi scheme is an investment fraud in which clients are promised a large profit with little or no risk. Companies that engage in a Ponzi scheme focus all their energy on attracting new customers to invest.
This new income is used to pay the original investors their returns, marked as a profit from a legitimate transaction. Ponzi schemes rely on a steady stream of new investments to continue providing returns for older investors. When this flow runs out, the system collapses.
Origins of the Ponzi scheme
The term “Ponzi Scheme” was coined after a con man named Charles Ponzi in 1920. However, the first recorded cases of this type of investment scam date back to the mid to late 1800s and were orchestrated by Adele Spitzeder in Germany. and Sarah Howe in the United States. In fact, the methods of what became known as the Ponzi scheme were described in two separate novels written by Charles Dickens, Martin Chuzzlewitpublished in 1844 and Little Dorrit in 1857.
Charles Ponzi’s original plan in 1919 focused on the US Postal Service. The Postal Service, at that time, had developed international reply coupons which allowed a sender to pre-purchase postage and include it in their correspondence. The recipient would take the coupon to a local post office and exchange it for the priority airmail stamps needed to send a reply.
Ponzi schemes rely on a steady stream of new investments to continue providing returns for older investors.
This type of exchange is known as arbitration, which is not an illegal practice. But Ponzi got greedy and expanded its efforts.
Under the name of his company, Securities Exchange Company, he promised returns of 50% in 45 days or 100% in 90 days. Due to its success in the postage stamp system, investors were immediately attracted. Instead of actually investing the money, Ponzi simply redistributed it and told the investors that they had made a profit. The plan lasted until August 1920 when The Boston post began to investigate the Securities Exchange Company. As a result of the newspaper’s investigation, Ponzi was arrested by federal authorities on August 12, 1920, and charged with several counts of mail fraud. In November 1920, Ponzi was sentenced to five years in prison.
Madoff and the biggest Ponzi scheme in history
The concept of the Ponzi scheme did not end in 1920. As technology changed, so did the Ponzi scheme. In 2008, Bernard Madoff was found guilty of running a Ponzi scheme that falsified trading reports to show that a client was making a profit on investments that did not exist.
Madoff promoted his Ponzi scheme as an investment strategy called split strike conversion which used ownership of S&P 100 stocks and options. Madoff would use blue chip stocks which have highly accessible historical trading data in which he could return to falsify his records. Then, forged transactions that never occurred were flagged as yielding the desired periodic yield.
During the global financial crisis of 2008, investors began withdrawing funds from Madoff’s business, exposing the illiquid nature of the company’s true financial condition. Madoff said his company had about $50 billion in debt owed to about 4,800 customers. Sentenced to 150 years in prison with forfeiture of $170 billion in assets, Madoff died in prison on April 14, 2021.
Ponzi schemes can be made over decades. Investigators suspect Madoff’s Ponzi scheme was started in the early 1980s and lasted more than 30 years.
Ponzi scheme red flags
Regardless of the technology used in the Ponzi scheme, most share similar characteristics. The Securities and Exchange Commission (SEC) has identified the following characteristics to watch out for:
- A guaranteed promise of high returns with little risk
- A steady stream of returns regardless of market conditions
- Investments that have not been registered with the Securities and Exchange Commission (SEC)
- Investment strategies that are secret or described as too complex to explain
- Clients are not allowed to view official documents relating to their investment
- Customers having difficulty withdrawing their money
What is an example of a Ponzi scheme?
Imagine a very basic example where Adam promises 10% back to his friend Barry. Barry gives Adam $1,000 with the expectation that the value of the investment will be $1,100 in one year. Then Adam promises 10% back to his friend Christine. Christine agrees to give Adam $2,000.
With $3,000 now in hand, Adam can make Barry whole by paying him $1,100. Additionally, Adam can steal $1,000 from the collective fund pool if he thinks he can get future investors to give him money. For this plan to work, Adam must continually get money from a new customer in order to repay old ones.
What is the difference between a Ponzi scheme and a pyramid scheme?
A Ponzi scheme is a mechanism to entice investors with a promise of future returns. The operator of a Ponzi scheme can only maintain the scheme as long as new investors are brought into the fold.
On the other hand, a pyramid scheme recruits other people and entices them to bring in other investors. A member of a pyramid scheme only earns a portion of their profits and is “used” to generate profits by members higher up the pyramid.
Why is it called a Ponzi scheme?
Ponzi schemes are named after Charles Ponzi, a 1920s businessman who successfully persuaded tens of thousands of clients to invest their funds with him. The Ponzi scheme promised a specific amount of profit after a certain period of time through the buying and selling of discounted postal reply coupons. Instead, it was using newly invested funds to pay off old obligations.
How do you identify a Ponzi scheme?
The SEC has identified a few traits that often signify a fraudulent financial scheme. It is important to understand that almost all types of investing carry some level of risk and many forms do not carry guaranteed profits. If an investment opportunity (1) guarantees a specific return, (2) guarantees that return within a certain time frame, and (3) is not registered with the SEC, the SEC advises investing with caution because these identifiers of fraud.
What is the most famous Ponzi scheme?
The most famous modern Ponzi scheme was orchestrated by Bernie Madoff. His firm executed the biggest Ponzi scheme in history, defrauding thousands of investors out of billions of dollars for decades.
When clients give money to their financial advisors or investment companies, they expect a level of fiduciary duty. Unfortunately, these funds can be fraudulently mismanaged through Ponzi schemes. By taking money from one investor to pay off another, Ponzi schemes are not real investment schemes; these are fraudulent investment schemes that have resulted in the loss of billions of dollars.