Ponzi scheme

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1910 police mugshot of Charles Ponzi, the namesake of the scheme

A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from existing capital or new capital paid by new investors, rather than from profit earned by the individual or organization running the operation. Operators of Ponzi schemes usually entice new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the high returns requires an ever-increasing flow of money from new investors to sustain the scheme.[1]

The scheme is named after Charles Ponzi,[2] who became notorious for using the technique in 1920.[3] Ponzi did not invent the scheme (for example, Charles Dickens' 1844 novel Martin Chuzzlewit and 1857 novel Little Dorrit each described such a scheme),[4] but his operation took in so much money that it was the first to become known throughout the United States. Ponzi's original scheme was based on the arbitrage of international reply coupons for postage stamps; however, he soon diverted investors' money to make payments to earlier investors and himself.

Characteristics[edit]

Typically, extraordinary returns are promised on the original investment[5] and vague verbal constructions such as "hedge futures trading", "high-yield investment programs", or "offshore investment" might be used. The promoter sells shares to investors by taking advantage of a lack of investor knowledge or competence, or using claims of a proprietary investment strategy which must be kept secret to ensure a competitive edge.

Ponzi schemes sometimes commence operations as legitimate investment vehicles, such as hedge funds. For example, a hedge fund can degenerate into a Ponzi scheme if it unexpectedly loses money (or simply fails to legitimately earn the returns promised and/or thought to be expected) and the promoters, instead of admitting their failure to meet expectations, fabricate false returns and, if necessary, produce fraudulent audit reports.

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.[6]

Initially the promoter will pay out high returns to attract more investors, and to lure current investors into putting in additional money. Other investors begin to participate, leading to a cascade effect. The "return" to the initial investors is paid out of the investments of new entrants, and not out of profits.

Often the high returns encourage investors to leave their money in the scheme, with the result that the promoter does not have to pay out very much to investors; he simply has to send them statements showing how much they have earned. This maintains 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 cannot 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, their requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent.

Unraveling of a Ponzi scheme[edit]

When a Ponzi scheme is not stopped by the authorities, it sooner or later falls apart for one of the following reasons:[1]

  1. The promoter vanishes, taking all the remaining investment money (which excludes payouts to investors already made).
  2. Since the scheme requires a continual stream of investments to fund higher returns, once investment slows down, the scheme collapses as the promoter starts having problems paying the promised returns (the higher the returns, the greater the risk 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. External market forces, such as a sharp decline in the economy (for example, the Madoff investment scandal during the market downturn of 2008), cause many investors to withdraw part or all of their funds.

Similar schemes[edit]

See also[edit]

References[edit]

  1. ^ a b c "Ponzi Schemes – Frequently Asked Questions". U.S Securities and Exchange Commission. U.S Securities and Exchange Commission. Retrieved 23 June 2012. 
  2. ^ "Ponzi Schemes". US Social Security Administration. Retrieved 24 December 2008. 
  3. ^ Peck, Sarah (2010), Investment Ethics, John Wiley and Sons, p. 5, ISBN 978-0-470-43453-6 
  4. ^ Markopolos, Harry; Casey, Frank (2010), No One Would Listen: A True Financial Thriller, John Wiley and Sons, p. 50, ISBN 978-0-470-55373-2 
  5. ^ "What is a Ponzi scheme?". Mijiki. Mijiki.com. Retrieved 23 June 2012. 
  6. ^ Kurdas, Chidem (2012), Political Sticky Wicket: The Untouchable Ponzi Scheme of Allen Stanford 

Further reading[edit]

External links[edit]