What Is a Ponzi Scheme?
A Ponzi scheme is an investment scam that pays early investors with money taken from later investors to create an illusion of big profits. A Ponzi scheme promises a high rate of return with little risk to the investor. It relies on word-of-mouth, as new investors hear about the big returns earned by early investors. Inevitably, the scheme collapses when the flow of new money slows, making it impossible to keep up the payments of alleged profits.
A Ponzi scheme is similar to a pyramid scheme in that both use new investors' funds to pay earlier backers. A pyramid scheme usually relies on rewarding early participants to recruit more participants but collapses when the supply of potential participants dwindles.
Key Takeaways
- A Ponzi scheme relies on a growing stream of new investors to create an illusion of profit.
- Some of the new money is used to pay earlier investors, making the scam look legitimate and highly profitable.
- Most of the money is pocketed by the scam's operator.
- The scam collapses when the supply of new investors slows and the supposed profits evaporate.
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Understanding Ponzi Schemes
A Ponzi scheme is a type of investment fraud in which investors are promised big profits at little or no risk.
The money is not invested. Rather, the scam artist concentrates on attracting more investors. A growing number of victims is needed to pay out the supposed profits being distributed to earlier investors.
When the flow of new investment slows, the scam artist doesn't have enough money to pay out those supposed profits. That's when the Ponzi scheme collapses.
Origins of the Ponzi Scheme
The Ponzi scheme gets its name from a swindler named Charles Ponzi, who in 1920 became a millionaire by promoting a nonexistent investing opportunity.
Ponzi wasn't the first to perpetrate this type of fraud. Earlier schemes were reported in the 19th century and Charles Dickens dramatized the methods in two novels, "The Life and Adventures of Martin Chuzzlewit" (1844) and "Little Dorrit," (1857.)
Charles Ponzi's original scheme, conceived in 1919, focused on the U.S. Postal Service and international mail. He received correspondence from someone in Spain who had prepaid international postage. This international postage reply coupon could be exchanged in the U.S. for postage to send a reply back to Spain. This gave Ponzi an idea.
There were tiny differences between the charges for the coupons and their redemption prices, based on differences in currency exchange rates. Scaled up, this could return a profit. The concept was a form of arbitrage, which is not illegal.
Ponzi schemes rely on a constant flow of new investments to continue to provide returns to earlier investors.
However, Ponzi was hardly engaging in this practice. It would eventually be discovered that he only had $61 worth of these postal coupons. He was collecting money from investors and paying out just enough to keep the scheme going.
It lasted until August 1920, when The Boston Post began investigating Ponzi's Securities Exchange Company and its promise of a 50% return in 90 days and later just 45 days. Ponzi was arrested by federal authorities on August 12, 1920, and charged with several counts of mail fraud. He served time in federal prison.
After his release, he was tried and convicted on state charges in Massachusetts. He then spent time running from the law and being arrested in other states, before being imprisoned in Massachusetts to serve his sentence. Following his release from state prison, Ponzi was deported to his native Italy.
Bernie Madoff and the Biggest Ponzi Scheme Ever
Charles Ponzi didn't run the last Ponzi scheme. In 2008, Bernard Madoff was convicted of running a Ponzi scheme that falsified trading reports to show his clients were earning profits on investments that didn't exist.
Madoff promoted his Ponzi scheme as an investment strategy called the split-strike conversion that traded in blue-chip stocks and options. Madoff simply used historical trading data to create false records of profits from trading activity that never occurred.
During the 2008 global financial crisis, investors began to withdraw funds from Madoff's firm, exposing the company's illiquid nature.
Madoff eventually admitted that his firm had $50 billion of liabilities owed to 4,800 clients. However, the government determined the real size of the fraud to be $64.8 billion. Sentenced to 150 years in prison and forfeiture of $170 billion in assets, Madoff died in prison on April 14, 2021.
Ponzi schemes can be carried out over decades. It is suspected that Madoff's Ponzi scheme started in the early 1980s and lasted over 20 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 traits to watch for:
- A guaranteed promise of high returns with little risk
- A consistent flow of returns regardless of market conditions
- Investments are not registered with the SEC
- Sellers are not licensed to sell investment products
- Investment strategies that are "secret" or described as too complex to explain
- Failure to provide clients with documentation for their investment
- Difficulties withdrawing money
What Is an Example of a Ponzi Scheme?
Adam promises a 10% return on a $1,000 loan to his friend Barry. Barry gives Adam $1,000 with the expectation that he'll be paid $1,100 in one year. Next, Adam promises 10% returns to his friend Christine. Christine gives Adam $2,000.
With $3,000 now on hand, Adam pays Barry his $1,100. He spends the rest of the money, confident that he can persuade someone else to give him money before Christine's money is due to be repaid.
The best Ponzi schemes, however, rely on long-term investors. If Adam can persuade Barry and Christine to let him continue to invest their money, he'll need to pay them only the periodic interest he has promised. He can spend the rest, confident that new investors will supply enough to keep the scam running.
What's the Difference Between a Ponzi Scheme and a Pyramid Scheme?
Both a Ponzi scheme and a pyramid scheme rely on a steady stream of new investors who are motivated by reports of the big profits earned by early investors. A Ponzi scheme repays each investor using money deposited by new investors, falsifying records of nonexistent transactions to characterize the money as profit.
A pyramid scheme usually promises a lucrative business opportunity that requires an initial investment. Each investor is rewarded for attracting new investors. The earliest participants really do make a profit, earning money for every new recruit and those the new recruit signs up. Each new recruit makes less money than the previous one until no more recruits can be found.
Why Is It Called a Ponzi Scheme?
Ponzi schemes are named after Charles Ponzi, a businessman who successfully persuaded tens of thousands of clients to invest their money in a nonexistent venture for a guaranteed high profit. Ponzi's earliest clients got their money, but it was paid out of money contributed by later investors. Ponzi made millions before his con was exposed.
How Do You Identify a Ponzi Scheme?
The SEC has identified a few traits that often signify a fraudulent financial scheme. If an investment opportunity guarantees a specific high rate of return, guarantees that return by a certain time and is not registered with the SEC, the SEC advises caution.
What Is the Most Famous Ponzi Scheme?
The most famous modern Ponzi scheme was orchestrated by Bernie Madoff. His firm defrauded thousands of investors out of billions of dollars over decades. The scheme unraveled when he was unable to meet an unexpectedly high level of withdrawals.
The Bottom Line
The con artists who create Ponzi schemes aren't investing their clients' money in anything. They are creating an illusion of profits by paying early investors from the funds deposited by later investors. Meanwhile, they are pocketing the bulk of the money for their own use. Beware of promises of steady high profits at no risk to you.
