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  • Writer's pictureJacqueline Chen

Introducing Ponzi Schemes

A Ponzi scheme is an investment fraud where funds from recent investors pay profits to earlier investors, who believe that the profit is being made from legitimate business activity. Coined after Charles Ponzi in 1919 (although the first recorded instances of Ponzi schemes can be traced back to the mid-to-late 1800s where they were orchestrated by Adele Spitzeder in Germany and Sarah Howe in the United States and also described in novels by Charles Dickens), it is based on the premise of “robbing Peter to pay Paul” because Ponzi schemes rely on a constant flow of new investments to provide returns to older investors. Companies that engage in Ponzi schemes focus all their energy on attracting new clients to make investments because once the flow stops, the scheme falls apart. To maintain cash flow, investors may face difficulties when trying to get their money out of the investment.

Charles Ponzi

Charles Ponzi’s original scheme focused on the US Postal Service which had developed international reply coupons that allowed people to pre-purchase postal reply coupons that could be included in their correspondence. Because of fluctuating exchange and postal rates, there was potential to make a legal profit. As such, Ponzi started buying and selling postal reply coupons through his connections in Italy and reselling them, promising his investors outrageous returns of 50% in 45 days, or 100% in 90 days. However, Ponzi paid investors with money from other investors, not actual profit. The scheme quickly broke down in August of 1920 when The Boston Post started investigating and investors started pulling out their money. Ponzi was arrested by federal authorities on August 12, 1920, and charged with several counts of mail fraud.

The Unraveling

Despite their fragile nature, Ponzi schemes can last for a time as long as they remain undetected and money is continually being circulated, either by getting new investors or enticing clients to continue reinvesting into the business. When Ponzi schemes fail, it is usually because of a handful of reasons or a combination of reasons.

  1. The number of investors slows Depending on how high the promised return is, a deceleration in the number of new investors can mean that the operator can no longer pay promised returns on time. As people start asking for their money, more and more people start panicking when they realize they cannot take out their money.

  2. External marketing forces Sharp declines in the economy can cause investors to try withdrawing part or all of their funds.

  3. Dash and run Ponzi scheme operators can choose to abandon their scheme and take all the remaining investment money, a choice many usually make if they no longer have enough money to pay returns.

How to Spot a Ponzi Scheme

So how can you tell if a business is a Ponzi scheme? The U.S. Securities and Exchange Commission (SEC) provides a detailed list of many “red flags” that investors should keep an eye out for:

  1. High investment returns with little or no risk Although every investment carries some degree of risk, Ponzi schemes seduce investors by “guaranteeing” them a profit despite their high return rates. Thus, any “guaranteed” investment opportunity should be treated with caution.

  2. Overly consistent returns Investment values fluctuate over time, especially those with high returns. Thus, an investment that consistently generates positive return rates despite overall market conditions is suspicious.

  3. Difficulty receiving payments Ponzi scheme promoters try their best to persuade participants from cashing out their returns by offering even higher returns for allowing their money to stay within their business. As such, situations, where investors do not receive a payment or have difficulty cashing out, should be a huge alert.

Pyramid Schemes

Pyramid schemes and Ponzi schemes sound similar and are similar but there are several characteristics distinguishing the two. For one, in Ponzi schemes, the schemer interacts directly with all of its victims and is the mastermind behind the entire operation. In contrast, pyramid schemes recruit participants who will need to recruit additional participants in order to get an investment return. Moreover, pyramid schemes generally collapse faster because they require an exponential increase in participants to sustain it. By persuading most existing participants to continue reinvesting their money, Ponzi schemes only need a small number of new participants and can survive for much longer.

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