A Ponzi Scheme is an investment scam in which investors are paid out returns from their own money, or money paid in by subsequent investors, instead of from any actual profit earned. Ponzi schemes almost always offers returns that other investments cannot guarantee in order to entice new investors, such as short-term returns that are abnormally high. The continuation of the returns that a Ponzi scheme promises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going. It is similar to, but not the same thing, as a Pyramid Scheme.
Such a scheme is doomed to collapse eventually, because the earnings, if any, are less than the payments made. Usually, the scheme is interrupted by legal authorities before it collapses because a Ponzi scheme is suspected or because the promoter is selling unregistered securities. As more investors become involved, the likelihood of the scheme coming to the attention of authorities increases.
It is named for Charles Ponzi, who became infamous after he used the technique in early 1920. He had emigrated from Italy to the United States in 1903. Although Ponzi did not invent the scheme, his operation took in so much money that it was the first to become known throughout the United States. His original scheme was in theory based on arbitraging international reply coupons for postage stamps, but soon diverted investors’ money to support payments to earlier investors and Ponzi’s personal wealth.
How a Ponzi Scheme Works
In this hypothetical example, an advertisement is placed that promises amazing returns on an investment, for instance, 20% interest on a 45 day contract. The aim is typically to deceive people who have little knowledge of finance or financial jargon. Phrases that sound impressive but are basically meaningless are used to dazzle investors; terms like “hedged option trading,” “high-yield investment programs,” “offshore investment” could be used. The operator will then proceed to sell stakes to investors, who are in reality victims of a con operation. It is typical to use claims of a “proprietary” investment strategy, which must be kept secret to ensure competitive edge, to hide the reality of the scheme.
Only a few investors are tempted, usually for small sums. Forty five days later, the investor receives the original capital plus the 20 percent return. At this point, the investor will have an incentive to put in additional money and word begins to spread. Other investors grasp at the opportunity to participate, leading to a viral effect owing to the promise of large returns. Of course, the “return” to the initial investors is being paid out of the investments of new entrants, and not out of profits.
This scheme initially works well because the early investors commonly reinvest their money in the scheme, since it does pay much better than any alternative investment. So the person running the scheme does not actually have to pay out very much, they just have to keep sending out statements to investors showing them how much they earned by keeping the money, in order to maintain the deception that the scheme is a fund with high returns.
Eventually, one of three things will happen.
- The promoter disappears, taking all the remaining investment money, minus the small percentage of payouts to investors, with him or her.
- The scheme collapses under its own weight as new investment slows down and the promoter begins having problems paying out the promised returns. Such solvency crises often trigger panics, as more people start asking for their money, similar to a bank run.
- The scheme is exposed because the promoter fails to validate the claims when asked to do so by legal authorities. In other words, someone becomes suspicious and reports the scheme to authorities.
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