A Ponzi scheme (//; also a Ponzi game) is a fraudulent investment operation where the operator, an individual or organization, pays returns to its investors from new capital paid to the operators by new investors, rather than from profit earned through legitimate sources. 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.
Ponzi schemes occasionally begin as legitimate businesses, until the business fails to achieve the returns expected. The business becomes a Ponzi scheme if it then continues to operate under fraudulent terms. Whatever the initial situation, the perpetuation of the high returns requires an ever-increasing flow of money from new investors to sustain the scheme.
The scheme is named after Charles Ponzi, who became notorious for using the technique in the 1920s. The idea, present in novels (for example, Charles Dickens' 1844 novel Martin Chuzzlewit and 1857 novel Little Dorrit each described such a scheme), was actually performed in real life by Ponzi with his operation which 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.
Typically, well above-average returns are promised on the original investment, and vague verbal guises 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 quite easily degenerate into a Ponzi-type scheme if it unexpectedly loses money (or simply fails to legitimately earn the returns promised or thought to be expected) and if 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.
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, rather than solely from 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 an investment 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
When a Ponzi scheme is not stopped by the authorities, it sooner or later falls apart for one of the following reasons:
- The promoter vanishes, taking all the remaining investment money.
- 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.
- 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.
- A pyramid scheme is a form of fraud similar in some ways to a Ponzi scheme, relying as it does on a mistaken belief in a nonexistent financial reality, including the hope of an extremely high rate of return. However, several characteristics distinguish these schemes from Ponzi schemes:
- In a Ponzi scheme, the schemer acts as a "hub" for the victims, interacting with all of them directly. In a pyramid scheme, those who recruit additional participants benefit directly. (In fact, failure to recruit typically means no investment return.)
- A Ponzi scheme claims to rely on some esoteric investment approach and often attracts well-to-do investors, whereas pyramid schemes explicitly claim that new money will be the source of payout for the initial investments.
- A pyramid scheme typically collapses much faster because it requires exponential increases in participants to sustain it. By contrast, Ponzi schemes can survive simply by persuading most existing participants to reinvest their money, with a relatively small number of new participants.
- An economic bubble: A bubble is similar to a Ponzi scheme in that one participant gets paid by contributions from a subsequent participant (until inevitable collapse). A bubble involves ever-rising prices in an open market (for example stock, housing, or tulip bulbs) where prices rise because buyers bid more, and buyers bid more because prices are rising. Bubbles are often said to be based on the "greater fool" theory. As with the Ponzi scheme, the price exceeds the intrinsic value of the item, but unlike the Ponzi scheme:
- In most economic bubbles, there is no single person or group misrepresenting the intrinsic value. A common exception is a pump and dump scheme (typically involving buyers and holders of thinly-traded stocks), which has much more in common with a Ponzi scheme compared to other types of bubbles.
- Whereas Ponzi schemes will typically result in criminal charges after they are discovered by the authorities, other than pump and dump schemes economic bubbles do not typically involve unlawful activity, or even bad faith on the part of any participant. Laws are only broken if someone is perpetuating the bubble by knowingly and deliberately making misrepresentions to inflate the value of an item (as with a pump and dump scheme). Even when this occurs, wrongdoing (and especially criminal activity) is often much more difficult to prove in court compared to a Ponzi scheme. Therefore, the collapse of an economic bubble rarely results in criminal charges (which require proof beyond a reasonable doubt to secure a conviction) and, even when charges are pursued, they are often against corporations, which can be easier to pursue in court compared to charges against people but which also can only result in fines as opposed to jail time. The much more commonly-pursued legal recourse in situations where an economic bubble is suspected to be the result of some form of nefarious activity is to sue for damages in civil court, where the standard of proof is only balance of probabilities and where mens rea does not need to be demonstrated.
- Following the collapse of a Ponzi scheme, even the "innocent" beneficiaries (including anyone who unwittingly profited without being aware of the fraudulent nature of the scheme as well as the recipients of charitable donations from the perpetrators while the scheme was in operation) will be liable to repay any such profits or donations for distribution to the victims. This typically does not happen in the case of an economic bubble, especially if it cannot be proven that the bubble was caused by anyone acting in bad faith.
- Items traded in an economic bubble are much more likely to have an intrinsic value that is worth a substantial proportion of the market price. Therefore, following collapse of an economic bubble (especially one in a commodity such as real estate) the items affected will often retain some value, whereas an investment that is part of a Ponzi scheme will typically be worthless (or very close to worthless). On the other hand, it is much easier to obtain financing for many items that are the frequent subject of bubbles. If an investor trading on margin or borrowing to finance investments becomes the victim of a bubble, he or she can still lose all (or a very substantial portion) of his or her investment capital, or even be liable for losses in excess of the original capital investment.
- Black Friday (1869), also referred to as the Gold Panic of 1869
- Bucket shop (stock market)
- Get-rich-quick scheme
- List of Ponzi schemes
- Madoff investment scandal
- Matrix scheme
- Pump and dump
- Tulip mania
- White-collar crime
- Hustle (TV series)
- United States Postal Inspection Service
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