Ponzi Schemes

A Ponzi scheme is an investing fraud promising high return rates with low risk to investors. A Ponzi scheme can be also named as a pyramid scheme, which generates profits for investors with money taken from newcomers.

Both these structures fall down immediately when the flow of new clients stops and there are no more fresh funds to maintain their organisation. In the end of this roguish system the scheme disintegrates. 

Definition of Ponzi Schemes

A Ponzi scheme represents an investing program where backers were promised to have huge profits with minimum risks. Organisations which join Ponzi schemes concentrate all their attention to engage further investors to get incomes.

The received money helps to pay initial investors their earnings, flagged as a gain from a legal transaction. Ponzi schemes are based on an ongoing flood of funds to keep on giving money to older clients. When this cash flow ends, the pyramid concept gets revealed in its primal fragility.  

Ponzi Scheme background

The word "Ponzi Scheme" was imposed in 1920 after a crook named Charles Ponzi. Nevertheless, the early documented cases related to these kinds of investment scams were noticed in the 1800s, and were organised by Sarah Howe and Adele Spitzeder. Actually the ways of what subsequently was named later as the Ponzi Scheme were mentioned in two different books written by Charles Dickens, Martin Chuzzlewit  and Little Dorrit.

In 1919 the initial scheme of Charles Ponzi laid an eye on the American Postal Service. At those times the service had arranged International Reply Coupons that let a person who sends to pay the costs for a postage in advance and add it in their mail. The addressee would take the coupon to a  post office and exchange it for the priority postage stamps which were necessary to send a reply. 

This exchange is called arbitrage, which is not an illegal practice. But Ponzi became insatiable and enhanced his efforts.

Under the title of his company, Securities Exchange Company, Ponzi guaranteed incomes of 50% in 45 days or 100% in 90 days. Investors were attracted very soon due to his successful scheme with postage stamps. Instead of really investing the funds, Ponzi simply redeployed it and assured the investors they made money. The scheme was in use until August of the same year when The Boston Post began inquiring about the organisation’s work. At the end of the newspaper's work, Ponzi was caught by federal authorities on the 12th of August in 1920, and indicted on a few charges of mail scam. In November Ponzi was condemned to stay in prison for five years.

The brightest example of Ponzi Scheme in history

The idea of the Ponzi scheme did not die in 1920. As the times and technologies modernised, so did the Ponzi scheme. In 2008, Bernard Madoff was condemned for running a Ponzi scheme that faked trading checks to assure a client was gaining a profit on investing that didn't actually exist.

Madoff presented his Ponzi scheme as an investment strategy named the split-strike conversion that used property of S&P 100 shares and options. Madoff would use blue-chip stocks which have highly available historical trading data which he could return to to fake his records. Then, adulterated transactions which never took place were reported to bring the needed income.

During the 2008 Global Financial Crisis, investors began to take out the funds from Madoff's company, uncovering the illiquid essense of the firm's true financial image. Madoff said that his firm had around $50 billion of obligations owed to approximately 3,000 investors. Charged to 150 years in prison with confiscation of equities of $170 billion, Madoff died in prison in 2021.

Ponzi Scheme red flags

Despite the technological methods used in the Ponzi scheme, most have similar features. The Securities and Exchange Commission (SEC) has named the following traits to be aware of:

1. A promise of high incomes with little risk
2. An ongoing amount of received money no matter what market conditions are
3. Investments that do not have registrance from the SEC
4. Investing plans kept in secret or described as too sophisticated to tell
5. Clients not permitted to have a look at official paperwork for their investment
6. Investors having difficulties with removing their money 

Ponzi Scheme illustrated

Let it be a basic example where David guarantees 10% returns to his friend John. John gives David $5,000 with the expectation that the investment value will be $5,500 in one year. David then promises 10% returns to his friend Mary. Mary agrees to give Adam $3,000.

At this moment with $8,000 on hand, David can reimburse John whole by paying him $5,500. In addition, David can snatchl $1,500 from the fund poll if he believes he can find future clients to give him funds. For this method to function, David must continually receive money from new clients to pay off old ones.

Ponzi Scheme vs. pyramid scheme

A Ponzi scheme is a method to find potential investors with guaranteed returns in the future. The founder of a Ponzi scheme can only sustain the scheme as long as new clients are included in the members’ list.

On the other hand, a pyramid scheme attracts other people and encourages them to further recruit other clients. The pyramid member receives only a portion of his income and is "used" to profit by members higher up the pyramid.

Ponzi Scheme’s author

As it was mentioned previously, Ponzi schemes are named after Charles Ponzi, a businessman who in 1920 successfully convinced tens of thousands of people to invest their money in his company. Ponzi's scheme promised a certain amount of profit after a certain amount of time by buying and selling discount coupons for postal responses. the purchase and sale of discounted postal reply coupons. Instead, he was using the newly invested money to pay off old liabilities.

Usually people become swindlers due to their poor family background, criminal and marginal ancestors. However, the founder of the historic fraudulent scheme was raised in formerly wealthy conditions. Ponzi came from a once prosperous Italian family, he was accepted into the University of Rome and had four years to study for a degree, though his friends perceived their academic period to be an extra long vacation, and thus they had been spending a lot of money on opera, cafés, bars and other entertainment. Consequently Ponzi broke down with no degree and money in his pocket. In order to come back on track, he moved over to the United States with the hope of gaining money for his impoverished family and himself.

Ponzi Scheme’s identification 

The SEC has determined several signs  that often indicate a roguish financial scheme. It’s a very crucial thing to keep in mind that practically all types of investing involve a certain level of risks, and many forms do not imply a guaranteed return. If an investment project (1) guarantees a specific refund, (2) promises that it will return by a defined time, and (3) is not signed up in the SEC, the SEC recommends investors to be very cautious and careful before they give funds to someone as this one can be identified as a scammer.

Example of Ponzi Scheme

A well-known example of this kind of fraud was made up by Bernie Madoff around a decade ago. His firm invented the famous Ponzi scheme, luring crowds of investors out of huge sums of dollars over many long years.