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The Ponzi Scheme

What if you were told that you could get a 40% return on your investment in just 90 days compared with 5% for bank savings accounts?

Would you join in? Well one man was able to scam investors out of $1 million (in 1921!) using what is now dubbed ‘The Ponzi Scheme‘.

What is a Ponzi Scheme?

Named after Charles Ponzi, who ran an investment scheme that duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s.  A Ponzi scheme is an investment scheme in which returns are paid to earlier investors, entirely out of money paid into the scheme by newer investors.  Ponzi schemes are similar to pyramid schemes, but differ in that Ponzi schemes are operated by a central company or person, who may or may not be making other false claims about how the money is being invested, and where the returns are coming from.

Ponzi schemes don’t necessarily involve a hierarchal structure, as in a pyramid scheme; there is merely one person or company that is collecting money from new participants and using this money to pay off promised returns to earlier participants. A Ponzi Scheme is basically borrowing from one source simply to pay off another.

Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40% return in just 90 days compared with 5% for bank savings accounts. Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period in 1921.

Why Invest in Ponzi Schemes?

Why would so many people invest in a scheme that didn’t work?  The real reason was that the early investors did see the great returns on their money.  Ponzi used the money from later investors to pay off his earlier obligations to make the scheme look legitimate.  A few people remove their money + 10% and are quite happy with it. So the system keeps going. Ponzi Scheme is basically borrowing from one source simply to pay off another.

The reason why it attracts a lot of investors and keeps many of them invested is the promise of unrealistically high gains. People can’t get this kind of gains in any other type of investment. It was a new twist on the age-old pyramid scheme. An estimated 40,000 people had entrusted an estimated fifteen million dollars (about $140 million in U.S. funds today) in Ponzi’s scheme.

However, the system is destined to collapse because there are little or no underlying earnings from the money received by the promoter. The scheme is often interrupted by legal authorities before it collapses, because a Ponzi scheme is suspected and/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.

Common types of Ponzi scheme operate under a variety of names including “high yield investment program” and “high yield debentures”. Their common characteristics are very high returns with no clear underlying business to generate them.

More complex forms of Ponzi scheme can be harder to detect. They may well appear to be legitimate investments. They may even be part of an investment that includes both legitimate and Ponzi elements. An example of the latter is an investment or finance company that offers very high returns to depositors, and does lend the money (as a real finance company would) to make returns, but does so knowing that the return on loans will not suffice to cover the interest paid to depositors.

Anything that offers very high returns without correspondingly high risk should be regarded with great suspicion. Any investment sold through unusual channels (stock spam email or cold calling) or by a business that is not appropriately regulated is also both suspicious and probably illegal. It is usually possible to check with regulators whether someone selling investments is regulated or not.

Today’s Ponzi Schemes

In December 2008, former chairman of the NASDAQ Stock Market, Bernard Madoff, was arrested and charged with a single count of securities fraud, but one which if proved, may rank among the biggest frauds ever – totaling $50 billion of fraudulent losses. If these figures are accurate, this would be the biggest Ponzi scheme in history.

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