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Contents
Introduction......................................................................................................................... 3
Origin of Ponzi scheme: Charles Ponzi .............................................................................. 3
Workings of Ponzi scheme ................................................................................................. 4
Collapse of the Ponzi scheme ............................................................................................. 5
Bernard Madoff’s Ponzi scheme......................................................................................... 5
Other notable Ponzi schemes .............................................................................................. 7
Victims of Ponzi scheme..................................................................................................... 7
Ponzi scheme and Pyramid scheme .................................................................................... 8
How to smell a Ponzi .......................................................................................................... 9
Conclusion ........................................................................................................................ 10
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Introduction
In simple words, Ponzi scheme is a fraudulent investment that promises to you give great
returns which you won’t find in market place for your investment. Fraudulent is in sense
that the schemer never makes any actual investment. The returns provided for the
investors are from the fund provided by later investors. Thus new investor is always
required for this scheme. The main reason for the inevitability of scheme’s collapse is at
some point the schemer is failed to attract new investor. The schemer usually attracts
investors by reassuring great or consistent return with little risks or no risks at all. The
scheme got its name from Charles Ponzi, who first ever performed notable Ponzi scheme
in 1920s.
Origin of Ponzi scheme: Charles Ponzi
This idea of scheme was discovered years before the use of this technique in 1920s. The
idea was stated in different novels before 1920s. This idea was included in Charles
Dickens’s novel Martin Chuzzler and Martin Chuzzler. This idea was then publicly
implement by Charles Ponzi in 1920s. The term was named after him.
In 1920s, whenever a person want to send a mail overseas, he or she has to buys an
international reply coupon. Charles Ponzi realized that he could buy these coupon in
places where it worth less and sell to places like United States where it worth more. Thus
the difference in prices was his source of profit. He realized it is very promising business
idea so he raised fund from some investor promising that he would give a return of 50
percent in just 90 days. Investors were very much interested so they handed out their fund
to Mr. Ponzi. But the business didn’t go well as expected by Mr. Ponzi; he could not gain
enough profit to fulfill the promises made to his investors. He kept his mouth shut about
it. Meanwhile the “50 percent returns in 90 days” scheme spread like wildfire, every
investor wanted to hand over their money to Mr. Ponzi. He took the money as well then
he used this fund from the new investors to pay the promised returns to old investor. Old
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investors were very happy to and told others. Other investor came to Mr. Ponzi with their
money. In this way, Mr. Ponzi used funds from new investors to give away to old
investors promising the returns were from this glorious coupon business. Soon, he was
making millions. Some people became suspicious thinking that how he can be buying and
selling 160 millions of reply could when there are only 27000 coupons in the world.
Eventually authorities busted him.
Workings of Ponzi scheme
It starts with a person who convinces few investors that he has got a brilliant business
idea that gives great profit and he needed invested. He usually promises a great return
with less risk or no risk at all. He never totally discloses his business idea saying that it is
way too complicated for investors to understand. The schemer uses this lack of complete
knowledge in investors to carry out such scheme. From the money schemer got from the
investor, he buys or rents little office space and some fancy furniture which act as props
to convince more investor and con them. Soon he has to pay returns for the first batch of
investors but he doesn’t have the enough money so the schemer convinces more investors
to invest in his business. From the money receive, he himself keeps a slice of it and rest is
used to pay out the return of first batch of investors.
Soon the second batch of investors will also need returns for their return, the process
repeats. Schemer invites third batch of investors to invest in his venture and use this
money to pay the returns of second batch of investors and gives himself a bulky
commissions. This process continues. In many scenarios due to great returns, investors
reinvest their returns in hope of same great returns. The schemer just sends them
statement show how much they have earned in their investments. This make schemer run
the scheme more easily. In times some investors may want to withdraw their investment,
in such conditions the schemer returns their investment. This gives other investor a sense
of liquidity of the investment which makes this investment more attractive.
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Collapse of the Ponzi scheme
As the scheme continues the number investors increases which makes the scheme
complicated there is always some investors whose returns are to be made. As no actual
business is being carried out by the schemer, he is always required to find more investors
to pay out returns of old investors. If someone doesn’t get the returns investors will get
suspicious and the scheme will fail. So the collapse of this scheme becomes inevitable as
it is not possible to always find new investors. The scheme is now in huge pressure to pay
out the returns for the adding investors. It is now only the matter of time before the
scheme gets flashed in public. Such scheme gets flashed to public generally in these three
ways:
The schemer gets vanished with the fund remaining.
As there is always a necessity for inviting new investors in other to pay out
returns of previous investors. Whenever the schemer no longer can find enough
new investor the returns in the investment declines and the investors panic. With
such panic investors tries to withdraw their initial investment, but the schemer
can’t give them back as he doesn’t have any cash left. And eventually people will
find out about the scheme.
External market factors can also cause the scheme to come out like depression.
During such time many people tries to withdraw their money. The scam of Bernie
Madoff is good example.
Bernard Madoff’s Ponzi scheme
In December of 2008, Bernard Madoff revealed that the asset management arm of this
firm, Bernard L. Madoff Investment Securities, was nothing but a big chuck of lie. It
turned out to be a Ponzi scheme from which Madoff had took estimated 65 billion of
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money from his investors over a period of around two decades. This scheme was would
not have been revealed if Madoff hadn’t confessed his crime. This was the largest and
longest running Ponzi scheme the world had ever seen. Madoff not only conned the fat-
cat billionaires and celebrities, individual investors, banks and even charities lost their
money in the scheme. Billionaire and celebrities like Zsa Zsa Gabor, Kevin Bacon and
Steven Spielberg lost their money to this man. In March 2009, Madoff pled guilty to the
charges against him and sentenced him to 150 years in prison the following June.
Madoff was about to pull out the longest and the largest Ponzi scheme with a fund raised
over 50 billion. There are several reasons behind this success. One of the main reasons
behind this largest and longest running Ponzi scheme was that he was a well established
man and esteemed financial expert. He was also among those who helped to established
NASDAQ (National Association of Securities and Dealers Automated Quotations
System) stock exchange and he also served as chairperson. Due to this fact he was a
reputed person among public. Meanwhile he was also running his scheme; he gained the
trust of his investor because whenever they requested a withdrawal, Madoff’s invested
would get them their money promptly. Unlike other Ponzi schemer, Madoff did not
tempted investor to reinvest their returns. In addition to that, he did not promise investors
a high rate of returns but he promised a moderate rate of return. He was providing a
seemingly a constant rate of returns to their invested. However this was a bit suspicious
but it didn’t cause much of a suspicion in public because of his reputation.
Due to such suspiciously consistent rate of returns despite the market fluctuation, some of
investment companies tried to raised a finger against him and even SEC (Securities and
Exchange Commission) did lots of effort but they were all unfruitful. In his confession,
Madoff himself told that he was quite surprised how SEC were unable to revealed his
scheme.
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Other notable Ponzi schemes
As we mentioned earlier, Charles Ponzi didn’t invent the scheme himself. Ponzi’s
biographer, Mitchell Zuckoff, writes in his book of Charles’s predecessors, Sarah Howe
and William Franklin Miller. In 1880s Boston, Sarah offered female investors a chance to
make money in the Ladies Deposit. She garnered half a million dollar from more than
thousand of women, using some of the fund to pay off returns and pocketing the rest.
Couple of decades later, William Franklin Miller came along and tried the scheme again.
He garnered around a million dollar from the investor. Miller promised unheard of high
rate of returns which made investors pour in their money in the hand of Miller.
Between 1996 and 1997 in Albania, several schemes using Ponzi method swindled a total
of 2 billion from public which was equal to 30 percent of the country’s gross domestic
product. Once the schemes were exposed, riots broke out all over the country causing
several deaths.
Victims of Ponzi scheme
Besides being a fraudulent scheme, not all victims are unlucky. Some of the early victims
were able to make out pretty well from the scheme. They were able to benefit from the
high rate of returns and walk out with their investment. However the later investors
certainly lose money. These early lucky victims act as catalyst in the success of these
schemes. Some people knowingly invest in the Ponzi scheme with full knowledge of the
working of the scheme to benefit out from the high rate of returns. They just hope there
aren’t in the bottom rung of the investors. Questions can be raised whether those lucky
investors should be forced to compensate the loss for the later unlucky investors.
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Ponzi scheme and Pyramid scheme
Many people unknowingly interchange these both terminologies or associate Ponzi
scheme with pyramid scheme. Although both of these schemes share some of the
similarities they are completely different. They both are fraudulent activities for easy
money. In both scheme, only minor factor of victims get benefited while major factors of
the victims losses money and these benefit are in the expenses of the loss of other
victims. In these both schemes there is no actual investment.
Despites these similarities, there is fundamental differences between them. The workings
of these schemes are completely different. The main difference is that the schemer will
ask the investor only to invest the money in Ponzi scheme, nothing more than that.
Schemer takes care of the rest. But in pyramid scheme, investors are asked to provide the
money to the schemer and also asked to recruit more investors.
The structures of these schemes are completely different. The basic structure of the
pyramid scheme as name suggests is in the shape of a pyramid in which the schemer
stays at the top and there is multiple level of investor in the shape of pyramid. While in
Ponzi scheme, the schemer stays in the center of circle of investors. All investors are
directly connected to the schemer.
The returns on these schemes are also different. In pyramid scheme, returns are gained
for recruiting new members and are received from the recruited members. Whereas in
Ponzi scheme, the returns are provided for making the investment and are provided by
the schemer from the fund received from new rung of investors.
The Ponzi scheme relatively lasts longer than pyramid scheme because unlike Ponzi
scheme, members are needed to be increased exponentially.
Despite these differences, many people use these words interchangeably and some also
term Ponzi scheme as a type of pyramid scheme. However when you’re a victim of these
schemes, the differences will be insignificant.
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How to smell a Ponzi
Generally a Ponzi scheme is pretty hard to spot in real life but here are some of tip that
can prevent you from falling into such scheme:
Fools run in
Do not ever invest because of someone’s pressure. However if you want to invest,
gain all the necessary information about the investment and take a good time to
think about it in sane mind. Never rush in investment before knowing its pro and
cons.
Unrealistic returns
The one of the main feature of a Ponzi scheme is that the schemer promises very
unrealistic rate of returns. If someone promises you an unbelievable returns you
should do detailed background study about these investment. If something is too
good to be true, it probably is.
Consistent returns
In recent Ponzi scheme performed by Madoff, he didn’t promise an unrealistic
return so many people were fooled due to that. But one suspicious part of his
scheme is that Madoff was providing his investors seemingly consistent returns.
Markets are never consistent; the returns in investment fluctuate with time. So if
someone is providing consistent returns on investment despite the market
fluctuations, he might be running a Ponzi scheme.
Investment detail
This is a key feature of a Ponzi scheme. The schemer never exposes the detail in
their investment showing excuses like its complicated or it is very exclusive. A
suspicious lack of details a key feature of a Ponzi scheme.
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Diversification of your portfolio
This is not feature of Ponzi scheme but a measure to minimize your loss even if
you unfortunately fall in one. One should always diversify their portfolio. One
should invest in multiple places and multiple industries. It is said by expertise any
investment should never account for more than quarter of your whole portfolio.
Conclusion
In short, Ponzi scheme is a fraudulent investment scheme where you are promised of
providing great returns or a steady moderate returns but in fact there is no actual
investment and the returns for old investors are provided from the fund raised from a new
rung of investors. The collapse of this scheme is inevitable as the schemer is always in
need of new investors. However many people perform theses scheme as it is a cheap
source of easy money. And it is accounted as success if they can continue in their scheme
until they died. In recent scheme of Madoff, he was able to continue his scheme to around
two decades. One can prevent themselves from falling into these schemes by having a
detailed knowledge about their investment and research well if the rate returns are high as
compare to other investment opportunity in market because if something is too good to be
true, it probably is.