Wikipedia : Ponzi Schemes
A Ponzi scheme is a fraudulent investment operation that pays returns to investors out of the money paid by subsequent investors rather than from profit. The term, "Ponzi scheme," is used primarily in the United States, while other English-speaking countries do not distinguish colloquially between this scheme and other pyramid schemes.
The Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going.
The system is destined to collapse because the earnings, if any, are less than the payments. 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.
The scheme is named after Charles Ponzi, who became notorious for using the technique after emigrating from Italy to the United States in 1903. Ponzi did not invent the scheme, but 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.
Knowingly entering a Ponzi scheme, even at the last round of the scheme, can be rational in the economic sense if a government will likely bail out those participating in the Ponzi scheme.
1 Hypothetical example
2 What is and is not a Ponzi scheme
3 Notable Ponzi schemes
3.1 Charles Ponzi
3.2 Bernard Madoff
Suppose an advertisement is placed that promises extraordinary returns on an investment – for example, 20% on a 30-day contract. The objective is to deceive laypeople who have no in-depth knowledge of finance or financial jargon. Verbal constructions that sound impressive but are essentially irrelevant will be used to dazzle investors: terms such as "global currency arbitrage", "hedge futures trading", "high-yield investment programs", "offshore investment" might be used. The promoter will then proceed to sell investors--who are essentially marks in a confidence trick--stakes, by taking advantage of a lack of investor knowledge or competence.
Without the benefit of precedent or objective prior information about the investment, only a few investors are tempted, usually for smaller sums. Thirty days later, the investor receives the original capital plus the 20% return. At this point, the investor will have more incentive to put in additional money and, as word begins to spread, other investors grab the "opportunity" to participate, leading to a cascade effect deriving from the promise of extraordinary returns. However, the "return" to the initial investors is being paid out of the investments of new entrants, and not out of profits.
One reason that the scheme initially works so well is that early investors – those who actually got paid the large returns – commonly reinvest their money in the scheme (it does, after all, pay out much better than any alternative investment). Thus those running the scheme do not actually have to pay out very much (net) – they simply have to send 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.
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 could not 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, the requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent.
The catch is that at some point one of three things will happen:
The promoters will vanish, taking all the remaining investment money (minus the payouts to investors) with them;
the scheme will collapse under its own weight, as investment slows and the promoters start having problems paying out the promised returns (the higher the returns, the greater the chance of the ponzi scheme collapsing). Such liquidity 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 their claims when asked to do so by legal authorities.
What is and is not a Ponzi scheme
A multilevel pyramid scheme is a form of fraud similar in some ways to a Ponzi scheme, relying as it does on a disbelief in 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 multilevel 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, insider connections, etc., and often attracts well-to-do investors; multilevel schemes explicitly claim that new money will be the source of payout for the initial investments.
A multilevel scheme is bound to collapse a lot faster, due to the necessity of 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.
A bubble. A bubble relies on suspension of disbelief and an expectation of large profits, but it is not the same as a Ponzi scheme. A bubble involves ever-rising (and unsustainable) prices in an open market (be that shares of a stock, housing prices, the price of tulip bulbs, or anything else). As long as buyers are willing to pay ever-increasing prices, sellers can get out with a profit. And there doesn't need to be a schemer behind a bubble. (In fact, a bubble can arise without any fraud at all - for example, housing prices in a local market that rise sharply but eventually drop sharply because of overbuilding.) Bubbles are often said to be based on "greater fool" theory. Although, according to the Austrian Business Cycle Theory, bubbles are caused by expanding the money supply beyond what genuine capital investment supports, and in this case would qualify as a Ponzi scheme, with expanded credit taking the place of an expanded pool of investors.
Although non-fraudulent in intent, a pension fund can share some of the characteristics of a Ponzi scheme in that, except during the final period of the fund's life-span, the outgoing cash used in any month to pay pensions is usually taken from the incoming contributions of the active members of the pension scheme. In a year of poor equity returns such as 2008, a pension fund can often perform worse for its members than a Ponzi scheme.
Robbing Peter to pay Paul. When debts are due and the money to pay them is lacking, whether because of bad luck or deliberate theft, debtors often make their payments by borrowing or stealing from other monies they have. It does not follow that this is a Ponzi scheme, because from the basic facts set out there is no indication that the lenders were promised unrealistically high rates of return via claims of unusual financial investments. Nor (from these basic facts) is there any indication that the borrower (banker) is progressively increasing the amount of borrowing ("investing") to cover payments to initial investors (as, again, Ponzi was not the first to do).
Notable Ponzi schemes
Main article: List of Ponzi schemes
The eponymous Ponzi scheme was coordinated by Charles Ponzi, who went from anonymity to being a well-known Boston millionaire in six months using such a scheme in 1920. Profits were supposed to come from exchanging international postal reply coupons. He promised 50% interest (return) on investments in 45 days or “double your money” in 90 days. About 40,000 people invested about $15 million all together; in the end, only a third of that money was returned to them.
Main article: Bernard Madoff
On December 11, 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. One of Madoff's biggest investors, René-Thierry Magon de la Villehuchet of Access International Advisors, committed suicide around December 23, 2008 following the disclosure of the scheme. At the time of this writing, it is unclear to what extent Access International's funds were involved in the scheme. Villehuchet is alleged to have lost as much as $1.4 billion in Madoff's scheme.
While the scheme was typical of a Ponzi in its structure, it differed in its pace and its marketing. Rather than offer (suspiciously) high returns to all comers, Madoff instead offered modest, but steady returns to an exclusive clientele, returns produced in both up and down markets. The investment method was stated to be through a combination of stock purchases tracking some index and related puts and calls (contrary "bets" on the index's direction), but with the exact details a proprietary secret. Madoff exploited social networks to promote it among a largely upper class Jewish clientele, with significant funds invested from educational and social charity funds directed by the clients. The slow pace and "insider" marketing enabled the scheme to survive for an unusually long time and also to grow far larger than would be expected of a common Ponzi. All worked well for Madoff until the general market downturn of 2008 motivated a larger than usual number of investors to cash out their positions. With little actual liquidity, the scheme collapsed. In fact, the stated methodology was not possible, since the existing markets in puts and calls were not large enough to support the claimed activities, an observation noted by several critics prior to the collapse. The scheme also differed in that even some hedge funds invested in Madoff's funds, with some investors unknowingly exposed through multiple fund investments that they believed to be diversified.