Ponzi scheme

• 1. Introduction

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  A Ponzi scheme takes its name from Charles Ponzi, an Italian con artist who became famous across the United States in the 1920s. The fraud draws in investors with promised profits. It then pays the early investors using money handed over by the later ones. The old saying for the trick is "to rob Peter to pay Paul." Something this crude sounds like it should fail at once. Yet the illusion can hold for as long as new money keeps arriving and most investors never ask for their full repayment. How does a business that barely exists keep its investors content? What finally brings it down? And how can anyone tell it apart from the other frauds, manias and financial terms that look so much like it?

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• 2. Early Cases

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  From 1869 to 1872, Adele Spitzeder carried out in Germany one of the first recorded frauds to match the modern definition. In the 1880s, Sarah Howe did something similar in the United States through an outfit called the Ladies' Deposit. Howe accepted money only from women and offered them 8% interest every month. She then stole what they had handed over. She was eventually discovered and served three years in prison.

  Charles Dickens put a scheme of this kind into his novel Martin Chuzzlewit in 1844 and again into Little Dorrit in 1857. Fiction had described the pattern long before anyone attached Ponzi's name to it.

  In the 1920s, Charles Ponzi pulled in a sum large enough to make him known throughout the United States. His pitch was built on international reply coupons, which could supposedly be swapped for postage stamps at a profit. That arbitrage proved unworkable. Ponzi soon began diverting new investors' money to pay earlier investors and himself. Earlier frauds of this type drew little notice, but his drew heavy newspaper coverage in the United States and abroad, both while it ran and after it collapsed. That fame is what fixed his name to the crime.

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• 3. The Con Artist's Playbook

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  Phrases such as "hedge futures trading", "high-yield investment programs" and "offshore investment" are the usual cover stories. They sound sophisticated and explain almost nothing. Some operators go further and claim a secret, proprietary strategy, which neatly excuses them from describing it. The promised profits are said to come from a business or a clever idea. In truth the business may not exist, the idea may not work as described, or the returns may be invented or inflated. Operators also tend to prey on investors who lack the knowledge to question them, and they quietly divert client funds to their own use.

  A monthly statement is often all it takes to keep the story going. High returns tempt people to leave their money untouched, so the operator rarely has to pay out much. Some operators offer plans that lock money away for a set period in exchange for even higher returns, which keeps fresh cash in hand. When a few investors do withdraw within the allowed terms, their requests are usually handled quickly. That prompt service convinces everyone else that the fund is solvent and sound.

  Hedge funds show how an honest start can turn crooked. A fund that unexpectedly loses money, or fails to earn the returns it expected, may choose to fabricate results or produce fraudulent audit reports rather than admit the shortfall. From that moment on, it can be considered a Ponzi scheme.

  Allen Stanford used bank certificates of deposit to defraud tens of thousands of people. Such certificates are normally low-risk and insured, but the Stanford certificates were fraudulent.

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• 4. How They Fall

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  Most investors in a collapsed scheme lose much or all of what they put in, and some operators simply vanish with the cash. With little or no genuine income, the scheme needs a constant flow of fresh money to stay alive. It collapses when recruiting new investors becomes hard or when many existing investors cash out together.

  Promoters who plan to run tend to pick a particular moment. They go when the returns owed are about to exceed the incoming investments, because the pool of money is largest then.

  A slowdown in new investors can also be fatal for a scheme whose operator never meant to flee. The higher the promised returns, the greater the danger. A shortage of cash often sparks panic as more people ask for their money, much like a run on a bank.

  A sharp decline in the wider economy can speed things up, because it pushes many investors to withdraw sooner than planned. The Madoff investment scandal during the 2008 financial crisis is the example given. Causes can also stack. News of a police investigation may send investors rushing for their money and make the promoters flee earlier than intended.

  In theory a scheme could even "succeed" financially, at least if it never began as a deliberate fraud. A failing hedge fund reporting false returns might make good its numbers through one successful high-risk bet. Operators who face imminent collapse and criminal charges may see little extra risk in further crimes, such as insider trading, to cover the shortfall. Hedge funds are monitored less heavily than mutual funds. Without a whistleblower or other illegal acts, false reports there often stay hidden until the fund implodes.

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• 5. Warning Signs

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  The U.S. Securities and Exchange Commission, or SEC, lists seven red flags that many Ponzi schemes share. The first is high returns with little or no risk. Every investment carries some risk, and larger potential gains normally mean larger risk, so any "guaranteed" opportunity is suspect.

  The second is returns that are suspiciously steady. Investment values rise and fall, especially for high-return products. One that keeps paying regular gains whatever the market does deserves suspicion.

  The third and fourth concern paperwork and licensing. Ponzi schemes typically involve investments not registered with regulators such as the SEC or the Financial Conduct Authority, known as the FCA. Registration matters because it gives investors access to key facts about a company's management, products, services and finances. Most schemes also involve unlicensed individuals or unregistered firms, although American federal and state securities laws require investment professionals and their firms to be licensed or registered.

  The fifth is a strategy that is secretive or complex. If an investment cannot be understood, or if no complete information about it can be found, that alone is a warning. The sixth is trouble with paperwork, since errors in account statements may show that funds are not being invested as promised. The seventh is difficulty receiving payments or cashing out.

  Criminologist Marie Springer adds further signals. One is a salesperson or adviser who is overly pushy, perhaps using high-pressure tactics. Another is first contact that came through a cold call, a social network, a language-based radio station or a religious radio advertisement. Clients who cannot find out which trades or investments were actually made should also worry. So should clients asked to write checks to an individual instead of the corporation, or to mail them to an address other than the corporate one. Her last flag appears when an investment reaches maturity and clients are pressured to roll over both the principal and the profits.

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• 6. Pyramids and Exit Scams

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  A pyramid scheme resembles a Ponzi scheme because it too depends on a belief in a financial reality that does not exist, including the hope of extremely high returns. Several features set them apart. In a Ponzi scheme the schemer is a "hub" who deals directly with every victim. In a pyramid scheme, people who recruit others benefit directly, and failing to recruit usually means no return at all.

  Ponzi schemes claim to rest on some esoteric investment approach, and they often attract well-to-do investors. Pyramid schemes openly say that new money is what pays the earlier participants.

  Speed of collapse is another difference. A pyramid scheme usually falls much faster, since it needs participants to multiply exponentially. A Ponzi scheme can last, at least briefly, if it simply persuades most existing participants to reinvest while recruiting only a relatively small number of new ones.

  An exit scam is the closest relative of a Ponzi scheme that ends with the operator absconding. The difference is that an exit scam has no investment vehicle and no promised returns. Exit scammers either take payment for products they never ship, usually after building a reputation for reliable delivery, or steal funds held in escrow for third parties. The second kind often involves operators of illegal darknet markets that facilitate the sale of illicit goods and services.

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• 7. Bubbles and the Law

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  Stocks, housing, cryptocurrency, tulip bulbs and the Mississippi Company are all examples of markets in which an economic bubble can form. In a bubble, prices climb because buyers keep bidding higher, and buyers bid higher because prices are climbing. Bubbles are often said to rest on the "greater fool" theory. As in a Ponzi scheme, the price ends up above the true value of the item. Unlike in a Ponzi scheme, most bubbles have no single person or group misrepresenting that value. A common exception is the pump and dump scheme, usually aimed at buyers and holders of thinly traded stocks, which looks much more like a Ponzi scheme.

  Economist Robert J. Shiller called a bubble a "naturally occurring Ponzi", one formed "not in response to a manipulator's baton but to natural market forces". In his telling, one person's expectations stoke the next person's.

  The legal consequences differ sharply. Ponzi schemes usually bring criminal charges once authorities find them. Bubbles, other than pump and dump schemes, do not necessarily involve unlawful activity or even bad faith. A law is broken only if someone knowingly and deliberately misstates facts to inflate an item's value. Even then, wrongdoing is much harder to prove than in a Ponzi case, and criminal convictions require proof beyond a reasonable doubt. Charges, when pursued, often target corporations, which can only be fined and not jailed. The more common recourse is a civil suit for damages. There the standard of proof is only the balance of probabilities, and the plaintiff need not show criminal intent.

  In some jurisdictions, even "innocent" beneficiaries of a collapsed Ponzi scheme must repay their gains so the money can go to victims. That can include anyone who unknowingly profited, and even charities. Perpetrators often donate generously to charities while a scheme runs, hoping to raise their profile and gain from favorable coverage. This rarely happens after a bubble, especially when nobody can prove bad faith.

  Real estate shows how the aftermath differs. After a bubble bursts, the affected items usually keep some value, whereas an investment in a Ponzi scheme is typically worth nothing or close to it. Bubble assets are also easier to finance. An investor who bought on margin or borrowed to invest can lose all or most of their capital, or even owe more than they originally put in.

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• 8. Modern Echoes

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  Economist Hyman Minsky coined the term "Ponzi finance" for borrowing patterns that cannot be sustained. Such a borrower can meet debt payments only by continually finding new financing, often at an accelerating pace or at rising interest rates. Eventually no lender will provide more at any rate, and the borrower becomes insolvent.

  In economics, a "Ponzi game" is a hypothesis about governments. A government defers repaying its public debt by issuing new debt. Each time existing debt matures, it borrows from new or existing lenders to pay off the old.

  Cryptocurrencies have given scammers a new generation of Ponzi schemes. Misuse of initial coin offerings, or ICOs, is one method, and the Financial Times has called the results "smart Ponzis." Most such schemes recover little, and investors lose their funds permanently. Regulators have not yet settled how to classify ICOs, which gives scammers wide room to work. Pseudonymous transactions and the involvement of countless jurisdictions also make perpetrators harder to identify and pursue in court.

  In May 2022, TerraUSD collapsed. It was a stablecoin propped up by a complex algorithmic mechanism that offered 20% yields, and Wired described it as "Ponzinomics." Another well-known case was the ICO of AriseBank, or AriseCoin, which claimed to be founding the world's first "decentralized bank." The SEC successfully recovered the stolen funds. The founders of the fraudulent cryptocurrency Bitconnect carried out a similar scheme.

  In September 2022, Jamie Dimon, the CEO of JPMorgan, described cryptocurrencies as "Decentralised Ponzi Schemes."

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