A Ponzi scheme (/ˈpɒnzi/; also a Ponzi game) is a form of fraud which lures investors and pays profits to earlier investors by using funds obtained from more recent investors. The victims are led to believe that the profits are coming from product sales or other means, and they remain unaware that other investors are the source of profits. A Ponzi scheme is able to maintain the illusion of a sustainable business as long as there continue to be new investors willing to contribute new funds, and as long as most of the investors do not demand full repayment and are willing to believe in the non-existent assets that they are purported to own.
The scheme is named after Charles Ponzi who became notorious for using the technique in the 1920s. The idea had already been carried out by Sarah Howe in Boston in the 1880s through the "Ladies Deposit". Howe offered a solely female clientele an eight-percent monthly interest rate, and then stole the money that the women had invested. She was eventually discovered and served three years in prison. The Ponzi scheme was also previously described in novels; Charles Dickens' 1844 novel Martin Chuzzlewit and his 1857 novel Little Dorrit both feature such a scheme. Ponzi carried out this scheme and became well known throughout the United States because of the huge amount of money that he took in. His original scheme was based on the legitimate arbitrage of international reply coupons for postage stamps, but he soon began diverting new investors' money to make payments to earlier investors and to himself.
Typically, Ponzi schemes require an initial investment and promise above average returns. They use vague verbal guises such as "hedge futures trading", "high-yield investment programs", or "offshore investment" to describe their income strategy. It is common for the operator to take advantage of a lack of investor knowledge or competence, or sometimes claim to use a proprietary, secret investment strategy in order to avoid giving information about the scheme.
The basic premise of a Ponzi scheme is "To rob Peter to pay Paul". Initially, the operator will pay high returns to attract investors and entice current investors to invest more money. When other investors begin to participate, a cascade effect begins. The "return" to the initial investors is paid by the investments of new participants, rather than from profits of the product.
Often, high returns encourage investors to leave their money in the scheme, so that the operator does not actually have to pay very much to investors. The operator will simply send statements showing how much they have earned, which maintains the deception that the scheme is an investment with high returns. Investors within a Ponzi scheme may even face difficulties when trying to get their money out of the investment.
Operators also try to minimize withdrawals by offering new plans to investors where money cannot be withdrawn for a certain period of time in exchange for higher returns. The operator sees new cash flows as investors cannot transfer money. If a few investors do wish to withdraw their money in accordance with the terms allowed, their requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent and financially sound.
Ponzi schemes sometimes begin as legitimate investment vehicles, such as hedge funds that can easily degenerate into a Ponzi-type scheme if they unexpectedly lose money or fail to legitimately earn the returns expected. The operators fabricate false returns or produce fraudulent audit reports instead of admitting their failure to meet expectations, and the operation is then considered a Ponzi scheme.
A wide variety of investment vehicles and strategies, typically legitimate, have become the basis of Ponzi schemes. For instance, Allen Stanford used bank certificates of deposit to defraud tens of thousands of people. Certificates of deposit are usually low-risk and insured instruments, but the Stanford CDs were fraudulent.
Unraveling of a Ponzi Scheme
If a Ponzi scheme is not stopped by authorities, it usually falls apart quickly for one of the following reasons:
1. The operator vanishes, taking all the remaining investment money.
2. Since the scheme requires a continual stream of investments to fund higher returns, if the number of new investors slows down, the scheme collapses as the operator starts having problems paying the promised returns (the higher the returns, the greater the risk of the Ponzi scheme collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run.
3. External market forces, such as a sharp decline in the economy (for example, the Madoff investment scandal during the market downturn of 2008), cause many investors to withdraw part or all of their funds.
Actual losses are extremely difficult to calculate. The amounts that investors thought they had, were never attainable in the first place. On the other hand, they could have invested differently without being scammed. The wide gap between "money in" and "fictitious gains" make it virtually impossible to know how much was lost in any Ponzi scheme.