What is a Ponzi Scheme?

A Ponzi scheme is an investment scam that involves the diversion of new investments to pay dividends to existing investors. Fraudulent companies that partake in Ponzi schemes typically lure new investors into their schemes by promising them high rates of return as well as negligible risks. Investors that participate in Ponzi schemes are driven to believe that their investments are going into sustainable business endeavors and that profits paid to them are derived from product sales or other legitimate means. Although Ponzi schemes are similar to pyramid schemes in their modes of operation, in the case of the latter, investors are actually aware that they are earning dividends by enrolling new participants.

How Does a Ponzi Scheme Work?

A Ponzi scheme is a fraudulent tactic of soliciting investments, used by unscrupulous businesses, that involves offering lucrative benefits to unsuspecting investors, irrespective of market conditions. The primary focus of such businesses is to maintain a constant inflow of investments for as long as possible. These new investments are used to pay dividends to current investors, who are led to believe that the returns originate from legitimate business transactions. A halt in the inflow of new investments as well as reinvestments by existing investors marks the end of the Ponzi scheme. 

History of the Ponzi Scheme 

The Ponzi scheme owes its name to Charles Ponzi, an Italian swindler who devised this tactic in 1919 to defraud a large number of immigrant investors. Ponzi started a legitimate business of arbitrating international reply coupons (IRCs) for postage stamps. He soon began leveraging investments from unsuspecting investors in an effort to further expand his business. However, Ponzi soon started using money he acquired from new investors to pay dividends to existing investors. His business flourished for over a year, before authorities finally unearthed what was to be one the the most infamous scams to have ever occurred in the United States. Ponzis victims lost an astounding $20 million to his scheme. However, Ponzis scheme was not the first of its kind, and unfortunately, nor was it the last. Sarah Howe had used a similar tactic to swindle Boston women in the later part of the 19th century. In fact, the largest Ponzi scheme ever recorded happened as late as 2008, when Bernard Madoff, a financier had already swindled investors of approximately $65 billion over a 17-year period by forging trading reports to indicate profits. 

Characteristics of a Ponzi Scheme 

Although Ponzi schemes involve the usage of different technologies and encompass different businesses, they all share the following distinct attributes:

1. A promise of high rates of return with negligible risk.
2. Steady payment of dividends irrespective of the overall conditions prevailing in the markets.
3. Soliciting money for investments that have not been registered with the United States Securities and Exchange Commission (SEC).
4. A lack of proper license documents on the part of the investment professionals and their firms.
5. Withholding of information pertaining to investment strategies.
6. Disallowing investors to view official documents pertaining to their investments.
7. Difficulties on the part of investors in receiving or encashing dividends.

Ponzi Schemes vs. Pyramid Schemes 

Ponzi schemes are comparable with pyramid schemes in their basic manners of functioning. Both schemes are based on convincing gullible investors to invest in nonexistent business ventures, by promising unrealistically high rates of returns. However, there are certain fundamental differences between the two:

1. While in a Ponzi scheme, the schemer or a group of schemers recruits all investors, in a pyramid scheme, existing investors recruit fresh investors, thus helping to propagate the scheme in a pyramid-like progression.
2. A Ponzi scheme is founded on the conviction of investors that rarefied investment strategies are the source of extraordinary dividends. However, in a pyramid scheme, it is explicitly communicated to investors that new investments are the sole source of returns for initial investments.
3. Unlike pyramid schemes, Ponzi schemes are much more flexible in that they do not necessarily require the induction of new investors in order to survive. A ponzi scheme only fails completely when existing investors fail to renew their investments.