Ponzi Scheme is an investment scheme that provides incomes of earlier investors on account of the funds received from later investors. At first, it may seem perfectly legitimate, but Ponzi scheme is usually destroyed as soon as the flow of funds from new investors is no longer sufficient to make payments to the old ones.
In some cases, Ponzi scheme is primarily used in good faith intended to make a profit and to meet all investors’ obligations. However, in most cases, the scheme is created for fraudulent purposes to bring benefits to its organizers, who make almost no effort to make a profit for investors.
In more simple words, investors are promised high returns and in a short time they will receive them, but they come not from entrepreneurial activity, but at the expense of new investors lured with the same promises. And the pyramid will exist as long as the high dividends will attract new investors.
Pyramid schemes are doomed to failure, because the incomes investors always receive are less than the payments they make. As a rule, pyramids are shut down by law enforcement agencies before they collapse, because Ponzi scheme essentially “sells air”, and attract the authorities’ attention due to the significant number of investors.
The scheme is named after Charles Ponzi, who is notorious for using this affair in early 1920. Ponzi is not the author of the idea, but he was the first con artist in the United States who managed to get a huge amount of investment. After successful immigration to the United States in 1903, Ponzi created his investment scheme built on arbitrage transactions with reply coupons.
To finance these activities he collected money from investors by offering them high interest rates. Further, funds received from new investors, were partly allocated to the payment of income to earlier investors, and some of them Ponzi spent on his needs.
Ponzi Scheme vs Financial Pyramids
There is common misconception that Ponzi scheme is a type of classical financial pyramid, but there are several subtle differences between these two schemes. Although both of these strategies are examples of fraudulent investment schemes that pretend to be serious organizations promising high returns in a short period of time, Ponzi scheme has a central figure that gets most of the money from fraud. In contrast, the pyramid scheme implies creating a network of investors who, in turn, actively attract new investors and usually receive interest on any investments made as a result of their efforts. That is in a classic pyramid scheme all cash flows are not tied to one person.
Moreover, Ponzi scheme does not rely solely on new investors to continue functioning. As an accompanying strategy Ponzi scheme also implies bringing back earlier investors who have already earned some income from their initial investment, by persuading them to reinvest these funds. This strategy is not typical for most financial pyramids which mainly rely on continuous attraction of new investors to be able to continue functioning.
While most countries have laws that prohibit such practices and have punishments in the form of penalties and / or imprisonment, sometimes Ponzi scheme is very difficult to identify at the stage of development. Over time, while expanding and scaling up the scheme inevitably becomes obvious and usually ends with lawsuits and bankruptcy. However, at this stage most of the investors receive significant losses, which are unlikely to be paid back.