Overview
A Ponzi scheme usually offers abnormally high short-term returns in
order to entice new
investors. The
high returns that a Ponzi scheme
advertises (and pays) require an ever-increasing flow of money from
investors in order to keep the scheme going.
The system is doomed to collapse because there are little or no
underlying earnings from the money received by the promoter. However,
the scheme is often interrupted by legal authorities before it
collapses, because a Ponzi scheme is suspected and/or because the
promoter is selling unregistered securities. As more and more investors
become involved, the likelihood of the scheme coming to the attention
of authorities will continue to increase.
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 was not the first to invent such a scheme, but his
operation took in such a large amount of money that it was the first to
become known throughout the United States. Today''s schemes are often
considerably more sophisticated than Ponzi''s, although the underlying
formula is quite similar and the principle behind every Ponzi scheme is
to exploit lapses in judgment arising from an investor''s lack of
information.
Hypothetical example
A mugshot of Charles Ponzi
An advertisement is placed promising extraordinary returns on an
investment – for example 20% for a 30 day contract. The precise
mechanism for this incredible return can be attributed to anything that
sounds good but is not specific: "global currency arbitrage", "hedge futures trading", "High Yield Investment Programs" or something similar.
With no proven track record for the investors, only a few investors
are tempted, usually for smaller sums. Sure enough, 30 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. More and more people invest, and see
their investments return the promised large returns.
The reality of the scheme is that the "return" to the initial
investors is being paid out of the new, incoming investment money, not
out of profits. There is no "global currency arbitrage", "hedge futures
trading", or "high yield investment programs" actually taking place.
Instead, when investor D puts in money, that money becomes available to
pay out "profits" to investors A, B, and C. When investors X, Y, and Z
put in money, that money is available to pay "profits" to investors A
through W.
One reason that the scheme initially works so well is that early
investors – those who actually got paid the large returns – quite
commonly reinvest (keep) 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 that show how much the
investors have earned by keeping the money in what looks like a great
place to get a high return.
The catch is that at some point one of three things will happen:
the promotors will vanish, taking all the investment money (less payouts) with them;the scheme will collapse of its own weight, as investment slows and
the promotors start having problems paying out the promised returns
(and when they start having problems, the word spreads, and more people
start asking for their money, similarly to a bank run);the scheme is exposed, because when legal authorities begin
examining accounting records of the so-called enterprise, they find
that much of the "assets" that should exist, do not.
What is and is not a Ponzi scheme
A 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 rreturn. However, several characteristics
distinguish pyramid 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 pyramid scheme, those who
recruit additional participants benefit directly (in fact, failure to
recruit typically means no investment return).
A Ponzi scheme relies on some esoteric investment approach, insider
connections, etc., and often attracts well-to-do investors; pyramid
schemes explicitly claim that new money will be the source of payout for the initial investments.
A pyramid scheme is bound to collapse a lot faster, simply because
of the demand for exponential increases in participants to sustain it
(Ponzi schemes can survive simply by getting most 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.)
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.)