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Ponzi schemes: What are they, and how do they work? A comprehensive guide

Investing your hard-earned money can be a smart and financially sustainable decision. However, there are often cases where investors get caught in fraudulent investment schemes, losing entire fortunes. Ponzi schemes, one of the most common in the financial world, are notorious for targeting unsuspecting investors with appealing promises and leaving them with empty pockets. In this guide, we explain what a Ponzi scheme is, how it works, and what you can do to reduce the risk of getting scammed.

Ponzi schemes: What are they, and how do they work? A comprehensive guide

Table of Contents

Table of Contents

What is a Ponzi scheme?

The Ponzi scheme definition (also known as a “Rob Peter to Pay Paul” scheme) describes an investment fraud that pays early investors with funds taken from new investors. The scam relies on the scammer’s constant lookout for fresh, inexperienced investors with promises of “little or no risk” investments, high returns, and genuine profits.

In reality, however, scammers use the money to pay returns to existing investors, creating an illusion of constant income. When the scheme reaches its limit and the scammers are no longer able to attract new investors, they grab all the invested money and disappear before any victims can figure out that they’ve been defrauded.

Origins of the Ponzi scheme

The name “Ponzi scheme” derives from an Italian hustler, Charles Ponzi, who made millions by promoting nonexistent investment opportunities in the early 20th century. While he wasn’t the first to do so, Ponzi’s greed in scamming investors earned him bad press, years in prison, and the dubious honor of an investment fraud named after him.

Initially, Ponzi’s scheme involved the purchase of international postal reply coupons (a form of currency used for replying to international mail in the 1920s). Ponzi promised investors returns (as high as 50%) on investments in these coupons, claiming that he could exploit price differences in international postage rates to generate profits.

It turned out, however, that Ponzi used the money to repay his earlier investors while keeping some of the money for his personal needs. The scheme was eventually uncovered in 1920 by the Boston Post, causing the whole venture to collapse and permanently immortalizing ol’ Charles as a synonym for financial fraud.

How does a Ponzi scheme work?

In short, a Ponzi scheme is an investment scam that promises investors substantial profits with little or no risk. It revolves around attracting a constant flow of new investors and paying their money to earlier investors as a return on their “investment.” The cycle continues for as long as it can with the scammers looking for new financial contributors to expand the network further and repay existing investors.

While it may not seem too nefarious initially, Ponzi schemes can cause massive problems that affect both individuals and financial systems. The threats posed by ponzi schemes are listed below.

Loss of money

The Ponzi scheme collapses as soon as the new investors stop coming in. The scammers then try to hastily disappear before anyone catches on, taking all the investments with them. While some cautious investors may be able to recover some of the invested funds by pulling out of the scam early, it is more likely that they will not be able to retrieve their money.

Deception and fraud

Ponzi scheme perpetrators often try to establish trust and credibility to lure in potential investors. To do so, they rely on such measures as fabricating investment portfolios, falsifying financial statements, or even establishing superficial businesses. These strategies are considered fraudulent by law, making their perpetrators and promoters subject to criminal charges.

Systemic risk

The collapse of large Ponzi schemes can cause ripple effects in financial markets, leading to investor panic and market instability. A successful Ponzi scheme can damage investors’ confidence in financial institutions, shaking economic stability.

Cyber risk

Scammers can use data breaches, phishing attacks, and other cybersecurity threats to gather information about their next victims or to pose as legitimate investors. Moreover, in recent years, the scope has expanded, with a surge of Ponzi schemes involving cryptocurrencies, online platforms, and other digital assets.

Ponzi scheme vs. pyramid scheme: The main differences

Ponzi schemes are similar to another popular investment fraud, the pyramid scheme. However, the two are separate types of financial scams with differing strategies and goals.

While in Ponzi schemes the focus is on generating overly consistent returns, in pyramid schemes, the main emphasis is recruitment. Although in both cases, new investments are what keep the scam going, pyramid schemes draw attention to their participants, incentivizing them to attract as many new members as possible.

Ponzi schemes, however, do not require their participants to strongly promote the scam but instead try to lure investors in with a false sense of legitimacy. To do so, scammers may even create fake, unregistered firms to convince their victims to invest money.

Here are the main differences between a Ponzi scheme and a pyramid scheme:

Ponzi schemePyramid scheme
Aims to generate returns for investorsAims to recruit new investors
Participants are encouraged to invest moneyParticipants are incentivized to promote and recruit as many new members as possible
Usually involves investing in unregistered businesses or servicesUsually involves purchasing starter kits, training materials, or inventory as a condition of joining the scheme
Uses keywords such as “exclusive investment opportunities,” “guaranteed consistent returns,” “no downside.”Uses keywords such as “multi-level marketing,” “unlimited earning potential,” “building your downline and upline.”

What is an example of a Ponzi scheme?

A perfect example of a Ponzi scheme is the Woodbridge Group of Companies case, which took place in 2017. The company’s founder and CEO, Robert Shapiro, used the firm to attract investors, encouraging them to fund real estate flipping (rapid purchasing and selling) projects. According to the U.S. Securities and Exchange Commission (SEC), the invested money flowed into the network of Shapiro’s controlled companies to repay the initial investors and finance his own needs.

Shapiro promised high return rates (up to 10% from every investment), defrauding his investors of over $1.2 billion, of which at least $21 million he spent on plane charter services, country club fees, and luxury items.

The scheme collapsed in 2017 when the Woodbridge Group of Companies suddenly filed for bankruptcy. After a thorough examination, the SEC revealed that Shapiro and his co-conspirators defrauded approximately 9,000 investors. For his actions, Shapiro received criminal charges and a 25-year prison sentence. The defrauded original investors later reached a $25.5 million settlement with one of Shapiro’s law firms as compensation for lost investments.

How to identify a Ponzi scheme

Identifying a Ponzi scheme can be challenging if you’re not a seasoned investor. However, certain red flags can help you notice a potential scam.

Ponzi scheme red flags

  • Promises little or no risk. In the financial world, investing always comes with risks. Therefore, if someone offers a risk-free financial opportunity, it’s most likely a scam.
  • Overly consistent returns. Financial markets are dynamic systems in which prices constantly move up and down. Investments with consistently high returns are another sign of a potential Ponzi scheme.
  • Unregistered an/or unlicensed business. Scammers often try to disguise Ponzi schemes as legitimate businesses to inspire trust. However, most are absent from the SEC’s EDGAR system or another business registry.
  • Secretive or overcomplicated investment strategies. For “safety precautions,” scammers may be reluctant to share their investment strategies or present complex investment models that are often shady upon closer scrutiny.
  • Restrictive access and/or error in paperwork. If an investment account statement shows discrepancies in numbers, it may be a sign that something is off. If a client does not receive investment paperwork, it’s a strong indication of suspicious financial activity behind the scenes.
  • Difficulties when receiving or divesting money. In most Ponzi schemes, perpetrators often try to dissuade the victims from cashing out their returns. If a business (or investment company) is reluctant to transfer money and instead offers excuses – it’s likely a scam.

How to report a Ponzi scheme

When it comes to reporting Ponzi schemes, timing can be crucial. If there are any reasons to believe that a person is dealing with a Ponzi scheme, the first step should always be informing the authorities. Alerting local police’s financial crime unit and filing a report with regulatory agencies that oversee financial crimes (for example, the Securities and Exchange Commission in the US or the Financial Conduct Authority (FCA) in the UK) are key to mitigating the damage as soon as possible.

For additional assistance, seeking legal counsel and reporting the scheme to consumer protection organizations may help you recover lost money.

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