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

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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:

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.

FAQ

Are Ponzi schemes illegal?

In short – yes. Ponzi schemes are classified as financial fraud, breaking various investment, consumer protection, and other finance-related laws. For example, Ponzi schemes often involve money laundering or include document forgery to create the illusion of a legitimate business, which can result in additional charges and prison time.

What is the most famous Ponzi scheme?

Besides the infamous original Charles Ponzi venture, at least a few dozen large-scale Ponzi schemes have made the news. However, one of the most notorious is former NASDAQ stock exchange chair Bernard “Bernie” Madoff’s scheme, which operated for decades and defrauded investors of billions of dollars.

Madoff used his investment firm (founded in 1960) to attract investors with promises of consistent and high returns. He would bait the victims with his purported investment model, which, by his claims, involved buying and selling stocks using a split-strike conversion strategy. In reality, however, he was refinancing initial investors with the new investors’ money while enjoying a luxurious lifestyle.

Madoff’s scheme collapsed in 2008 during the global financial crisis. The con artist pleaded guilty to multiple charges and was sentenced to a mad (pun intended) 150 years in prison. To this day, Madoff’s “enterprise” remains one of the largest and most infamous Ponzi schemes in history.

Is cryptocurrency a Ponzi scheme?

Cryptocurrency itself is not a Ponzi scheme. However, there have been cases where scammers used cryptocurrency as a false investment opportunity.

For example, in 2014, Ruja Ignatova and Sebastian Greenwood founded OneCoin, a fake cryptocurrency that operated as a Ponzi and pyramid scheme at the same time. Experts speculate that the scam earned the perpetrators billions of dollars from thousands of investors worldwide. In 2017, when allegations started pouring in, and authorities began directing their attention to OneCoin, Ignatova disappeared, leaving her associates to take the fall for the fraud. While the perpetrators were convicted and sentenced for their crimes in 2019, Ignatova’s whereabouts are unknown to this day, with mysterious rumors surrounding her fate.

How do you identify a Ponzi scheme?

Identifying a Ponzi scheme is usually pretty easy if you remember one crucial fact – no investment guarantees returns. While Ponzi scheme promoters may try to convince their clients otherwise, this rule of the financial world is unquestionable.

Knowing that the market is constantly changing (prices move up and down daily) can also help spot potential scammers. It’s important to be vigilant of sweet-looking deals and opportunities because if it sounds too good to be true – it most likely is.

Are Ponzi schemes still possible?

Yes. Ponzi schemes continue with scammers looking to use new and upcoming business ventures (like cryptocurrencies or social media businesses). While Ponzi schemes follow new trends to blindside upcoming and inexperienced investors, they are still recognizable by their get-rich-quick narrative and oversaturated promises.

What happens if you get caught in a Ponzi scheme?

If you get caught in a Ponzi scheme, you will likely experience financial damage. The victims of Ponzi schemes often suffer substantial money losses, with no guarantee of recovery even through the means of the law.

If you suspect you or someone from your environment has become a victim of a Ponzi scheme, inform your local police force’s financial crime unit and the country’s regulatory agencies (for example, SEC in the US, FCA in the UK) immediately.