Overview

A Ponzi scheme (/ˈpɒnzi/, Italian: [ˈpontsi]) is a form of fraud that lures investors and pays apparent profits to earlier investors with funds from more recent investors. Named after Italian con artist Charles Ponzi, this type of scheme misleads investors by either falsely suggesting that profits are derived from legitimate business activities (whereas the business activities are non-existent), or by exaggerating the extent and profitability of the legitimate business activities, using new investments to fabricate or supplement these profits.

A Ponzi scheme can maintain the illusion of a sustainable business as long as investors continue to contribute new funds, and as long as most of the investors do not demand full repayment or lose faith in the non-existent assets they are purported to own.

History

Some of the first recorded incidents to meet the modern definition of the Ponzi scheme were carried out from 1869 to 1872 by Adele Spitzeder in Germany and by Sarah Howe in the United States in the 1880s through the "Ladies' Deposit". Howe offered a solely female clientele an 8% monthly interest rate and then stole the money that the women had invested. She was eventually discovered and served three years in prison. Ponzi-style schemes were also previously described in novels; Charles Dickens's 1844 novel Martin Chuzzlewit and his 1857 novel Little Dorrit both feature such a scheme.

In the 1920s, Charles Ponzi carried out this scheme and became well known throughout the United States because of the huge amount of money that he took in. His original scheme was purportedly based on the legitimate arbitrage of international reply coupons for postage stamps, but it proved infeasible, and he soon began diverting new investors' money to make payments to earlier investors and to himself.

Unlike earlier similar schemes, Ponzi's gained considerable press coverage both within the United States and internationally both while it was being perpetrated and after it collapsed – this notoriety eventually led to the type of scheme being named after him.

Characteristics

In a Ponzi scheme, a con artist offers investments that promise very high returns with little or no risk to an investor. The returns are said to originate from a business or a secret idea run by the con artist. In reality, the business does not exist, the idea does not work in the way it is described, or the extent of returns is made up or exaggerated. The con artist pays the high returns promised to their earlier investors by using the money obtained from later investors.

Instead of engaging in a legitimate business activity, the con artist attempts to attract new investors to make the payments that were promised to earlier investors. The operator of the scheme also diverts clients' funds for the operator's personal use.

With little or no legitimate earnings, Ponzi schemes require a constant flow of new money to survive. When it becomes hard to recruit new investors, or when large numbers of existing investors cash out, these schemes collapse. As a result, most investors end up losing much or all of the money they invested. In some cases, the operator of the scheme may simply disappear with the money.

Red flags

According to the U.S. Securities and Exchange Commission (SEC), many Ponzi schemes share characteristics that should be "red flags" for investors.

Methods

Typically, Ponzi schemes require an initial investment and promise above-average returns. They use vague verbal guises such as "hedge futures trading", "high-yield investment programs", or "offshore investment" to describe their income strategy. It is common for the operator to take advantage of a lack of investor knowledge or competence, or sometimes claim to use a proprietary, secret investment strategy to avoid giving information about the scheme.

The basic premise of a Ponzi scheme is "to rob Peter to pay Paul". Initially, the operator pays high returns to attract investors and entice current investors to invest more money. When other investors begin to participate, a cascade effect begins. The schemer pays a "return" to initial investors from the investments of new participants, rather than from genuine profits.

Often, high returns encourage investors to leave their money in the scheme, so that the operator does not actually have to pay very much to investors. The operator simply sends statements showing how much they have earned, which maintains the deception that the scheme is an investment with high returns. Investors within a Ponzi scheme may face difficulties when trying to get their money out of the investment.