Definition
A Ponzi scheme is a fraudulent investment scheme where the operator generates returns for older investors through revenue paid by new investors, rather than from legitimate business activities. The scheme leads victims to believe that profits are coming from product sales, when in fact they are coming from the payments made by new recruits. It’s named after Charles Ponzi, who famously used the technique in the 1920s.
Key Takeaways
- A Ponzi scheme is a type of financial fraud wherein revenue generated for earlier investors primarily comes from later investors instead of legitimate business activities or profits.
- These schemes are typically characterized by the promise of high returns with little to no risk. The lack of a genuine, profit-generating underlying business makes them unsustainable in the long term.
- Finally, Ponzi schemes inevitably collapse. This occurs either when there are no more new investors to lure or when too many investors ask for their money back at the same time.
Importance
The term “Ponzi Scheme” is significant in finance because it refers to a fraudulent investing scam promising high rates of return with little risk to investors. It’s named after Charles Ponzi, a businessman who became notorious for using this method in the 1920s.
In this scheme, the returns to the initial promoters are paid out of the investments of new entrants, rather than from profits of the operation. It works on the principle of “robbing Peter to pay Paul,” leading eventually to a collapse when the scheme requires a continual flow of money from new investors to sustain.
Understanding this term is important as it helps investors identify and avoid such scams, thus promoting more secure and ethical investment practices.
Explanation
The purpose of a Ponzi scheme, named after 1920s swindler Charles Ponzi, is ostensibly to generate high returns for investors through some supposedly lucrative business venture. However, the reality is quite different.
A Ponzi scheme operates on the principle of ‘robbing Peter to pay Paul.’ In other words, instead of generating real profits through legitimate investments, the scheme’s organizer uses the money contributed by later investors to pay artificially high returns to early investors. The apparent success of the scheme, as seen in the high returns enjoyed by the early investors, encourages more and more investors to participate, thereby providing an ongoing supply of funds for the scheme’s continuation.
However, the basic structure of a Ponzi scheme is fundamentally unstable, and it is not used for any legitimate or sustainable business model. Instead, it’s used by fraudsters to extract money from unwitting investors.
When the flow of incoming investment slows down or stops, the organizer may disappear with whatever funds are still available, leaving remaining investors to realize their losses. Thus, while it might seem like an attractive proposition at first glance due to the promise of high returns, a Ponzi scheme is actually a sophisticated form of financial fraud that is ultimately damaging to the investors who participate in it.
Examples of Ponzi Scheme
Bernie Madoff Investment Scandal: Perhaps one of the most famous Ponzi schemes in the world, Bernie Madoff defrauded thousands of investors out of billions of dollars over the course of almost two decades. Madoff promised consistent, high returns to his clients, and used the funds from new investors to pay older ones. The scheme was exposed in 2008 when Madoff confessed it to his sons who then reported him to the authorities.
Charles Ponzi’s Securities Exchange Company: Charles Ponzi, the namesake for this type of financial fraud, established the Securities Exchange Company in
Ponzi promised investors a 50% return on their investment in just 90 days. The returns were supposedly generated through international reply coupons, used for overseas postage. Ponzi was paying early investors using the investments of later investors. In 1920, the scheme collapsed and Ponzi was arrested.
Zeek Rewards: Zeek Rewards, an American company, was shut down by the SEC in 2012 for operating a $600 million Ponzi scheme. The company purportedly sold shares in a profitable penny auction business. Instead of investing the funds as promised, the company’s CEO was using the money from new investors to pay the older ones, typical of a Ponzi scheme. When the operation was shut down, it was deemed one of the largest Ponzi schemes in history in terms of number of investors, having affected over 1 million people.
Frequently Asked Questions – Ponzi Scheme
What is a Ponzi Scheme?
A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors. In this scheme, the returns for older investors are paid by the proceeds of new investors, rather than from profits of the underlying business venture.
Who was Ponzi and why is it called a Ponzi Scheme?
Charles Ponzi, an Italian immigrant, first carried out the scheme in the 1920s. He promised clients a 50% profit within 45 days, or 100% profit within 90 days. Since then, similar fraudulent investment operations are referred to as Ponzi Schemes.
What are the signs of a Ponzi Scheme?
Common signs of a Ponzi scheme include guaranteed high investment returns, consistent returns regardless of market conditions, investments that are not registered with regulators, secret or immensely complex investment strategies, and issues with receiving payments or cashing out your investments.
What happens if I’m a victim of a Ponzi Scheme?
If you realized you’re a victim of a Ponzi scheme, it’s important to act immediately. Report the crime to law enforcement authorities and contact a lawyer. You can also report it to the Federal Trade Commission and your state’s securities administrator.
How is a Ponzi Scheme different from a Pyramid Scheme?
Though similar in nature, Ponzi schemes and Pyramid schemes are different. In a Ponzi scheme, the schemer acts as a “hub” for the victims, interacting with all of them directly whereas, in a pyramid scheme, each participant recruits other participants to return the investment.
Related Entrepreneurship Terms
- Investment Fraud
- Pyramid Scheme
- High Returns
- Fake Earnings
- Debt Securities
Sources for More Information
- U.S. Securities and Exchange Commission (SEC) – The SEC provides a wealth of information regarding Ponzi schemes and how to recognize them. Check under their “Investor Education” or “Enforcement” sections.
- Federal Bureau of Investigation (FBI) – The FBI is a trusted source of information about various types of fraud, including Ponzi schemes. Look under their “White-Collar Crimes” section.
- Investopedia – This is a highly reliable source of information on financial topics including Ponzi schemes. Use their search bar to find related articles.
- Federal Trade Commission (FTC) – The FTC provides information about deceptive and unfair business practices including Ponzi schemes. Check under their “Consumer Information” section.
