How a Ponzi Scheme Works

Posted 4 Feb 2009

With all of the stories about Bernard Madoff and his $50 billion Ponzi scheme, I thought it would be interesting to learn exactly how a Ponzi scheme operates.

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A Ponzi Scheme Explained

A Ponzi scheme is a fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from profit. The term, “Ponzi scheme,” is used primarily in the United States, while other English-speaking countries do not distinguish colloquially between this scheme and other pyramid schemes.

Here’s an example scenario to give you an idea exactly how it operates.

Suppose an advertisement is placed that promises extraordinary returns on an investment – for example, 20% on a 30-day contract. The objective is to deceive laypeople who have no in-depth knowledge of finance or financial jargon. Verbal constructions that sound impressive but are essentially meaningless will be used to dazzle investors: terms such as “hedge futures trading,” “high-yield investment programs,” “offshore investment” might be used. The promoter will then proceed to sell investors–who are essentially victims of a confidence trick–stakes, by taking advantage of a lack of investor knowledge or competence.

Without the benefit of precedent or objective prior information about the investment, only a few investors are tempted, usually for smaller sums. Thirty 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, leading to a cascade effect deriving from the promise of extraordinary returns. However, the “return” to the initial investors is being paid out of the investments of new entrants, and not out of profits.

One reason that the scheme initially works so well is that early investors – those who actually got paid the large returns – commonly reinvest 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 showing them how much they earned by keeping the money, in order to maintain the deception that the scheme is a fund with high returns.

Promoters also try to minimize withdrawals by offering new plans to investors, often where money is frozen for a longer period of time, in exchange for higher returns. The promoter sees new cash flows as investors are told they could not transfer money from the first plan to the second. If a few investors do wish to withdraw their money in accordance with the terms allowed, the requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent.

The catch is that at some point one of three things will happen:

1. The promoters will vanish, taking all the remaining investment money (minus the payouts to investors) with them;
2. the scheme will collapse under its own weight, as investment slows and the promoters start having problems paying out the promised returns (the higher the returns, the greater the chance of the Ponzi scheme collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run;
3. the scheme is exposed because the promoter fails to validate their claims when asked to do so by legal authorities.

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