Ponzi Scheme

A Ponzi scheme is a fraudulent financial activity in which the perpetrator promises consistent, above-market guaranteed returns on an investment but which in reality simply involves paying early investors out of the payments from new investors, in essence "robbing Peter to pay Paul."

To be successful, the fraud requires a constant flow of money from new investors to pay the earlier investors, who legitimise the scheme by validating that they did indeed earn the promised returns. However, the money was never invested in anything.

Ponzi schemes ultimately collapse when not enough new investors can be found to pay off the old ones, earlier investors stop investing and demand their money back, or the fraud catches the attention of securities regulators, law enforcement or the media.[1]

Ponzi schemes get their name from Charles Ponzi, who perpetrated a fraud in the early 1920s in New England promising investors a 50% return on their money in 90 days. The scheme initially involved Ponzi buying coupons for U.S. postage stamps more cheaply overseas and then selling them at higher prices back in the U.S., but he eventually turned to paying his earliest investors with the new money coming in. However, scams such as this likely predate Ponzi.[1]

The Ponzi fraud eventually ended in August 1920, when The Boston Post launched an investigation into the scheme, which ignited a run on Ponzi's company with investors demanding their money. He was arrested on 12 August 1920 and charged with mail fraud, to which he pleaded guilty. He served 14 years in prison.[2]

Red Flags To Watch For

According to the U.S. Securities and Exchange Commission, there are several red flags investors should look out for if they suspect a Ponzi scheme:[1]

  • High guaranteed returns with little or no risk. By contrast, all investments generally involve some element of risk, with those promising the highest returns having the most risk.
  • Overly consistent returns. Many fraudsters—including Bernie Madoff (see below)—promise consistent, above-market returns even as virtually all financial markets fluctuate. "Be suspect of an investment that continues to generate regular, positive returns regardless of overall market conditions," the SEC says.
  • Unregistered investments. Ponzi schemes usually involve securities or other investments that have not been registered with federal or state regulators. Unregistered investments mean investors have no access to legitimate information about the company offering the deal or about how the investment works.
  • Unlicensed sellers. Most Ponzi schemes are offered by unlicensed individuals or unregistered firms. "Federal and state securities laws require investment professionals and their firms to be licensed or registered," the SEC says.
  • Secretive and/or complex strategies. Likewise, the seller often tells investors that there is a "secret" behind the investment that they are unable or unwilling to divulge.
  • Problems with paperwork and/or payments. Ponzi schemes generally start to unravel when the promoter fails to deliver statements and payments as promised. At this point, however, it may be too late for an investor to get their money back.

Difference From Pyramid Schemes

Ponzi schemes are similar to pyramid schemes, which are usually built on the constant recruitment of new sellers or distributors who pay people hire up the chain for a product that proves to be nonexistent or largely worthless.

While the small number of people at the top of the pyramid make money, the vast number of people at the lower stages have been defrauded. Ponzi schemes, by contrast, are usually sold by a few people involved in the scam. In both cases, the product or investment proves to be nonexistent.[1]

The Bernie Madoff Scam

Other than the original Ponzi scheme, probably the most famous—and surely the largest—such fraud was the one perpetrated in 2008 at the height of the global financial crisis by Bernard L. Madoff Investment Securities LLC.[3]

Madoff is a former chairman of the NASDAQ stock exchange who had worked on Wall Street for nearly 50 years, and he swindled customers out of an estimated US$34 billion to US$50 billion, if not more.[3]

In 2009 Madoff was sentenced to 150 years in prison after pleading guilty to 11 criminal counts, including securities fraud.[4]

Because of his Wall Street pedigree, as well as his being a part of New York social and philanthropic circles, Madoff was able to dupe thousands of investors out of massive amounts of money, including many large sophisticated investment firms and banks, including Fairfield Greenwich Advisors (US$7.5 billion in claims), Tremont Group Holdings (an investment firm owned by OppenheimerFunds and Massachusetts Mutual Life Insurance Co., US$3.3 billion), Spanish bank Banco Santander (US$2.9 billion) and Bank Medici of Austria (US$2.1 billion).[5]

In addition, many well-known celebrities were taken in by Madoff, including Hollywood executives Steven Spielberg and Jeffrey Katzenberg; the actors Kevin Bacon, Kyra Sedgwick, Zsa Zsa Gabor and John Malkovich; and Fred and Jeff Wilpon, the owners of the New York Mets baseball team. Elie Wiesel, the late Holocaust survivor, said his Foundation for Humanity lost US$15.2 million in the scam.[6]

Summary

A Ponzi scheme is a financial fraud in which the perpetrator promises consistent, above-market guaranteed returns on an investment but which in reality simply involves paying early investors out of the payments from new investors. The scam gets its name from Charles Ponzi, who perpetrated such a fraud in the early 1920s in New England, although similar frauds go back longer than that.

The costliest Ponzi scheme of all time took place in 2008, when Wall Street executive Bernie Madoff scammed as much as US$50 billion from thousands of investors, many of them large, sophisticated institutions and well-known individuals.

FXCM Research Team

FXCM Research Team consists of a number of FXCM's Market and Product Specialists.

Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.

References

1

Retrieved 30 Oct 2018 https://www.investor.gov/introduction-investing/investing-basics/glossary/ponzi-schemes

2

Retrieved 07 Nov 2018 https://www.biography.com/crime-figure/charles-ponzi

3

Retrieved 30 Oct 2018 https://www.thoughtco.com/ponzi-scheme-definition-and-overview-1147436

4

Retrieved 07 Nov 2018 https://www.cnn.com/2013/03/11/us/bernard-madoff-fast-facts/index.html

5

Retrieved 07 Nov 2018 http://s.wsj.net/public/resources/documents/st_madoff_victims_20081215.html

6

Retrieved 07 Nov 2018 https://www.bankrate.com/lifestyle/

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