Did You Know This

Wednesday, December 24, 2008

Did you know what a Ponzi scheme is ?


A Ponzi scheme is a fraudulent investment operation that pays returns to investors out of the 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.

The Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going.

The system is destined to collapse because the earnings, if any, are less than the payments. Usually, the scheme is interrupted by legal authorities before it collapses because a Ponzi scheme is suspected or because the promoter is selling unregistered securities. As more investors become involved, the likelihood of the scheme coming to the attention of authorities increases.

The scheme is named after Charles Ponzi, who became notorious for using the technique after emigrating from Italy to the United States in 1903. Ponzi did not invent the scheme, but his operation took in so much money that it was the first to become known throughout the United States. His original scheme was in theory based on arbitraging international reply coupons for postage stamps, but soon diverted investors' money to support payments to earlier investors and Ponzi's personal wealth.

Entering a Ponzi scheme can be rational even at the last round of the scheme if a government will likely bail out those participating in the Ponzi scheme.


Suppose an advertisement is placed that promises extraordinary returns on an investment – for example 20% for a 30-day contract. The golden key is to bamboozle ordinary people who have no in-depth knowledge of finance or financial terms. High flown terms that sound impressive but are essentially meaningless or have unrelated meanings will be used to dazzle investors; terms such as "global currency arbitrage", "hedge futures trading", "high-yield investment programs", "offshore investment" might be used. Taking advantage of the lack of investor financial sophistication, the promoter will then proceed to sell them a stake in his pot of gold.

With no proven track record for the investors, only a few investors are tempted, usually for smaller sums. 30 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. More and more people invest, and see their investments return the promised large returns.

The reality of the scheme is that the "return" to the initial investors is being paid out of the new, incoming investment money, not out of profits. No "global currency arbitrage", "hedge futures trading" or "high yield investment program" is actually taking place. Instead, when investor D puts in money, that money becomes available to pay out "profits" to investors A, B, and C. When investors X, Y, and Z put in money, that money is available to pay "profits" to investors A through W.

One reason that the scheme initially works so well is that early investors – those who actually got paid the large returns – quite 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, for example 50% return per month for one year. They then get 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, promoters do promptly process the redemptions, so this gives the illusion to all other investors that fund is solvent.

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

the promoters will vanish, taking all the remaining investment money (minus the payouts to investors) with them;
the scheme will collapse under its own weight, as investment slows and the promoters start having problems paying out the promised returns. When the promoters start having problems, the word spreads and more people start asking for their money, similar to a bank run;
the scheme is exposed, because when legal authorities begin examining accounting records of the so-called enterprise they find that many of the "assets" that should exist do not.

On December 11, 2008, Federal Bureau of Investigation agents arrested Madoff on a tip-off from his sons, Andrew and Mark, and charged him with one count of securities fraud. On the day prior to his arrest, Madoff told his senior executives at the firm that the management and advisory segment of the business was "basically, a giant Ponzi scheme." Five days after his arrest, Madoff's assets and those of the firm were frozen and a receiver was appointed to handle the case. Madoff's alleged fraud may be valued at a loss of up to a $50 billion in cash and securities.Banks from outside the U.S. have announced that they have potentially lost billions in U.S. dollars as a result. To date, it is the largest investor fraud ever attributed to a single individual.
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