What Is a Ponzi Scheme?

A Ponzi scheme is a form of financial pyramid. It's an investment structure where the returns for those who jumped on the bandwagon early are paid from the funds raised from newcomers. Meanwhile, a slice of this money is secretly funneled into the orchestrator's account.

Of course, this isn't something openly broadcasted. A compelling narrative is spun for the investor, leading them to believe that they're pumping money into a lawful business that either provides services or manufactures goods, thus generating profit. However, in reality, there is no operational activity beyond pooling users' money. Therefore, it's viewed as deceitful.

Ponzi scheme infographic. Source — Sperrinlaw

Typical red flags of a Ponzi scheme include:

• Promises of substantial short-term returns from initial investments;
• Assertions about low risk coupled with a 100% investment return guarantee;
• An absence of transparency, with no access to business details, documents, or reports.

While some financial pyramids can be rather straightforward to pinpoint, there are scams cleverly camouflaged as legal enterprises.

The Origin of the Ponzi Scheme

Charles Ponzi, an Italian immigrant who arrived in Boston, USA, in 1903, is considered the mastermind behind the concept of the financial pyramid, or what's more commonly known as the Ponzi scheme. In 1919, Ponzi borrowed money from a friend and founded a venture named “The Securities and Exchange Company,” which allegedly profited from reselling international postal reply coupons via arbitrage operations.

Interestingly, these coupons were never securities in the traditional sense; they could only be swapped for postage stamps. Despite this well-known fact, investors were enticed to put their money into Ponzi's enterprise. Ponzi managed to attract their interest by promising high returns. He issued promissory notes assuring that for each $1,000 contribution, the investor would receive $1,500 after a period of three months. This dubious venture proved lucrative for Ponzi, who was reportedly making $200,000 per day after a year in operation.

Charles Ponzi. Source — Bettmann Archive

However, the Ponzi scheme eventually crumbled. Journalists from The Post Magazine started scrutinizing Ponzi's enterprise and unearthed alarming facts. They estimated that to justify the investments made into the company, there had to be over 100 million postal reply coupons in circulation. However, there were only around 27,000 such coupons in existence at the time. The situation became dire for Ponzi when FBI agents joined the investigation and conclusively proved that no coupon arbitrage was occurring. Instead, Ponzi's firm was merely settling its debts by selling new securities.

Upon Ponzi's arrest in August 1920, it was revealed that while he had $4 million in his bank accounts, his outstanding debts reached $7 million. Consequently, “The Securities and Exchange Company” was declared insolvent, and Ponzi received a five-year prison sentence. Yet, his incarceration didn't reform him, and Ponzi resumed his fraudulent activities after being released from prison.

How does a Ponzi scheme differ from a pyramid scheme?

The Ponzi scheme is often conflated with a pyramid scheme due to their similar names and nature. The confusion is also exacerbated by the fact that fraudsters may utilize both of these approaches. However, they are distinct strategies.

In a pyramid scheme, participants pay a fee to join and are tasked with recruiting new members to earn additional income. The more individuals you can bring into the scheme, the greater your earnings. As the number of participants swells, the scheme's stability diminishes and it becomes increasingly precarious.

This instability arises from the nature of exponential growth that pyramid schemes rely on, which implies that the scheme must grow indefinitely for all participants to continuously profit. Since this is implausible, the scheme is doomed to collapse at some point, leaving those who joined last to bear the losses while the early entrants at the top reap substantial benefits.

Pyramid Scheme Infographics. Source — Encrypted

On the other hand, a Ponzi scheme doesn't necessitate the recruitment of new participants for profits. Instead, current investors willingly spread the word about a promising investment opportunity they've discovered. Ponzi schemes usually feature a charismatic leader who persuades individuals of the safety and potential profitability of the investments.

In a Ponzi scheme, participants are merely asked to deposit a sum of money, with the promise that this amount will grow substantially over time. However, they are later strongly dissuaded from withdrawing their returns, with the scheme highlighting the advantages of leaving their money to grow or “reinvesting” it.