A Ponzi scheme is a fraud

Fraud

In criminal law, a fraud is an intentional deception made for personal gain or to damage another individual; the related adjective is fraudulent. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and also a civil law violation...

ulent investment

Investment

Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...

 operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from any actual profit earned by the individual or organization running the operation. The Ponzi scheme usually entices new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent. Perpetuation of the high returns requires an ever-increasing flow of money from new investors to keep the scheme going.

The system is destined to collapse because the earnings, if any, are less than the payments to investors. 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

Charles Ponzi

Carlo Pietro Giovanni Guglielmo Tebaldo Ponzi, , commonly known as Charles Ponzi, was a businessman and con artist in the U.S. and Canada. Born in Italy, he became known as a swindler in North America for his money making scheme. His aliases include Charles Ponei, Charles P. Bianchi, Carl and Carlo...

, who became notorious for using the technique in 1920. Ponzi did not invent the scheme (for example, Charles Dickens's 1844 novel The Life and Adventures of Martin Chuzzlewit described such a scheme), but his operation took in so much money that it was the first to become known throughout the United States. Ponzi's original scheme was based on the arbitrage

Arbitrage

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...

 of international reply coupon

International reply coupon

An international reply coupon is a coupon that can be exchanged for one or more postage stamps representing the minimum postage for an unregistered priority airmail letter of up to twenty grams sent to another Universal Postal Union member country...

s for postage stamps; however, he soon diverted investors' money to make payments to earlier investors and himself.

Characteristics

Typically extraordinary returns are promised on the investment, and vague verbal constructions such as "hedge

Hedge (finance)

A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

 futures trading

Futures contract

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

," "high-yield investment programs," "offshore investment

Offshore investment

Offshore investment is the keeping of money in a jurisdiction other than one's country of residence. Offshore jurisdictions are a commonly accepted solution to reducing tax burdens levied in most countries to both large and small scale investors alike...

" might be used. The promoter sells shares to investors by taking advantage of a lack of investor knowledge or competence, or using claims of a proprietary investment strategy which must be kept secret to ensure a competitive edge.

Initially the promoter will pay out high returns to attract more investors, and to lure current investors into putting in additional money. Other investors begin to participate, leading to a cascade effect. However, the "return" to the initial investors is paid out of the investments of new entrants, and not out of profits.

Often the high returns lead investors to leave their money in the scheme, leading the promoter to not actually have to pay out very much to investors; they simply have to send statements to investors showing them how much they earned. This maintains 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

Insolvency

Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...

.

Unraveling of a Ponzi scheme

At some point one of the following happens:

1. The promoter vanishes, taking all the remaining investment money (minus payouts to investors already made).
2. Since the scheme requires a continual stream of investments to fund higher returns, once investment slows down, the scheme collapses as the promoter starts having problems paying the promised returns (the higher the returns, the greater the risk of the Ponzi scheme collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run
   Bank run
   A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
   
   .
3. External market forces, such as a sharp decline in the economy (for example, the Madoff investment scandal
   Madoff investment scandal
   The Madoff investment scandal broke in December 2008 when former NASDAQ chairman Bernard Madoff admitted that the wealth management arm of his business was an elaborate Ponzi scheme....
   
    during the market downturn of 2008), cause many investors to withdraw part or all of their funds.

Similar schemes

• A pyramid scheme
  Pyramid scheme
  A pyramid scheme is a non-sustainable business model that involves promising participants payment or services, primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public...
  
   is a form of fraud similar in some ways to a Ponzi scheme, relying as it does on a mistaken belief in a nonexistent financial reality, including the hope of an extremely high rate of return. However, several characteristics distinguish these schemes from Ponzi schemes:
  • In a Ponzi scheme, the schemer acts as a "hub" for the victims, interacting with all of them directly. In a pyramid scheme, those who recruit additional participants benefit directly. (In fact, failure to recruit typically means no investment return.)
  • A Ponzi scheme claims to rely on some esoteric investment approach and often attracts well-to-do investors; whereas pyramid schemes explicitly claim that new money will be the source of payout for the initial investments.
  • A pyramid scheme typically collapses much faster because it requires exponential increases in participants to sustain it. By contrast, Ponzi schemes can survive simply by persuading most existing participants to reinvest their money, with a relatively small number of new participants.
• An economic bubble
  Economic bubble
  An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...
  
  : A bubble is similar to a Ponzi scheme in that one participant gets paid by contributions from a subsequent participant (until inevitable collapse). A bubble involves ever-rising prices in an open market (for example stock, housing
  Real estate bubble
  A real estate bubble or property bubble is a type of economic bubble that occurs periodically in local or global real estate markets...
  
  , or tulip bulbs
  Tulip mania
  Tulip mania or tulipomania was a period in the Dutch Golden Age during which contract prices for bulbs of the recently introduced tulip reached extraordinarily high levels and then suddenly collapsed...
  
  ) where prices rise because buyers bid more because prices are rising. Bubbles are often said to be based on the "greater fool" theory. As with the Ponzi scheme, the price exceeds the intrinsic value
  Intrinsic value
  Intrinsic value can refer to:*Intrinsic value , of an option or stock.*Intrinsic value , of a coin.*Intrinsic value , in ethics and philosophy.*Intrinsic value , in philosophy....
  
   of the item, but unlike the Ponzi scheme, there is no person misrepresenting the intrinsic value.

See also

• List of Ponzi schemes
• Bucket shop (stock market)
  Bucket shop (stock market)
  As defined by the U.S. Supreme Court a Bucket shop is "[a]n establishment, nominally for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets, or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain,...
  
  
• Double Shah
  Double Shah
  Syed Sibtul Hassan Shah, alias Double Shah , was a teacher who started a financial scam, a Ponzi scheme, in Pakistan. Syed Sibtul Hassan Shah is a resident of Pak town - a lower middle class area - in Wazirabad, a tehsil of Gujranwala...
  
  
• Get-rich-quick scheme
  Get-rich-quick scheme
  A get-rich-quick scheme is a plan to acquire high rates of return for a small investment. The term "get rich quick" has been used to describe shady investments since at least the early 1900s....
  
  
• Matrix scheme
  Matrix scheme
  A matrix scheme is a business model involving the exchange of money for a certain product with a side bonus of being added to a waiting list for a product of greater value than the amount given...
  
  
• White-collar crime
  White-collar crime
  Within the field of criminology, white-collar crime has been defined by Edwin Sutherland as "a crime committed by a person of respectability and high social status in the course of his occupation" . Sutherland was a proponent of Symbolic Interactionism, and believed that criminal behavior was...
  
  

External links

• What is a Ponzi scheme? Ponzi scheme definition with distinctions, history, and other information
• Ponzi scheme Illustration of a Ponzi scheme
• The Ponzi Scheme and Tax Loss Describing tax recovery methods