Loading the player...

What is a 'Ponzi Scheme'

A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by acquiring new investors. This is similar to a pyramid scheme in that both are based on using new investors' funds to pay the earlier backers. For both Ponzi schemes and pyramid schemes, eventually there isn't enough money to go around, and the schemes unravel.

BREAKING DOWN 'Ponzi Scheme'

A Ponzi scheme is an investment fraud where clients are promised a large profit at little to no risk. Companies that engage in a Ponzi scheme focus all of their energy into attracting new clients to make investments. This new income is used to pay original investors their returns, marked as a profit from a legitimate transaction. Ponzi schemes rely on a constant flow of new investments to continue to provide returns to older investors. When this flow runs out, the scheme falls apart.

Origins of the Ponzi Scheme

The first notorious Ponzi scheme was orchestrated by a man named Charles Ponzi in 1919. The postal service, at that time, had developed international reply coupons that allowed a sender to pre-purchase postage and include it in their correspondence. The receiver would take the coupon to a local post office and exchange it for the priority airmail postage stamps needed to send a reply.

With the constant fluctuation of postage prices, it was common for stamps to be more expensive in one country than another. Ponzi hired agents to purchase cheap international reply coupons in other countries and send them to him. He would then exchange those coupons for stamps that were more expensive than the coupon was originally purchased for. The stamps were then sold as a profit.

This type of exchange is known as an arbitrage, which is not an illegal practice. Ponzi became greedy and expanded his efforts. Under the heading of his company, Securities Exchange Company, he promised returns of 50% in 45 days or 100% in 90 days. Due to his success in the postage stamp scheme, investors were immediately attracted. Instead of actually investing the money, Ponzi just redistributed it and told the investors they made a profit. The scheme lasted until 1920, when an investigation into the Securities Exchange Company was conducted.

Ponzi Scheme Red Flags

The concept of the Ponzi scheme did not end in 1920. As technology changed, so did the Ponzi scheme. In 2008, Bernard Madoff was convicted of running a Ponzi scheme that falsified trading reports to show a client was earning a profit.

Regardless of the technology used in the Ponzi scheme, most share similar characteristics:

  1. A guaranteed promise of high returns with little risk
  2. Consistent flow of returns regardless of market conditions
  3. Investments that have not been registered with the Securities and Exchange Commission (SEC)
  4. Investment strategies that are a secret or described as too complex
  5. Clients not allowed to view official paperwork for their investment
  6. Clients facing difficulties removing their money
RELATED TERMS
  1. Ponzi Mania

    Ponzi mania describes the mood of investors after Bernie Madoff's ...
  2. Mini Madoff

    Mini Madoff is a slang term for con men accused of committing ...
  3. Affinity Fraud

    An affinity fraud is an investment scam in which a con artist ...
  4. Securities Fraud

    Securities fraud is a form of white-collar crime that disguises ...
  5. Guaranteed Minimum Pension - GMP

    A guaranteed minimum pension could be earned in the U.K.'s public ...
  6. Pump And Dump

    Pump and Dump is a scheme that attempts to boost the price of ...
Related Articles
  1. Investing

    What Is A Ponzi Scheme?

    Protect yourself from scams by learning the structure behind this fraudulent investing scheme.
  2. Tech

    U.S. Government Files Suit Over Bitcoin Ponzi Scheme

    Despite being a new-fangled currency, Bitcoin has opened the possibility of very old scam techniques.
  3. Investing

    De Niro is a Delight as Madoff in HBO's "Wizard of Lies" Trailer

    Robert De Niro once played The Godfather, which was probably good preparation to play Bernie Madoff.
  4. Investing

    Bernie Madoff Runs Hot Chocolate Monopoly in Prison

    Not the Onion. Hot cocoa is used as prison currency, and Madoff is shaking people down.
  5. Insights

    How to Avoid the Top Financial Advisor Scams

    Investors need to be wary of financial advisor scams. Here are the most common and how you can protected yourself.
  6. Insights

    Crime Vs Time: Madoff Faces Off Against Fellow Fraudsters

    Madoff received the maximum allowable time for his sentence - much more than any white-collar criminal before him.
  7. Investing

    It's Not Illegal If The Government Does It

    The government allows itself the leeway to do many things that would be illegal for a private citizen or corporation.
  8. Insights

    Platinum Partners: Biggest Scam Since Madoff?

    Mark Nordlicht's Platinum Partners may have been at the forefront of one of the biggest investment scandals since Bernie Madoff.
  9. Small Business

    Multi-Level Marketing

    Learn how to differentiate between a legitimate marketing strategy and a pyramid scheme.
  10. Insights

    Auto Nation CEO: Tesla Could be a Ponzi Scheme

    Is Tesla a Ponzi Scheme? One skeptic says it could be.
RELATED FAQS
  1. How Mutual Funds Work in India

    Mutual funds operate somewhat similarly in India in relation to what types of funds are available, how they are structured ... Read Answer >>
  2. How does a pump and dump scam work?

    A pump and dump scam is the illegal act of an investor or group of investors promoting a stock they hold and selling once ... Read Answer >>
  3. When is a bond's coupon rate and yield to maturity the same?

    Find out when a bond's yield to maturity is equal to its coupon rate, and learn about the components of bonds and how they ... Read Answer >>
Trading Center