Ponzi Schemes: Definition, Examples, and Origins

What Is a Ponzi Scheme?

A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors. A Ponzi scheme is a fraudulent investing scam which generates returns for earlier investors with money taken from later investors. This is similar to a pyramid scheme in that both are based on using new investors' funds to pay the earlier backers.

Both Ponzi schemes and pyramid schemes eventually bottom out when the flood of new investors dries up and there isn't enough money to go around. At that point, the schemes unravel.

Key Takeaways

The Ponzi scheme generates returns for older investors by acquiring new investors, who are promised a large profit at little to no risk.
The fraudulent investment scheme is premised on using new investors' funds to pay the earlier backers.
Companies that engage in a Ponzi scheme focus their energy into attracting new clients to make investments, otherwise their scheme will become illiquid.
The SEC has issued guidance on what to look for in potential Ponzi schemes including guarantee of returns or unregistered investment vehicles with the SEC.
The largest Ponzi scheme was carried out by Bernie Madoff, conning thousands of investors out of billions of dollars.

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What Is A Ponzi Scheme?

Understanding Ponzi Schemes

A Ponzi scheme is an investment fraud in which 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 term "Ponzi Scheme" was coined after a swindler named Charles Ponzi in 1920. However, the first recorded instances of this sort of investment scam can be traced back to the mid-to-late 1800s, and were orchestrated by Adele Spitzeder in Germany and Sarah Howe in the United States. In fact, the methods of what came to be known as the Ponzi Scheme were described in two separate novels written by Charles Dickens, Martin Chuzzlewit, published in 1844 and Little Dorrit in 1857.

Charles Ponzi's original scheme in 1919 was focused on the US Postal Service. 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.

Ponzi schemes rely on a constant flow of new investments to continue to provide returns to older investors.

This type of exchange is known as an arbitrage, which is not an illegal practice. But 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 August of 1920 when The Boston Post began investigating the Securities Exchange Company. As a result of the newspaper's investigation, Ponzi was arrested by federal authorities on Aug. 12, 1920, and charged with several counts of mail fraud. In November 1920, Ponzi was sentenced to five years in prison.

Madoff and the Largest Ponzi Scheme in History

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 on investments that didn't exist.

Madoff promoted his Ponzi scheme as an investment strategy called the split-strike conversion that utilized ownership of S&P 100 stocks and options. Madoff would use blue-chip stocks which have highly accessible historical trading data which he could back into to falsify his records. Then, falsified transactions that never occurred were reported to yield the desired periodic return.

During the 2008 Global Financial Crisis, investors began to withdraw funds from Madoff's firm, exposing the illiquid nature of the firm's true financial picture. Madoff stated that his firm had approximately $50 billion of liabilities owed to approximately 4,800 clients. Sentenced to 150 years in prison with forfeiture of assets of $170 billion, Madoff died in prison on April 14, 2021.

Ponzi schemes can be carried out over decades. Investigators suspect Madoff's Ponzi scheme was started in the early 1980's and lasted over 30 years.

Ponzi Scheme Red Flags

Regardless of the technology used in the Ponzi scheme, most share similar characteristics. The Securities and Exchange Commission (SEC) has identified the following traits to watch for:

A guaranteed promise of high returns with little risk
A consistent flow of returns regardless of market conditions
Investments that have not been registered with the Securities and Exchange Commission (SEC)
Investment strategies that are secret or described as too complex to explain
Clients not allowed to view official paperwork for their investment
Clients facing difficulties removing their money

What Is an Example of a Ponzi Scheme?

Imagine a very basic example where Adam promises 10% returns to his friend Barry. Barry gives Adam $1,000 with the expectation that the value of the investment will be $1,100 in one year. Next, Adam promises 10% returns to his friend Christine. Christine agrees to give Adam $2,000.

With $3,000 now on hand, Adam can make Barry whole by paying him $1,100. In addition, Adam can steal $1,000 from the collective pool of funds if he believes he can get future investors to give him money. For this plan to work, Adam must continually get money from a new client in order to pay back older ones.

What's the Difference Between a Ponzi Scheme and a Pyramid Scheme?

A Ponzi scheme is a mechanism to attract investors with a promise of future returns. The operator of a Ponzi scheme can only maintain the scheme as long as new investors are brought into the fold.

On the other hand, a pyramid scheme recruits other people and incentivizes them to further bring along other investors. A member within a pyramid scheme only earns a portion of their proceeds and is "used" to generate profit by members higher along the pyramid.

Why Is it Called a Ponzi Scheme?

Ponzi schemes are named after Charles Ponzi, a 1920's businessman who successfully persuaded tens of thousands of clients to invest their funds with him. Ponzi's scheme promised a specific amount of profit after a specific amount of time through the purchase nd sale of discounted postal reply coupons. Instead, he was using new money invested to pay off old obligations.

How Do You Identify a Ponzi Scheme?

The SEC has identified a few traits that often signify a fraudulent financial scheme. It is important to understand that almost all types of investing incur some level of risk, and many forms do not carry with them guaranteed profits. If an investment opportunity (1) guarantees a specific return, (2) guarantees that return by a certain time, and (3) is not registered with the SEC, the SEC advises to invest with caution as these as identifiers of fraud.

What Is the Most Famous Ponzi Scheme?

The most famous modern Ponzi scheme was orchestrated by Bernie Madoff. His firm executed the largest Ponzi scheme in history, defrauding thousands of investors out of billions of dollars over decades.

The Bottom Line

When clients give money to their financial advisers or investment firms, they expect a level of fiduciary duty. Unfortunately, those funds can be fraudulently mismanaged through Ponzi schemes. By taking one investor's money to repay another, Ponzi schemes aren't actual investment plans. They are fraudulent investment schemes that have resulted in the loss of billions of dollars.