Ponzi Scheme

A Ponzi scheme is named after Charles Ponzi, who was notorious for the scheme, however he isn’t credited with devising the scheme as it was mentioned earlier in Charles Dickens’ Little Dorrit.

The scheme is an investment operation that pays investors their own money back or the money on new investors and not from the profits of any operations. The scheme attracts investors by offering higher returns than normal investments. To keep the scheme running the company needs a perpetual flow of new investors in order to pay their current investors.

As the scheme encourages more investors (as it needs to in order to stay running) it is more likely to be noticed by authorities that have the power to shut it down rather than allow it to collapse.

Investors obviously aren’t aware of the company’s investment strategy and are usually told that the strategy can’t be disclosed so that it doesn’t fall into the hands of any competition.

Promoters of the scheme encourage investors to leave their investments with the scheme as if they were to take their money out the scheme could collapse (or would be detrimentally affected).  They do so by offering these high returns and changing the particular investment asset that a investor owns claiming even higher returns.

There are 3 reasons why a Ponzi scheme may collapse; the first is that the promoter (of the scheme) runs away with the remaining money, the scheme runs out of new investors and so collapses, or there is an event in the market causing investors to withdraw their money from the scheme.

Another famous example of a Ponzi scheme was of that run by Bernard Madoff. He ran the largest Ponzi scheme to date but was arrested in 2008 after his sons alerted authorities to his frauds. It was estimated that the size of the fraud was $65 billion.

Page last updated on 20/10/13