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Understanding a Ponzi Scheme

Many investments come with a lot of risks. The risk of investment increases if an investor is involved in a Ponzi or Pyramid scheme. Since they are illegal, they need to identify these schemes cannot be stressed. That said, we will explain what these schemes are so that you know how to avoid them. 

The term "Ponzi Scheme" is coined from the name of an Italian criminal named Charles Ponzi. He became famous for his fraudulent money-making system after moving to North America to demonstrate his illegal activities. He was able to defraud hundreds of investors through his scheme in the early 1920s. What more, the scheme took place for more than a year.

Generally, a Ponzi scheme involves collecting money from newly deceived investors and paying to older investors. While this might make a lot of sense, there is a considerable problem — investors on the backend will not receive any payment. Therefore, the fraudster could leave anytime. 

The most famous Ponzi scheme happened more than a decade ago in the United States. It was organized by Bernard Madoff, who deceived investors in Bernard L. Madoff Investment Securities LLC. He was able to build an extensive network of investors, extorting cash from them in the process. Madoff defrauded almost 5000 investors.

However, he didn't invest the money in his scheme, and the fraud collapsed after a financial crisis was experienced in 2018. According to the SEC (Securities and Exchange Commission), the total amount Madoff defrauded from investors was approximately $65 billion. This dubious activity sparked an urgency for regulators and investment professionals to hunt for Ponzi schemes. 

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How Does a Ponzi Scheme Work? 

• First, the impostor acts as a promoter of an investment opportunity by promising huge returns. For instance, they take $500 from a real investor and promise to pay the initial value with 10% interest at the end of a specific period. That means the investor will get $550 at the end of the predefined period. (e.g., 30 days). 
• After this is done, the promoter uses the same format to bring more investors before the 30 days. So when the new investors pay their initial fee, he pays the first investor $550 from the money obtained from the other investors. What more, he may convince the first investor to re-invest the $500. 
• With this, the impostor has won the trust of the first investor or other early investors by paying them money obtained from new investors. Therefore, there is a confidence to reinvest and invite more people. 
• As the network grows bigger, the impostor will need more funds to sustain the 10% interest rates for old and new investors. 
• If the impostor cannot sustain the promised interest rates, he flees with the money obtained or is apprehended. 
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Understanding a Pyramid Scheme 

This works in the business sector. Here, the business promises payments or rewards for new members and those who invite other members. For instance, an impostor offers John and Joan a chance to purchase the distributorship rights at $500 each in a company. When purchased, they will both have the right to sell distributorships themselves earn their share for every new member recruited. However, the $500 obtained from their sales is shared with the impostor in a 50/50 agreement. 

For John and Joan to recover their initial investment, they sell two distributorships to two new people. Then this burden of recovering the initial investment is passed to recruits. However, the scheme will eventually break down because of the number of new members that get enrolled. This is what makes the Pyramid scheme an illegal practice. Presently, the majority of Pyramid schemes do not offer products or services. They are sustained by the money gotten from new membership recruitments. Still, some Pyramid schemes may present themselves as a legal multi-level marketing (MLM) company that offers products or services. This is done to hide their fraudulent practices. 

That said, most MLM companies are pyramid schemes, but not all MLM companies are illegal.

Similarities Between Ponzi and Pyramid Schemes 

• They are both financial frauds. 

• They both promise investors incredible returns on investment.
• Investors need to be enrolled for them to be sustainable. 
• They do not offer actual products or services. 

Differences Between Ponzi and Pyramid Schemes

• A Ponzi Scheme is presented as an investment management platform. Users are promised huge returns on what looks like a legitimate investment. However, the impostor defrauds one to pay another. 
• A Pyramid scheme is similar to network marketing. It requires membership inflow to generate profit. This way, members earn commissions for every new member brought in before forwarding the rest to the top of the pyramid. 

Avoiding Ponzi and Pyramid Schemes 

• Be Skeptical: Watch it! Any investment platform which offers huge returns with little investment is probably a scam. It is very good to be true, mainly when it is very difficult to understand. 
• Beware of unsolicited opportunities: Any unexpected invitation to participate in a profitable investment scheme is a bad idea. 
• Make investigations: The promoter should be investigated. A legal entity, financial advisor, or company should be registered under the proper governing body. 
• Trustless: Always verify the investment platform. It has to be legally registered, and if it is not, find out why. 
• Understand the investment: One mistake many make is investing in something they know little or nothing about. Always try to understand what you want to put your money in as it is shrouded in secrecy. 
• Take legal action: It is essential to report to the appropriate authorities when you come across a Ponzi or Pyramid scheme. 

Final Thoughts on Ponzis

We now understand that both Pyramid and Ponzi schemes are forms of financial fraud. However, a Pyramid scheme is different from a multi-level marketing campaign. 

They can be hugely devastating for any guilty party, and it is essential to take the necessary steps in order to avoid these schemes. There is no assurance that there will be an end to these practices, but we can apply caution to reduce casualties. 

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