Ponzi and pyramid schemes. How to avoid falling for them.
“I’m going to be rich!” Bob said to Alice. “I’m making 25% interest a month and it’s completely legitimate!” Euphoria! Greed! Fomo! The rest of course, is history.
So what is a ponzi scheme? What about a pyramid scheme? These ‘get-rich-quick’ schemes have plagued the planet for as long as assets have been readily tradable. In this article we are going to explain the ins and outs of the scams. With these tips, you’ll be able to stay more vigilant and avoid the inevitable crash and burn of these ventures.
History of the Ponzi scheme
The term Ponzi was conned from the man by the name of “Charles Ponzi”. Although not the first to run the scheme, the scam he ran became extremely infamous due to the articulate and charming nature of the young man. His scam began in 1919 at which point Ponzi had no assets or money. Just one year later his scam was unveiled. His investors had lost a total of $20 million ($225 million in today’s terms).
Mr Ponzi’s ‘business’ idea
In 1919 Charles Ponzi was trying to set up an advertising company. He received a letter from a Spanish company interested in his advertising plans. In the letter he received was something called an International Reply Coupon (IRC). An IRC was a form of postage stamp that would cover the cost for the reply.
The cost of the IRC was covered at the country of origin and costs of postage varied dramatically from one country to the other. Initially, Ponzi’s intentions were legal as he sought out a plan to buy IRC’s through his family and friends in Europe. He would go on to sell these in the United States, making up to 400% on his investment. Ponzi saw further potential; he created a business plan based on these IRC’s and approached many investors.
How did the Ponzi begin?
Mr Ponzi would end up creating his own stock company to raise funds and would also approach friends with an investment plan. He would promise them initially 100% returns over 90 days. The lock up period was later reduced to 50% over 45 days, giving the illusion that liquidity was very good. A friend that invested $1000 would have been given $500 interest after 45 days. Mostly, friends and investors were so ecstatic with their proven returns that they would let their money rollover.
You can bet they told all their friends too. It isn’t long until the amount of money people are investing starts getting into some serious numbers. Confidence is maintained since people who initially invested and were out of the lock-out period of 45 or 90 days could access all of their funds if they wished.
When did the gravy train stop?
Unfortunately for Mr Ponzi, the scheme had some problems. To begin with, trying to transfer the IRC tokens (that didn’t exist in the first place) would be a logistical nightmare. According to the numbers that investigators ran, you would need a titanic sized ship full of IRCs to match the investments. In total, there needed to be 160 million IRCs to cover investments, but only 27,000 were actually in circulation. A slight discrepancy.
When investigators and the public put two and two together, Mr Charles Ponzi’s life came crashing down. Ponzi was poised for a life of misery behind bars.
Ponzi schemes in the cryptocurrency world
Ponzi schemes have been forever rampant, especially where there are fresh persons exposed to the investment market. For this reason, the cryptocurrency communities have been an obvious target.
In 2016 a new cryptocurrency emerged, BitConnect. It got the attention of many due to its promised high returns and huge exposure over the internet. As well as the high promised returns, the platform offered a referral scheme where new signups through your referral link would generate new income for yourself. This is akin to a pyramid scheme. Youtubers were aggressively marketing Bitconnect and showing off their huge gains. Bitconnect were most definitely cashing in on the cryptocurrency rush of 2017, with people being blinded by fomo.
By December 2017, one Bitconnect token (BCC) was worth a whopping $463. Just like any other Ponzi scheme, the gravy train came to a screeching halt. On January 3rd the price crashed 65% in just 6 hours, and by January 30th the price fell to new depths of $6. The reason for the crash is due to something called the greater fool theory. When you run out of fools, there are no future funds to keep the dream alive. The only thing that is left are broken promises.
How to spot a Ponzi scheme
There are multiple red flags to look out for when investing. A ponzi scheme may be yielding many of the following red flags:
- High investment returns with little or no risk. Every investment carries some degree of risk. Be highly suspicious of any "guaranteed" investment opportunity.
- Overly consistent returns. All investments will prove to be volatile from time to time, regardless of their fundamentals. There is no such thing as a guaranteed or very consistent monthly return, especially with potentially high return investments.
- Unregistered investments. Ponzi schemes typically involve investments that have not been registered with the SEC or with state regulators. Without registration, information regarding the company, allocation of funds, background of CEOs and such is unknown.
- Unlicensed sellers. Federal and state securities laws require investment professionals and their firms to be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.
- Secretive and/or complex strategies. A common strategy is confusing investors with technical jargon that doesn’t make sense. If it doesn’t make sense, put your money elsewhere
- Issues with paperwork. Access to basic account or investment information should be readily available. Discrepancies in accountancy is also another obvious red flag.
- Difficulty receiving payments. Be suspicious if you do not receive a payment or have difficulty cashing out your investment. Keep in mind that Ponzi scheme promoters routinely encourage participants to "roll over" investments and sometimes promise returns offering even higher returns on the amount rolled over.
Ponzi vs Pyramid scheme- what’s the difference?
A ponzi scheme is a form on fraud on promised returns often from an unknown or unclear entity. The CEO can quite often be discreet with his business plan or may be an unknown person altogether. The idea is that the money starts at the top with the CEO and is fed down to its investors. The return on “investment” is actually just fresh funds supplied by new investors. Liquidity may in fact be very low, but due to people re-investing their initial stake, the scheme appears to be extremely lucrative and liquid.
A pyramid scheme is based on the idea that money is promised to come from fresh investors. Original investors are encouraged on recruiting new investors or “suckers” and are incentivised through referral schemes.
These schemes rely entirely on the inordinate desire of the greed of people. Without the promise of guaranteed returns, these fraudulent schemes wouldn’t get a second looking. If you’re looking to make an investment in the future, it’s best to put your emotions aside.