What is a Ponzi scheme?

With the price of Bitcoin recently taking a turn in the wake of the collapse of a crypto Ponzi scam, investors should take note of the signs so they do not fall into a similar trap.

The price of Bitcoin was recently hammered after news that the ill-gotten gains from a cryptocurrency Ponzi scheme have been flooding the market, suppressing the value of the blockchain-backed currency.

While the scheme isn’t the first Ponzi, and certainly not the last, it can useful for investors to investigate what these scams encompass and how to spot any warning signs that what is on offer may be ‘too good to be true’.

Ponzi schemes

Named after 1920s Italian conman Charles Ponzi, the scheme that bears his name is a form of fraud that promises high rates of return with seemingly little risk in order to draw in unsuspecting victims.

The inflows of capital from new investors is not used in any investment activity, instead, the money is used to pay earlier investors at the promised rates of return while the company focuses all of its efforts on drawing in more and more new investors to continue the cycle.

Ponzi schemes can continue as long as investors do not demand full repayment of their invested sum and believe that whatever non-existent assets they have still exist.

However, the company’s ability to draw in new funds is inevitably finite, and when there is no more new money coming in the scheme collapses, usually with the fraudsters escaping with all or a large portion of the invested funds.

While a Ponzi scheme also falls under the umbrella of a ‘pyramid scheme’, there are elements that make them distinct. For example, in a Ponzi scheme, a scammer will not need to constantly recruit new participants, as with a traditional pyramid scheme, but instead simply persuade existing ones to invest more cash.

The Madoff scandal

Perhaps the most famous example, and the longest-running, was that of Bernie Madoff, a US financier who for 20 years managed to draw in US$17.5bn of investments into an elaborate Ponzi scheme masquerading as the wealth management arm of his business, Bernard L Madoff Investment Securities, by promising above-average returns.

The existence of the scheme was only discovered during the global financial crisis in 2008, when the downturn in the market caused skittish investors to flood the firm with withdrawal requests, amounting to around US$7bn, that Madoff could not offset with new inflows, and with banks refusing to lend amidst the meltdown his enterprise became unsustainable.

Madoff was sentenced to 150 years in prison in 2009 with prosecutors estimating that the total size of the fraud was in the region of US$64.8bn.

‘Smart Ponzis’

The advent of cryptocurrencies, and the lack of a developed regulatory system around them, has given rise to what are occasionally referred to as ‘smart Ponzis’, a new generation of the scheme that uses digital assets to draw in victims.

One example is initial coin offerings (ICOs), the cryptocurrency industry’s equivalent of an initial public offering (IPO), except in this instance instead of shares investors are offered new crypto tokens that can be used for whatever product or service the company is providing, or to represent a stake in the firm similar to a shareholding.

However, due to the lack of regulation around ICOs and the crypto industry in general, ICOs are prime territory for scammers to draw in enthusiastic investors and abscond with the cash. As ICOs are not regulated in the same way as IPOs, these funds are often almost impossible to recover and the firm can often not be pursued by regulators as they do not oversee the space.

The problems with fraudulent ICOs finally drew the attention of national authorities in 2017, when the People’s Bank of China officially outlawed the practice and barred banks from offering services to facilitate ICOs.

In early 2018, social media giants Facebook Inc (NASDAQ:FB), Twitter Inc(NYSE:TWTR) and Google parent Alphabet Inc (NASDAQ:GOOG) followed the trend and banned all ICO advertisements from their platforms.

Ponzi scheme red flags

Avoiding Ponzi schemes, particularly complex ones, can be difficult to avoid even for experienced investors (see Madoff), there are certain red flags that can be spied that what is on offer may not be what it seems.

Any guarantee of high returns with little or no risk is one of the more prominent signs that you may be facing a Ponzi scheme, as well as if returns keep coming in regardless of wider market conditions.

Other warnings are investments that have not been registered with regulators or are described as being secret or too complex to explain to those investing, as well as those that either hide any official paperwork or place barriers to withdrawals that make it more difficult than normal for investors to withdraw their money. proactiveinvestors.co.uk

What is a Ponzi scheme?
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