What is a Ponzi Scheme? : Everything You Need to Know

Worsening economic situations, like growing inflation, call for putting our hard earned money to work and when we talk about putting money to work it often means investing.  Indeed, investing is one of the most secure ways to multiply your money. But, sometimes this principle can appear false and lead you on debt alerts.

Yes, investing can sometimes leave you penniless especially if you trust the wrong sources or people out of greed for hefty returns and Ponzi schemes are just one of many ways this can happen.

Ponzi Scheme!? But, what is a Ponzi scheme and how can you identify such schemes?

Well! That’s the very reason we are here. This blog will provide you in-depth information about what is a ponzi scheme and how you can identify and avoid Ponzi schemes to secure your hard earned cash.

What is a Ponzi Scheme?

Ponzi scheme is a fraud scheme that pays existing investors from the funds collected from early investors and creates the illusion of fund multiplication and profitable organization. Ponzi scheme organizers attract investors by promising high returns and low risk investments and when they start attracting substantial investments they dump investors by taking away all their money.

Initially, the fraudsters attract new investors through the “word of mouth” promotion by existing investors, who are unaware that the returns received to them from the ponzi scheme organizers is their own principal amount.

After a period of time, when the incoming of new investors in the scheme gets slowed down, the organizers collapse the Ponzi scheme resulting in huge loss of investors.

Why is it called a “Ponzi” Scheme?

Ponzi schemes got their name from a notorious fraudster named Charles Ponzi, who scammed investors in the 1920s. Although similar fraudulent activities occurred before in the mid-to-late 1800s also, it was Charles Ponzi's scheme that really put this type of fraud on the map.

Charles Ponzi attracted investors by promising them incredible returns: a 50% profit in just 45 days or a 100% return in 90 days. He explained that he was making money by buying cheap international postal reply coupons in other countries and redeeming them for U.S. postage stamps at a higher value. Essentially, he claimed to be profiting from the price difference between these postal coupons in the U.S. and abroad.

But in reality, Ponzi wasn't investing in postal reply coupons at all. Instead, he was using the money from new investors to pay returns to earlier investors, creating the illusion of a successful and profitable business. This deception worked for a while, attracting even more people who wanted in on the seemingly lucrative opportunity.

Ponzi's scheme lasted about a year before it inevitably collapsed. The downfall came when he couldn't find enough new investors to keep up with the returns promised to earlier ones. By the time it all fell apart, Ponzi had swindled his investors out of $20 million—a huge sum back then, equivalent to even more than $271 million in today's money.

Even though there had been similar scams before, Charles Ponzi's operation was so infamous that it brought widespread attention to this kind of fraud. As a result, these types of scams have been called Ponzi schemes ever since, highlighting the enduring impact of his deceitful actions on financial fraud awareness.

How Does a Ponzi Scheme Work?

A Ponzi scheme operates by misleading a group of investors with a complex and seemingly profitable investment plan. Scammers promise high returns with low risk, making the opportunity appear incredibly attractive. However, instead of investing the capital as promised, the scammers pocket the money.

The essence of a Ponzi scheme lies in its need for a continuous influx of new investors. The scammers use the funds from these new investors to pay returns to earlier investors. This creates the illusion of a successful investment strategy, as initial investors receive the promised dividends and are often persuaded to reinvest their profits.

Here's how a Ponzi Scheme works:

1. Initial Attraction: Scammers present an elaborated investment plan, promising high returns with minimal risk. Early investors are lured in by these attractive terms.
2. Payouts to Early Investors: Early investors receive returns, which are actually just funds from new investors. This payment cycle helps build trust and attracts more investors.
3. Continuous Recruitment: The scheme relies on a steady stream of new investors. As long as new money keeps coming in, the scammers can continue to pay returns to earlier investors, maintaining the facade of a legitimate investment.
4. Collapse: Eventually, the scheme falls apart when the flow of new investors slows down, or a large number of existing investors demand their money back. The scammers are unable to meet these demands because there is no actual investment generating profits. The money has simply been circulated among investors, with a significant portion siphoned off by the scammers.

When the scheme collapses, investors are left with nothing. They lose both their initial investments and the promised returns. The sudden collapse exposes the fraudulent nature of the scheme, often leading to legal repercussions for the scammers and financial ruin for the investors.

Characteristics of a Ponzi Scheme: How to Identify a Ponzi Scheme?

Before committing your funds to any investment, it's crucial to ensure it is legitimate. Here are some key indicators that can help you know whether an investment plan is a Ponzi scheme:

1. Abnormally High Returns

One of the strongest signs of a Ponzi scheme is the promise of unusually high returns with minimal risk. Scammers design these schemes to lure people with the prospect of high paybacks and low risk, making it easier to attract new investors. Be wary of such offers and avoid investment plans that seem too good to be true.

2. Unclear Business Model

Ponzi schemes often feature complex terms to hide their true nature. Scammers rely on investors who are either not tech-savvy or too lazy to scrutinize the details. It's essential to understand the business model thoroughly before investing. Avoid any investment you can't fully comprehend.

3. Guaranteed Consisten

Returns In any market-based investment, guarantees are a red flag. If an investment repeatedly promises "guaranteed" returns, it's best to stay away. Market conditions are inherently volatile, and no legitimate investment can offer constant returns regardless of market performance. Don't let the allure of assured profits cloud your judgment.

4. Non-Registered Enterprises

Be cautious of businesses not registered with the SEC or state regulators, as they can easily turn out to be fraudulent. Always verify the registration status of any enterprise before investing.

5. Reinvestment Pressure

If an investment scheme pressures you to reinvest your returns to claim previous rewards, it could be a Ponzi scheme. These schemes rely on a continuous influx of new money to pay earlier investors, and reinvestment is a common tactic to maintain this flow.

6. Blind Trust in Family and Friends

Many victims of Ponzi schemes were led into the trap by trusting relatives or friends. Fraudulent schemes often exploit personal relationships to build trust. Ensure you understand the investment thoroughly before trusting anyone's recommendation, regardless of your relationship with them.

By being vigilant and conducting thorough research, you can protect yourself from falling prey to any Ponzi scheme and ensure your investments are secure.

How to Avoid a Ponzi Scheme?

Trust Registered and Verified Institutions: Only invest with financial institutions and advisors that are registered and verified.

Ask Questions: Continuously question your investment advisor until all your doubts are resolved and you are fully satisfied with the answers.

Avoid FOMO: Don’t invest out of fear of missing out just because your friends and family have invested in a particular plan.

Research Thoroughly: Conduct thorough research on the enterprise's background and past performance before investing your money.

What is the difference between a Ponzi and Pyramid scheme?

What are Crypto-related Ponzi schemes?

The Crypto space is full of opportunities. It is well known for its high-profit potential and innovative technology. But the lack of public education and awareness about it sometimes leads to big fraud and scams.

The scammers display a fake crypto enterprise and attract investors with a complex investment plan and big profit. Investors who do not bother to know about cryptocurrency's functioning and technical aspects fall very easily into such traps. There is either a new and less heard cryptocurrency or some crypto investment plan that fraudsters use to set up a trap for crypto investors.

Examples of the biggest Ponzi schemes in crypto are -One coin, Bitconnect, and Gainbitcoin.

Here is a summary of them:

One coin

It was founded by Bulgarian fraudster Ruja Lgnatova who managed to continue it from 2014 to 2019. It was a fraud of $5.8 billion that marketed Onecoin as a "Bitcoin Killer" and big crypto innovation. It worked on a multi-level marketing model that pays its members cash and Onecoin each time they add new investors to the business. The coin was running without any blockchain and still managed to dupe many crypto investors.

Bitconnect

Bitconnect, launched in 2016, was another biggest Ponzi scheme related to crypto. The investors of Bitconnect need to purchase BCC tokens and lock them on the platform. Then they were asked to wait for crypto trading bots to use their locked funds to trade and make a profit. The project promised an unsustainable return of 40% to its investors, which caused its decline in 2018.

GainBitcoin

India has one of the largest numbers of crypto investors, and fraudster Amit Bharadwaj took advantage of this fact. He launched Gainbitcoin in 2016 as an India-based cloud mining platform. It promised to generate monthly returns of 10% for 18 months regardless of the market conditions. The project collected over 395,000 to 600,000 bitcoins amounting to over Rs 1 lakh crore in only a year. In 2017, the authorities could not find any physical mining equipment or operations with him to support this elaborate scheme. This scheme is becoming the biggest Ponzi scheme in the crypto world as the authorities are inquiring about it.

Conclusion

Ponzi schemes take advantage of investors' greed and lack of awareness. Such fake schemes showcase high-profit margins and low risk to become the first choice for investors. But in reality, they make no profit and only operate by shuffling money from new investors to the old investors. Every crypto investment depends on the market conditions and hence can not guarantee returns. One should do good research and clear all doubts before giving them his hard-earned assets.