How A Ponzi Scheme Works (And Why You Shouldn't Run One)

As long as there has been business, there have been people looking for easy ways to make lots of fast money from it. Cheating banks, businessmen, governments, and everyday consumers seems to come with the territory. As with most things, though, some people are much better at doing it than others.

One of the best known get-rich-quick schemes of all time is the Ponizi Scheme, an investment fraud devised by Charles Ponzi in 1920. While Ponzi was the one to give his name to the scheme, raking in almost $20 million, perhaps the most well known example is the 2008 case of Bernie Madoff. Madoff, taking in investments through his firm “Bernard L. Madoff Investment Securities LLC,” got people to invest upwards of a total of $36 billion in real money, with some estimates putting the total as high as $65 billion when all damages are accounted for.

Ponzi schemes really began to take off in the 1980s and 1990s in America with booms in both real estate and stock markets. Because there was so much money just floating around, Wall Street execs wanted easy ways to invest it and make even more money, prefect hunting grounds for Ponzi schemers.

Despite the huge deceptions and massive financial gains involved, Ponzi schemes aren't actually all that complicated. The following article will help explain how these schemers cheat the system and swindle the gullible, but also how most of them end up having the whole empire crash down around them. First things first, if we're going to understand what a Ponzi scheme is, it'll help to know what it isn't: a pyramid scheme.

It's A Ponzi, Not A Pyramid

Admittedly, pyramid and Ponzi schemes are pretty similar. The main difference in many ways is that pyramid schemes aren't necessarily illegal... but that doesn't mean they're wise investments. In fact, they're probably one of the worst investments you can make, since they don't only require a monetary commitment, but usually a huge time commitment on the investor's part as well; if you can't get more people buying what you're now selling or investing in what you're supporting, your returns stop and you're left with a franchise that won't generate returns.

In a pyramid scheme, a slick investor will ask you if you'd like to buy into a franchise. If you do, you'll gain access to a wide range of super products that everyone you know will want to buy, like makeup and tupperware, or services and investments. The problem is that all your profits depend on people signing up under you or buying your products, thus giving you a profit. Sometimes this model can work, but usually it ends in a legal parting from your money with no return. The most important thing here is that while the 'franchise' may not sell directly to the public, there is at least something to sell and deal with. This is not the case in a Ponzi scheme.

What Ponzi Schemes Are

If someone were in the market to get rich quick, but didn't have the resources or time to actually make a product or set up a real business to get investors, that someone would turn to the Ponzi scheme. We've already seen that a pyramid scheme at least offers investors some tangible return to their investment, even if it is still ultimately bogus. The most basic characteristic of the Ponzi scheme is that when someone gives their money to the schemer, they're doing so for the promise of huge returns for no work.

The job of the Ponzi schemer is to make the investment sound so realistic and enticing that the victim parts with their money in the hopes of having it magically multiplied. What the schemer then does is sit on that money while he or she draws in other investors with the same pitch. Over time, the schemer acquires enough money from multiple investors to pay the original investors back with interest.

Many Ponzi schemes can run this way for years if not decades. The return investors get back inspire them to make longer term investments at higher prices so the schemer can constantly shift the money back and forth, supplementing the returns with new investors as the fake firm grows in scale. The schemer himself simply needs to skim some money off the top every time, hoarding it away in offshore accounts, eventually stockpiling ludicrous amounts of money.

 How They Fail

We say the Ponzi scheme can run for years, but it really depends on how quickly the schemer can sucker in new suckers. If, for example the Ponzi wannabe is unable to get new investors right off the bat, the system collapses immediately because investors don't get their money back and the system is found out.

On top of that, the scheme is very susceptible to external factors like economic downturns, because those push investors to pull their money out or shy away from joining in all the fraudulent fun. This is exactly what happened to the Madoff scheme in late 2008. When the housing market and the rest of the economy crashed, investors who had given Madoff money demanded returns and opt outs. This not only led to greater financial strain on the system as a whole (many of the investors were banks or speculators who used other people's money), but revealed massive incompetence on the part of watchdogs and banking officials whose sole purpose was to prevent schemes of that nature from happening.

Why They Are Illegal

On the face of it, Ponzi schemes seem perfectly fair: they cash in on the eagerness and ignorance of investors with too much money and not enough sense. While that isn't necessarily always true (some Ponzi artists are smooth talkers and seem really legit), it isn't far off, either. The problem is that Ponzi artists aren't actually doing what they're saying. In other words, Ponzi schemes are illegal simply because they're a bundle of lies.

We've already seen that some pyramid schemes are legal. Namely, those that actually give the investors whatever it was they were promised for their money. However, some pyramid schemes are just as illegal as Ponzi schemes because they don't give the investor anything in return, and instead demand that the 'investor' recruit more members at new fees, funneling the money upwards, paying each person above. No one is actually getting what they're promised: positions, services, real returns, etc.

This is what makes the Ponzi scheme illegal. Like the illegal pyramid scheme, the con artist is promising something that does not exist: an investment in a phony business or idea. Because the schemer is accepting the supposed investment as a 'gift' and not as actual income, the lie becomes official and tax evasion is added to securities (investments/returns) fraud. Moral of the story: lies are not okay! Money or no money, those who cheat the system are eventually caught.

Game Of Thrones Showrunners Sign Massive Deal With Netflix

More in Economy