A Ponzi scheme is a form of investment scam whereby clients are promised lucrative returns. Ideally, organizations that engage in these fraudulent investing scams direct their attention to attracting new investors. The earlier investors are paid using the money collected from the new entrants as returns. The schemes promise individuals tremendously high return rates on their investments. Ponzi schemes are vital since they provide returns to the investors who invested in the initial days of launching the project by luring new investors. They evolved in 1919 and are typically named after Charles Ponzi, known for using deceit to persuade individuals to invest their money. Ponzi schemes have adverse impacts on the economy; thus, it is better to adopt ways to curb them.
Characteristics of Ponzi Schemes
Ponzi schemes occur both in developing and developed nations and have a particular characteristic: the promise to the new investors that they shall get high rates of return above the standard market rates for their investment. The schemes have become widespread recently because of advanced technological advancements and globalization. According to America’s securities and exchange commission, one commonly shared characteristic of Ponzi schemes is higher investment returns with minimal risks (Sadiraj & Schram, 2018). Typically, there is a positive correlation between the risks, returns, and projects that promise higher returns with little risks. Moreover, overly consistent returns are another crucial feature of the Ponzi scheme, with investment returns following a business cycle. Usually, when an economy is booming, returns are high and down during times of recession.
Another feature of these schemes is that their investments must be registered with the state regulators, including the securities and exchange commission. Most state and federal legislations on securities demand that investment companies and professionals be registered and licensed; however, Ponzi schemes are not. In addition, these schemes need to publish detailed information, including the complex and secretive strategies they use for their investments. Thus, they are called blind pools because they have no knowledge of how investments are made.
Similarly, Ponzi schemes need to submit performance reports and statements on the performance of their clients; instead, they are most likely to be error-prone and inconsistent in correspondence. Finally, there are challenges in receiving payments from Ponzi schemes as the perpetrators encourage the new entrants to turn over their higher returns and optimize their investment equities. If an investor tries to cash out their investment, they need help obtaining cashback as their principle states that they should do so gradually or not at all.
Examples of Ponzi Schemes: Charles Ponzi
One of the renowned Ponzi schemes in the history of America is the investment scam executed by Charles Ponzi. It was centered on the postal service, especially when it developed an international reply coupon that allowed an individual in a given nation to pay for a reply postage to a correspondent in another nation. The global reply coupons were priced at the postage fee in the country of purchase, although it could have been swapped out for stamps to include the postage expenses in the nation where it was redeemed.
A variance in these figures would result in a potential profit (Cohler, 2017). As a result of the post-Great War inflation, international reply coupons could be purchased in Italy and exchanged for remarkably high-value stamps. Charles argued that the net profit of these transactions could work for more than 400 percent, a kind of arbitrage that was entirely lawful.
Charles left his professional career to establish his international reply coupon scheme in motion. He founded a stock firm to generate funds from the general populace and turn to some of his friends in Boston. He convinced them he should double their investments within ninety days and shortened the period to forty-five days at 50 percent interest. Towards the end of 1919, Charles established a securities exchange firm in Massachusetts to advance his plans on an international reply coupon. During the month, approximately eighteen investors invested a total of USD 1 800 into his firm and paid them in the following month using money acquired from his next set of investors.
With time, Charles’ company expanded, and the founder hired agents to look for new investors across New Jersey and New England. Ironically, about three-quarters of Boston law enforcement officers were reported to have invested in Charles’ scheme. In late 1920, Charles raked in an impressive one million U.S. dollars daily (Makinson, 2022, para. 6). While this value might appear small compared with more extensive present-day frauds, what was explicitly remarkable about Charles’s scheme was the sheer speed with which he generated his millions of money in a short period.
Lou Pearlman
Lou Pearlman became famous after launching two of his most popular boys’ bands in the 1990s. As an American record producer, he would persuade banks and everyday individuals to invest in fabricated forms. After his boys’ band proved to be a global success story, investors were interested in sharing the wealth Lou had made for himself (Hare & Gerken, 2021). Lou started to work as a con artist, inspiring keen investors to buy into the fabricated firms that only existed in writing, namely Trans Continental Airlines Inc and Trans Continental Airlines Travel Services Inc. In 2007, Lou came under investigation, where he defended himself before Florida state officials by stating that the money he invested in a firm by the name Germany Savings.
However, Lou could not locate the company, and the officials commenced investigations investigating the organization that handled Lou’s financial reports. The officials effectively traced reports of two separate addresses sharing the same address as Germany Savings and another in South Florida, where no such company appeared to exist. Having swindled 300 million U.S. dollars from investors and banks in 2008, Lou pleaded guilty (Makinson, 2022, para.13). However, he died in federal custody in 2016 while serving a twenty-five years term for being charged with money laundering, conspiracy and false bankruptcy proceedings.
Bernie Madoff
Bernie Madoff’s Ponzi scheme remains the most notorious financial scam in U.S. history. He illustrated all aspects of a Ponzi and used his personality to disguise it. The attorney, Simona, on the enforcement staff of the Securities and Exchange Commission (SEC) in the middle of 2000, acknowledged that the team had been dubious of any defrauding allegations on Bernie since he did not qualify to be a Ponzi scheme. Madoff Investment Securities was the name of the firm that Bernie founded, and it was among the most highly successful stock dealers on the stock market. The company’s securities constituted about 10 percent of day-to-day trades in the 1990s. Bernie’s firm and the strength by which it impacted the industry made Bernie wealthier and allowed him to become the most respected figure in the whole market.
To enhance his curriculum vitae, Bernie introduced himself as a co-founder of a national association of securities dealers automated quotations and was the chairperson. Being a member of many private board committees and a prominent philanthropist, he became a Wall Street icon. Besides all that, no one would prove that Bernie was operating one of the biggest Ponzi schemes historically. He managed to dupe investors through Bernie’s brand name and his guise.
Bernie alleged that he could buy stocks and buy a derivative to cut losses together with trading with a covered option that basically puts a profit ceiling. For instance, Bernie could buy a stock for USD 100 and buy a derivative that enables him to secure his share price at a rate of USD 45. That meant that the put option could serve as a security if the stock purchased for USD 50 fell below USD 45, allowing him to still sell that stock for USD 45 (Henriques, 2018). Moreover, Bernie could sell call options for USD 80, allowing the call owner to exercise the derivative and buy Bernie’s shares for USD 80 if it rises to USD 80 and over, anticipating it continues to increase.
Bernie’s company became one of the largest market makers and was investigated on eight occasions for lucratively making exceptional returns. The worldwide recession of 2008 led to a decline in Bernie’s firm, where the investors attempted to withdraw roughly USD 7 billion from his funds. Many investors have been defrauded approximately 64.8 billion U.S. dollars in seventeen years by Bernie (Makinson, 2022, para. 7). Later on, in 2021, Bernie died jail while serving a one hundred and fifty-year sentence for securities fraud and money laundering, among other felonies. Some of the individuals and businesses defrauded by Bernie include banks such as Royal Bank of Scotland, HSBC Holdings, and actor Kevin Bacon, among other ordinary people.
Impacts of Ponzi Scheme on the Economy
Ponzi schemes unavoidably impose a financial loss on many of their investors and direct funds from profitable investments. When left unmanaged, they can increase dramatically and undermine trust in financial organizations and regulatory agencies and create fiscal drags if the government is to bail out its citizens. The experiences of diverse nations indicate that the dramatic growth rate required to bolster Ponzi schemes might result in an extensive institutional and financial loss (Mohammed, 2021).
There are countless negative impacts of Ponzi schemes all over the globe. One of these effects is death and loss of savings, as victims lose thousands of millions through such scams. Some clients who invest in these schemes take credits and loans from lending institutions and non-financial bodies. In addition, many are the breadwinners and underprivileged in their households. Such financial losses adversely affect these victims’ health, education, and overall livelihoods.
Additionally, Ponzi schemes result in leakages to finance structures as the financial body of a nation establishes the medium for lenders and borrowers to swap finances. The extra funds in the form of deposits is converted into investable money through this process. Hence, the activities of Ponzi schemes form a loophole in such systems and frameworks. Similarly, Ponzi schemes establish a burden for the taxpayers as the firms created by the fraudsters become liquidated, and their assets cannot settle the depositors’ dues. As a consequence, the government is forced to step in to pay some of the investors.
Funds that could have been channeled to development projects in a country are utilized to pay investors, thus, depriving the nation of the required finances for development. The schemes send bad signals to industry players and investors, reducing confidence and trust in the country’s financial system and regulatory institutions. People losing their jobs due to the collapse of some financial companies is significant in predicting an economic threat. As individuals lose their occupations and financial institutions collapse, more people will not be willing to use financial services.
Recommendations to Curb Ponzi Schemes
Financial bodies require effective and stern supervisory agents to keep in check scammers from the financial industry. Higher rates of joblessness and lack of financial literacy make individuals fall victim to these Ponzi schemes (Monroe, Carvajal & Pattillo, 2010). Thus, the regulating financial institutions must be watchful in their administrative duties and exchange information to locate and ward off the financial sector’s immediate and long-term adverse impacts.
Furthermore, governments must increase civic education on financial literacy, and those states hit by Ponzi implement legislation that categorically deals with such defrauding behaviors. The governments should pass legislations that allow them to directly arraign the victims to the appropriate courts for confiscating and seizing property when a firm or a person is involved in such malpractices.
In conclusion, Ponzi schemes shall continue to have devastating effects on the global economy in the near future. Poor supervision and regulations by banking institutions, along with investors looking for tremendous profits from their investments, might be attributable to the causes of the Ponzi schemes. Some of the effects of such projects include redirecting savings to unproductive areas, loss of lifetime savings, incurring fiscal expenses on the taxpayer if a government bails out their citizens.
They also include redirecting savings from financial institutions, and increasing bad loans. Regulatory agencies must increase their endeavors to locate Ponzi schemes by implementing efficient investigatory tools, including red flags that point out fraudulent scams. Lastly, extensive financial literacy schemes can help stop unregulated schemes. Therefore, the regulators should keep the general populace informed through general alerts regarding methods employed to swindle investors and the importance of questioning financial feasibility of big investment.
References
Cohler, A. (2017). The evolution and impacts of the Ponzi scheme and governmental oversight. An honour’s senior thesis project on the intricacies of Ponzi Schemes and its regulating authority, senior business administration major, concentration in finance, Ramapo College of New Jersey, Ramapo College Honour’s Symposium. Web.
Hare, B., & Gerken, M. (2021). 8 of the most notorious Ponzi schemes in U.S. history. CNN Business. Web.
Henriques, D. B. (2018). A case study of a con man: Bernie Madoff and the timeless lessons of history’s biggest Ponzi scheme. Social Research: An International Quarterly, 85(4), 745-766. Web.
Makinson, R. (2022). Top Fraudsters: 3 of the most famous Ponzi schemes. Finance Monthly. Web.
Mohammed, U. (2021). Effect of Ponzi schemes on a country: The case of Ghana. Journal of Financial Crime, 28(3), 926-939. Web.
Monroe, H. K., Carvajal, A., & Pattillo, C. A. (2010). Perils of Ponzis: Regulators need to stop Ponzi schemes before they gain momentum, especially in developing countries. Finance & Development, 47(001), 37-39. Web.
Sadiraj, K., & Schram, A. (2018). Inside information in Ponzi schemes. Journal of the Economic Science Association, 4(1), 29-45. Web.