What is a Ponzi scheme?

Disgraced US financier Bernard Madoff’s alleged Ponzi scheme is one of a number of such frauds which have come to light since the global financial crisis struck in 2008 [AFP]

Ponzi schemes – similar to what is known as pyramid schemes outside of the US – are a system that takes money from new investors, usually with the promise of significant returns, to pay dividends to existing investors.

The scam’s name was bequeathed in the 1920s by Charles Ponzi, who offered investors in the US great returns from postal coupons he said had been bought at a depressed value in Europe. However, the coupons’ profits were not real and Ponzi used new customers’ money to finance returns to earlier customers.

As word of considerable and surefire returns spread, more people invested with Ponzi, who continued the scheme.

The system collapsed when Ponzi ran out of new investors whose money was necessary to keep the scheme going. As Ponzi had made no real investments which could provide real profits, he could not pay back customers.

Ponzi, an Italian immigrant, was convicted of fraud and sent to prison for two years.

Hard to escape

Some Ponzi schemes may begin as financers suffer a loss and use new customers’ money to pay earlier customers’ promised returns, thinking they will make up the deficit with greater profits achieved in the following quarter or year.

However, in reality it is very hard to “win” a way out of a Ponzi scheme and thus financers continue the swindle to prevent revelation of their actions.

In the long run – if the conman has not already skipped town before the scam is exposed – it is difficult to continue finding new sources of finance to pay older investors and thus the scheme collapses.

This is what happened in the alleged $65bn Ponzi scheme spun by Bernard Madoff, the disgraced US financer and head of Nasdac.

Finance drought

It is likely that, after promising great returns for decades, when the global financial crisis hit in 2008 Madoff could no longer find investors with whose money he could use to pay returns to older investors.

Additionally, earlier investors began to ask for the money they had given him to be returned. However, a great deal of this cash would have been sent on to other investors or used to support Madoff’s lifestyle.

The financial crisis has also brought to light an alleged decade old Ponzi scheme run by Gordon Brownoff in the UK and Allen Stanford’s similar suspected fraud in the US and Caribbean.

One of the problems with such scams is that when regular high profits are being paid investors and regulators have been found to consistently fail to question those returns.