How Does a Ponzi Scheme Work?


Quick Answer

Ponzi schemes are financial schemes whereby the fraudulent party uses new investment capital to pay off older investors, thus making it appear that the investment is paid off when the fraudulent party only assumed new debt. The term originated in connection to a 1920's scheme developed by Charles Ponzi, in which he lured many New England investors into false postage stamp speculation.

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Full Answer

Ponzi schemes often start with the perpetrator offering a deal that seems too good to be true: a high return investment with very little risk. The original investors then become impressed when consistent returns appear as promised. The investors do not know that the returns are actually funds supplied by new investors, who are now unknowingly involved in the scheme. New investors learn of the old investor's success and expect like returns. Of course, this never happens because the investment doesn't actually exist; the perpetrator absconds with the remaining money.

According to the United States Securities and Exchange Commission, or SEC, Ponzi schemes are short-lived because the schemes depend upon the continued introduction of fresh money, while, at the same time, later generations of investors are increasingly discouraged from getting involved due to the lack of payout. According to the SEC, there are several warning signs that may alert investors to Ponzi schemes. An example of an alert is an extremely consistent return. By nature, most investment returns fluctuate. The SEC also identifies cases where investments are unregistered, sellers are unlicensed and where there are inordinate problems filing paperwork. Ultimately, late-coming victims of Ponzi schemes have difficulty receiving any payment whatsoever. One of the potentially disarming aspects of a Ponzi scheme is that the promoter often interacts on a personal basis with his victims, trying to establish a sense of trust.

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