What Is Ponzi Scheme and How to Protect Against a Scam?

UTC by John Caroline · 7 min read
What Is Ponzi Scheme and How to Protect Against a Scam?
Photo: Depositphotos

Crypto enthusiasts who are ignorant of Ponzi schemes are most probably to be the prime target of bad actors in the industry. Hence, it is necessary for everyone with investment interests to learn how to protect against a scam. Let’s dive into this helpful guide.

The operations of malicious actors seeking to rob people of their funds have been existing since the emergence of a financial system. The bad news is that the tendency of such activity to reoccur is inevitable. Thus, it doesn’t seem as if there will ever be an end to fraudulent actions in the financial space. To survive these unfortunate situations, the fight against fraudulent activities like a Ponzi scheme and the likes should not only be to punish alleged bad actors as commonly practised. And combating should be channelled into educating existing and potential investors on how to understand Ponzi schemes and how they operate, as well as the tactics needed to protect against a scam.

Ponzi Scheme Defined

Ponzi schemes are often dubbed get-rich-quick schemes considering the method by which they operate. They are malicious, illegal pyramid selling schemes that promise potential investors easy and quick access to wealth, and are often disguised with little or no risk to their investment.

A Ponzi scheme is always a scam organized by malicious actors. Basically, a Ponzi scheme can simply be likened to a fraudulent investment scheme which generates returns for earlier investors with money taken from later investors. They continue the trend until they run low on new investors and the scheme crashes while still having the funds of investors within their custody.

Ponzi schemes basically promise to make investors get rich quickly via quick, easy, and significant returns on investments. However, they often fold quickly and without warning, leaving the manipulated investors stranded and at loss on their principal investment and whatever returns are promised.

How Ponzi Scheme Works

As said earlier, Ponzi schemes are a type of pyramid scheme that operates in such a way that the operator, at the pyramid’s top, manages to attract the interest of a small group of investors by providing them with tremendous investment returns via funds secured from the second group of investors they may have referred. The second group, in turn, is paid with funds obtained from a third group of investors, and so on until the number of potential investors is exhausted and the scheme collapses.

Ponzi schemes never end well for investors as they promise them large sums of money if they invest. The scheme often appears to be working at the initial stage. This initial success then attracts the interest of new investors, their cash is then used to pay off the original investors, and the cycle continues until there’s a final crash.

There’s never a real profit with Ponzi schemes as they often operate by redistributing funds gathered from the investors. The money invested is always being “recycled”, hence the company never makes a real profit. It claims to be making progress and substantial growth as long as it still has the funds of investors to redistribute.

Thus, when investors keep putting their money in, the company appears to be doing well. Meanwhile, when people stop investing, the scheme collapses, thereby leaving the major operator with all the money.

Here’s a brief illustration of a typical Ponzi scheme. Let’s say Mr X (the operator) decides to introduce an unspecified investment scheme to a small group of people (Investors A, B, and C) and promises 10% returns to each of the investors. Investors A, B, and C agree to the terms and give Mr X $1,000, $2,000, and $2,500 respectively with the expectation that the value of the investment will be $1,100, $2,200, and $2,750 respectively after one year.

Moving forward, Mr X introduces the investment deal to another group of investors, also promising 10% returns to them. Luckily, Mr X is able to gather a collective amount of $7000 from his set of new investors.

With $12,500 now on hand, Mr X can redeem his promise to Investors A, B, and C by paying their collective expected returns of $6050. Meanwhile, Mr X can steal up to $5,000 from the collective pool of funds with the belief of getting more future investors to give him money. For the scheme to continue to exist, Mr X must continually get money from new investors to redistribute the funds into paying back older ones.

Warning Signs

Regardless of how extremely suiting, promising and genuine a Ponzi scheme can disguise to be, there are often some warning signals that can help investors pinpoint whether or not they are genuinely legitimate before investing their funds into them. These red flags often act as indicators that can help investors understand the nature of the scheme and decide if it is worthy of a trial. Being aware of these warning signs will help prevent further cases of fraud. Some of them are highlighted below:

  • Ponzi schemes often promise quick and significant returns with little or no risk.
  • Ponzi schemes do not possess legitimate proof of registration with the Securities and Exchange Commission (SEC).
  • Withdrawal services for investors are often complicated with Ponzi schemes.
  • Ponzi schemes often maintain a consistent flow of returns usually at the early stage regardless of the market conditions.
  • Ponzi schemes do not deploy clear and easy-to-understand investment strategies. They make investors understand that their investment models are too complex to understand.
  • Ponzi schemes do not often disclose the official paperwork for their investment.

Examples of Ponzi Schemes

The prime example of a Ponzi scheme is the Madoff investment scandal that took place in 2008. Bernie Madoff was a Wall Street broker whose wealth management business was a nearly twenty-year Ponzi scheme that defrauded investors of billions of dollars. He simply deposited investor proceeds into a bank account, and then made withdrawals whenever clients wished to make a redemption. Madoff’s scheme was revealed by whistleblower Harry Markopolos. In 2009, Madoff was given the maximum penalty of 150 years in prison, where he remained until his death in 2021.

Another example is Stanford Financial Group which sold certificates of deposits (CDs), a relatively safe type of investment, in 2012, but promised much higher interest rates than competitors. Then, the group’s founder Allen Stanford would use the money for funding his needs. The scam was valued at $7 billion, and Stanford received 110 years in prison.

Ponzi Scheme vs. Pyramid Scheme

A Ponzi scheme is often described as a type of pyramid scheme. Nonetheless, a Ponzi scheme is a fraudulent investment scheme often branded with a “too good to be true” kind of description, to attract investors with a promise of future mouthwatering returns. As explained earlier, it can only continue to exist as long as new investors are brought into the fold.

Meanwhile, a pyramid scheme on the other hand recruits other people and incentivizes them to further bring along other investors. A member within a pyramid scheme only earns a portion of their proceeds and is used to generate profit by higher members (often tagged as “uplines”) along the pyramid.

What to Do If You Are a Victim

Victims of Ponzi schemes should take certain necessary actions when they realize they have been frauded to prevent further damages whether or not funds may still be recovered.

It is advisable that victims of Ponzi schemes cancel all future payments with the investment while ceasing and eliminating all forms of contact and communication with the operators. Furthermore, previous communications made with the company, such as emails or letters should be documented. This may be used as proof or evidence of being scammed in case of legal interventions. The victim can go ahead to report the case to a legal body.

However, it has been observed that fraudsters do sell details of their victims, so victims are encouraged to watch out for fraudsters that may be aiming at them again using different identities.

Bottom Line

Ponzi schemes have caused lots of investors to lose their funds. These actors have their eyes fixed majorly on the crypto industry due to the advanced technological models often adopted in the industry.

Hence, it is expedient for investors, especially crypto users to learn and understand the necessary indications of these schemes while also protecting their funds against them.

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FAQ

What is a Ponzi scheme?

Ponzi schemes are malicious, illegal pyramid selling schemes that promise potential investors easy and quick access to wealth, and are often disguised with little or no risk to their investment.

How does a Ponzi scheme work?

Ponzi schemes operate in a way that the operator, at the pyramid’s top, manages to attract the interest of a small group of investors by providing them with tremendous investment returns via funds secured from the second group of investors they may have referred. The second group, in turn, is paid with funds obtained from a third group of investors, and so on until the number of potential investors is exhausted and the scheme collapses.

How to realize that you are a victim of a Ponzi scheme?

You can realize if you are a victim of a Ponzi scheme after observing if the investment scheme you’re involved with possesses any of the warning signals. Firstly, Ponzi schemes often promise quick and significant returns with little or no risk. They do not possess legitimate proof of registration with the Securities and Exchange Commission (SEC). Besides, Ponzi schemes often maintain a consistent flow of returns usually at the early stage regardless of the market conditions. Ponzi schemes do not deploy clear and easy-to-understand investment strategies. They make investors understand that their investment models are too complex to understand.

How to protect against Ponzi schemes?

One can protect against Ponzi schemes by learning how they work and understanding their operations in order to avoid any involvement with them.

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