How a Ponzi scheme works

At IYE Global we investigate a number of potential investments that would fall into the realm of a Ponzi scheme. In all cases, we report our findings to the relevant lawful authorities for criminal investigation and prosecution but what exactly is a Ponzi scheme and how do these schemes work?

First a little history.

Ponzi schemes get their name from the 1920’s fraudster Charles Ponzi, who was behind the first known scheme. It became notorious throughout the United States. Quite simply, a Ponzi scheme creates the illusion of a successful fund by paying initial investors with money received from subsequent investors, whereas in reality most of the money invested is swindled. It’s essentially smoke and mirrors, a confidence trick where schemes will promise high rates of return to attract initial investment, financing bogus ‘returns’ with incoming funds and thereby attracting further investment to continue the scam.

The effect is compounded where investors leave any returns in the scheme, as the scheme does not need to pay out as much.

The scheme survives initially by convincing clients that repayments are from investment returns, rather than from new investors’ capital. It all ‘works’ seamlessly until the value of investors asking for money and “profits” out of the scheme exceeds the value of new money coming into the scheme. Once that happens the scheme will collapse. For victims of Ponzi schemes, their only hope is that their money has been repaid before this happens, although even then, it may still be clawed back by liquidators at a later date.

Why do investors continue to fall for such schemes?

Hindsight is a marvellous thing and although it may seem easy to avoid, investing in a Ponzi scheme is far easier than you might think. Confidence tricksters are good at what they do!

They will typically offer very good rates of return: the majority we see at IYE Global today offer returns of 2-3% a month. That may seem ludicrous but in the right circumstances, such figures are attainable. Most serious investors diversify their portfolios, which usually means allowing for some high-risk activity.

To further confuse potential investors, those running Ponzi schemes often tell them that the scheme will employ little-known investment strategies or exploit unusual markets to maximise returns. The sheer range and complexity of financial products available means that investors do not always understand the mechanics of investment funds or the risks involved, and are therefore less wary of such investment activity.

The current and past reputation of those running Ponzi schemes also count. Highly respected and successful individuals will always attract investment, and will often be allowed far more trust from investors happy to put their faith in an established name without scrutinising their funds as rigorously as they might.

The example we used in our previous blog is a case in point: Freddy David was sentenced to six years imprisonment this week. He ran a £14.5 million Ponzi scheme to fund a gambling addiction. Freddy was a well-respected member of the Jewish community, regulated by the Financial Conduct Authority and had previously been a senior banker.

How do these schemes continue to thrive?

Ponzi schemes generally thrive in stronger economic climates because confidence is high. Investors are happier leaving their money in what they believe is well-performing fund. More investors are attracted to the fund as the repayments to original investors suggest that high returns can be made.

Conversely, investors in a weaker economic climate are often on the look-out for better returns and can fall prey to the higher rates offered.

How do they get uncovered?

Once the balance shifts from investment to withdrawal, a Ponzi scheme is doomed. There may be a ‘run’ on the scheme where one investor finds he cannot get his money out, triggering others to also start asking for their money back, or market conditions may cause multiple investors to simultaneously demand repayment, which is of course not possible.

It is usually at this point, the authorities step in and the game is up.

You may think the severity of recent fraud convictions in the UK and USA, in particular, would go some way to prevent fraudsters from setting up Ponzi schemes in the first place but that’s not been our experience. Extreme care is required to ensure the people and investments you are being offered are genuine. IYE Global offer a due diligence service that not only checks the validity of the investment but accesses intelligence and watch reports on those involved. If you’d like to ensure the investment you’re considering is genuine, please call us on: +44 (0)20 8914 7923 or use our contact form on the IYE Global website.