What is a Ponzi Scheme?

What is a Ponzi scheme? Where does it get its name? Are these systems forbidden in Switzerland? moneyland.ch answers these questions here.

What is a Ponzi scheme?

A Ponzi scheme is a type of scam in which con-artists convince their victims to trust them with investment capital. Typically, victims are offered high returns with low levels of risk. In reality, the scammers either generate no returns at all, or the actual gains do not match the promised yields. A key component of the system is that victims are required to continue reinvesting their money and purported returns on an ongoing basis, so that the scammer can continue to freely access the invested capital over a long period.

If an investor requests to have their money paid out, the scammers use other investors’ money to meet these demands. Ponzi schemes work as long as they can attract enough new money to continue paying out possible withdrawals from existing customers. But if too many investors demand their money (including promised returns) at any one time, the system collapses.

The popular saying, “robbing Peter to pay Paul” is often used when referencing this type of scam.

Why is it called a Ponzi scheme?

The term Ponzi scheme references con-artist Charles Ponzi. Although Ponzi did not invent this type of scam, his use of the system gained him notoriety in 1920.

Who was Charles Ponzi?

Charles Ponzi – born Carlo Ponzi – was an Italian con-artist who used the system now named after him to steal millions of dollars in the United States between 1919 and 1920. He convinced his clients to invest money into an arbitrage-based business. The invested money would – according to Ponzi – be used to buy international reply coupons from the International Universal Postal Union in Europe, where they were significantly cheaper than in the US. The coupons would then be sold in Boston at a profit.

Ponzi issued so-called Ponzi notes and promised those who bought them that they would double their capital within 90 days. Those returns were far more attractive than the several percent of interest per year offered by conventional banks. Resultingly, demand for the notes was high, and Ponzi soon began opening offices around the country to onboard new customers. Some people invested their entire savings into Ponzi notes, while others even took out loans to buy in to the scheme. The steady stream of new capital enabled Ponzi to pay out the promised gains to early investors who requested withdrawals. But many investors continued to reinvest their money instead of withdrawing it.

Ponzi never implemented his arbitrage business plan. The reply slip business proposed by Ponzi was not illegal. But the details of how the purchase, transportation, and sale of the postage slips could be implemented were unclear. Whether or not the market for reply coupons even had the potential for trade on that scale was also questionable – as Ponzi would have had to sell enormous quantities of coupons to earn the needed millions of dollars in profits just from price differences between postal union member countries.

Negative media reports questioned whether the exponential growth shown by Ponzi’s scheme could even be possible. This shook investor’s confidence in the scheme, and led to investigation by authorities. Ponzi use trickery to try to make it look as though the scheme contained sufficient money to meet all investor demands, but this was eventually discovered by authorities.

Ponzi’s scheme attracted a total of 15 million dollars – which translates into more than 200 million Swiss francs in today’s money when inflation is accounted for. By the time Ponzi was sentenced to five years in prison at the end of 1920, hardly any of that capital remained. He later received additional sentences related to the Ponzi scheme.

While Ponzi is best known for the postal coupon Ponzi scheme, he continued to employ other, similar schemes, and had already served two prison terms by the end of 1920. He later attempted a similar scam in Florida, this time based on real estate investment. This also landed him a prison sentence, and eventual deportation to Italy in 1934. Ponzi died in Brazil in 1949.

Are there any recent examples of Ponzi schemes?

Charles Ponzi was not the first and certainly not the last person to lure huge amounts of investment capital with this type of system. Here are two more recent examples:

• Bernie Madoff

The Madoff case was one of the biggest Ponzi schemes in financial history. In the 1990s, the experienced and respected banker Bernard “Bernie” Madoff promised investors stable returns of around 10 percent per year. Over a period of two decades, his scheme attracted around 20 billion dollars in client capital. Madoff’s fund was so large that other investment firms invested portions of their clients’ capital in it.

Accounting for the promised returns, Madoff’s firm owed its clients over 60 billion dollars by 2008. But payments were funded by new and existing capital. Madoff took advantage of the fact that many investors leave their money invested over long periods of time.

As the former director of the Nasdaq exchange, Madoff had a great deal of experience and good connections in the financial world. This enabled his illegal scheme to carry on as long as it did – even after it first came under suspicion. His firm was even audited by the US Securities and Exchange Commission (SEC) in 2006 and came out unscathed.

But during the financial crisis of 2007, investors increasingly began pulling out of their investments. Madoff realized that his Ponzi scheme would fall apart and at the end of 2008, he warned two of his sons who worked for the firm. His sons, who claim that they had no knowledge of the fraudulent activity, informed the SEC the following day. Madoff was sentenced to 150 years in prison.

• European Kings Club

A prominent example of a Ponzi scheme in Switzerland is the European Kings Club (EKC) scam of the 1990s. The club, founded by German hospitality specialist Damara Bertges, sold shares (which it called letters) to its members for 1200 francs with the promise of a 70 percent return after one year. There was no business model behind the scheme. Payouts were only possible because more and more people continue to join the club.

The EKC operated in Austria, Germany, and Switzerland. It sold exceptionally large numbers of letters in central Switzerland. Bertges advertised herself as the friend of smalltime investors. The club gained a cult following, which actively participated in onboarding new members to the Ponzi scheme.

When the authorities began to interfere, many club members saw this activity as sabotage. Even after Bertges received a jail sentence and it became clear that more than one billion francs had disappeared, many club members remained convinced that the scheme could have worked if the authorities had not intervened.

How can I recognize a Ponzi scheme?

In most cases, Ponzi schemes are only recognized as such after they are found out. As long as investors receive the promised returns and the actual business model remains unclear, you can never be completely sure. However, there are a number of clear warning signals:

• High returns without any risk: In finance, the size of returns is always linked to the level of risk involved. If you are promised a high return without a high risk of losing money, be skeptical.
• Extremely stable returns: Returns on investment are normally dependent on many different factors, so a certain amount of volatility is normal. Investments with steady returns which are not affected by market fluctuations should be viewed with a certain amount of suspicion.
• Lack of transparency: For a Ponzi Scheme to work, it is important that investors do not clearly understand and know how their capital is being used. If a scheme’s operators are not willing or able to explain exactly what your money will be invested in, you should be concerned.
• Hassles when withdrawing money: In some cases, Ponzi schemes make it difficult for their investors to withdraw their capital. If a scheme which you are invested in does not let you withdraw the money along the with promised returns, you should consider informing the relevant authorities.
• Unregulated investments: The risk of an investment scheme being a scam is higher if the company in question is not regulated by authorities like Swiss regulatory organizations or the US Securities and Exchange Commission.

A few general rules: Never invest in anything which you do not clearly understand. If an offer seems too good to be true, it is probably a scam.

Is a Ponzi scheme the same thing as a pyramid scheme?

No. Although Ponzi and pyramid schemes share many similarities and the terms are often used synonymously, there are key differences. The main difference is that in a pyramid scheme, promised returns are linked to onboarding new clients to the scheme. Victims are promised money as payment for convincing other people to invest in the scheme.

With Ponzi schemes too, returns can only be paid out if enough new money flows into the scheme. But this fact is generally hidden from victims. Instead, victims are told that the gains are achieved by the investments made with their capital. Another difference to Ponzi schemes is that the returns promised by Ponzi schemes are not linked to requirements for investors to actively onboard new clients.

But it is obviously beneficial for Ponzi scheme operators if victims onboard additional victims by proselytizing. In some cases, scams may incorporate aspects of both pyramid schemes and Ponzi schemes (as was the case with the European Kings Club).

Are Ponzi schemes illegal in Switzerland?

Yes, Ponzi schemes are forbidden by the Swiss federal antitrust law governing unfair competition (UWG/LCD). Among other things the law prohibits service providers from making incorrect or misleading statements about their services. This would apply, for example, to people or companies who claim to invest money to earn returns, but then pay out investors using new capital inflows. It is also forbidden to offer investors a service which has benefits that hinge on onboarding additional investors.

If you are economically disadvantaged by unfair business practices, you have the right to sue for damages.

More on this topic:
How to protect yourself from credit card fraud
Online Scams and Fraud
How to protect yourself from phishing attempts