What is a Ponzi scheme?

A Ponzi scheme is an investment opportunity which is actually built upon fraud. In such an operation, interest or returns paid to initial investors are actually given from the investments made by later investors. Assuming the scheme continues to operate, this has the possibility to continue until payments due exceed the remaining funds from new investments being made.

However, not all failed investment opportunities are fraudulent Ponzi schemes. The classification relies on the distinction mentioned above, specifically that returns are paid from subsequent investments, rather than an actual profit by the business operation. Some Ponzi schemes may have an amount of earnings, but those are less than the payments that are returned to investors, meaning that the system is set to collapse by its own design.

The name of this type of fraud is taken from the first truly infamous man to use the scheme: Charles K. Ponzi. In 1920, some years after arriving to the United States from Italy, Ponzi began his scheme. His claim was to be performing arbitrage with international postal reply coupons (IRC), used to purchase postage stamps.

Ponzi claimed that he would have money sent to agents abroad, such as in Italy, where they would purchase the coupons. Those would then be sent to the United States and redeemed for stamps of higher value. His claimed net profit after costs and expenses, and considering currency exchange rates, was over 400%.

However, after pulling in millions of dollars, it eventually became apparent that the investment plan was nothing but a fraud. It was uncovered that, in order to reach the level of investments that were made, 160 million coupons would have needed to be issued. In reality, only 27,000 had been. Soon afterward, Ponzi was arrested and indicted.

Such Ponzi schemes continue frequently until this day. The Bernard Madoff investment scandal is alleged to be a Ponzi scheme, or bear similarities to one in some areas of its structure. On the Internet, terms such as "high-yield investment program" ("HYIP") and "offshore investment" can often conceal an underlying Ponzi scheme. The U.S. Securities and Exchange Commission (SEC) may make a charge against the investment program is that it is selling unregistered securities.

Some Ponzi schemes offer a supposedly long-term opportunity, with only medium rate of return, which is still unsustainable since they do not have profits to cover such interest. Others offer extraordinarily high rates. Ponzi's plan offered 50% interest in 45 days, but similar fraudulent investment opportunities can be found offering far more, or even much less.

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