What is a Ponzi scheme?

A Ponzi scheme is an investment fraud in which the so-called profits of the early investors are paid with the money of the ones who come in later, not with real earnings. It's named after Charles Ponzi, who in 1920 took in between 15 and 20 million dollars in Boston from about 40,000 people by promising 50% in 45 days. It works as long as more money comes in than goes out; when new investors stop arriving or many ask for their money at once, it collapses. The SEC sums up the warning signs in its investor alert on Ponzi schemes.

How does a Ponzi scheme work, step by step?

The mechanism is always the same, whatever the century or the product:

1. The promise. A manager offers a high and, above all, steady return: 10% a year no matter what the markets do, or 30% a month as in 1876 Madrid. The explanation is vague or “secret”: postal coupons, an options strategy, a new currency.
2. The first ones get paid. The manager pays the first clients what he promised, right on time. He pays them with the money of those who come in afterward. Those payments are the fraud's best advertising.
3. Word of mouth. The ones who've been paid bring in family and friends. The scammer doesn't need to sell: his clients sell for him. It's Law of Deception No. 3: “Pay the first ones, and they'll bring you the next.”
4. Reinvestment. Most people don't withdraw their gains; they leave them in because their statements say they're growing. That gives the manager a huge margin: he only has to pay the few who ask for their money.
5. The collapse. It comes when less money comes in than is being claimed: a crisis, a rumor, a newspaper story or a wave of withdrawals. Madoff was brought down by the 2008 financial crisis; Ponzi, by an investigation in the Boston Post.

The difference from a real fund is that here there's nothing underneath. Either the manager doesn't invest, or he invests a tiny fraction. Ponzi, who took in millions, spent less than $100 on postal coupons.

Why does a Ponzi scheme always collapse?

Simple arithmetic. If you promise 10% a year without generating any profit, every year you need 10% more new money to come in just to cover what you already owe, on top of whatever the manager spends on his own lifestyle. The debt keeps growing, and new money has a limit: the number of people willing to believe.

A scheme can last a long time if it promises little and looks solid. Madoff offered moderate, regular returns, never spectacular ones, and operated for decades. Baldomera Larra promised to double people's money, and her savings bank barely lasted a few months. The bigger the promise, the sooner the end.

What are the most famous Ponzi schemes? Six examples

Six real cases, all documented by the courts or the press of the time, that show the same mechanism in different disguises:

1. Baldomera Larra (Madrid, 1876). The daughter of the Spanish writer Mariano José de Larra opened a savings fund, the Caja de Imposiciones, on Madrid's Plaza de la Paja and promised 30% a month. She paid the old investors with the new ones' money. When clients began demanding their money back, she fled; she was arrested in Paris and extradited to Spain. That was 44 years before Ponzi. We tell the story in the case of Baldomera Larra.
2. Charles Ponzi (Boston, 1919–1920). He promised 50% in 45 days by buying international reply coupons. He was arrested on August 12, 1920, and his surname became the name of the fraud. The full story is in the case of Charles Ponzi.
3. Bernard Madoff (New York, until 2008). A former Nasdaq chairman whose prestige nobody questioned. He confessed in December 2008, pleaded guilty to 11 counts and in June 2009 was sentenced to 150 years. His clients lost about $17.5 billion in principal, according to the trustee; the Justice Department's victim fund has returned more than $4 billion to more than 40,000 victims. Read the case of Bernie Madoff.
4. Allen Stanford (Antigua, until 2009). He sold certificates of deposit from his Caribbean bank with impossible interest rates, mostly to savers in Latin America. A jury convicted him in 2012, and the judge sentenced him to 110 years for a $7 billion fraud.
5. Lou Pearlman (Florida, until 2007). The creator of the Backstreet Boys and NSYNC took more than $300 million from investors with an airline and a savings plan that didn't exist. He was sentenced to 25 years, and his victims got back a few cents on the dollar.
6. The “romance Ponzi” (Europe, 2017–2019). At MATERIUM, that's what we call the method attributed to Shimon Hayut, the so-called Tinder Swindler: according to his victims, the luxury he used to seduce one woman was paid for with the previous one's money. It's the same logic, applied to a date.

What are the red flags of a Ponzi scheme?

• High, regular returns. No market goes up the same amount every month. Perfect consistency is a red flag, not a guarantee.
• A strategy nobody can explain. “It's secret,” “it's too technical,” “just trust me.”
• It isn't registered. Neither the manager nor the product shows up in the regulator's register.
• Paperwork produced by the manager himself. Statements, certificates and audits that don't come from an independent third party.
• Trouble withdrawing your money. Delays, new fees or pressure to reinvest.
• It's sold among people who know each other. A community, a club, a church or a family: trust takes the place of checking.

What should you do if you suspect a Ponzi scheme?

Don't invest any more and don't bring anyone in. In the US, look up the person and the firm on FINRA BrokerCheck and in the SEC's adviser search on Investor.gov; in the UK, check the FCA Register and the FCA Warning List. If you've already paid, keep all the evidence, talk to your bank and report it: in the US to the SEC, to the FTC at ReportFraud.ftc.gov and, if it happened online, to the FBI's IC3; in the UK to Report Fraud, the service that replaced Action Fraud. And be wary of anyone who offers to recover your money for a fee: that's a recovery scam, a second fraud.

To review a specific offer, use the scam checker. And if you're not sure whether what you're being offered is a Ponzi scheme, a pyramid scheme or an MLM, read the comparison of Ponzi vs pyramid scheme vs MLM.