PONZI SCHEME
1. Context
The government is working to clamp down on financial apps that are taking investors for a ride, with false promises of lucrative returns, finance minister Nirmala Sitharaman said on Sunday, adding that there was, however, no plan as yet to bring financial influencers under a separate regulatory framework.
2. About Ponzi Scheme
- It is a fraudulent investing scam promising high rates of return with little risk to investors.
- A Ponzi scheme is a fraudulent investing scam which generates returns for earlier investors with money taken from later investors.
- This is similar to a pyramid scheme in that both are based on using new investors' funds to pay the earlier backers.
- Both Ponzi schemes and Pyramid schemes eventually bottom out when the flood of new investors dries up and there is not enough money to go around.
- At that point, the schemes unravel.
2. Key points
- The Ponzi scheme generates returns for older investors by acquiring new investors, who are promised a large profit at little to no risk.
- The fraudulent investment scheme is premised on using new investors' funds to pay the earlier backers.
- Companies that engage in a Ponzi scheme focus their energy on attracting new clients to make investments, otherwise, their scheme will become illiquid.
- The SEC has issued guidance on what to look for in potential Ponzi schemes including guarantee of returns or unregistered investment vehicles with the SEC.
- The largest Ponzi scheme was carried out by Bernie Madoff, conning thousands of investors out of billions of dollars.
3. Understanding Ponzi Schemes
- A Ponzi scheme is an investment fraud in which clients are promised a large profit at little to no risk.
- Companies that engage in a Ponzi scheme focus all of their energy on attracting new clients to make investments.
- This new income is used to pay original investors their returns, marked as a profit from a legitimate transaction.
- Ponzi schemes rely on a constant flow of new investments to continue to provide returns to older investors. when this flow runs out, the scheme falls apart.
4. Origins of the Ponzi Scheme
- The term "Ponzi Scheme" was coined after a swindler named Charles Ponzi in 1920.
- However, the first recorded instances of this sort of investment scam can be traced back to the mid-to-late 1800s and were orchestrated by Adele Spitzeder in Germany and Sarah Howe in the United States.
5. Ponzi Scheme Red Flags
Regardless of the technology used in the Ponzi Scheme, most share similar characteristics. The Securities and Exchange Commission has identified the following traits to watch for:
1. A guaranteed promise of high returns with little risk
2. A consistent flow of returns regardless of market conditions
3. Investments that have not been registered with the Securities and Exchange Commission (SEC)
4. Investment strategies that are secret or described as too complex to explain
5. Clients are not allowed to view official paperwork for their investment
6. Client facing difficulties removing their money
| For Prelims: Ponzi Scheme, Pyramid Scheme |
|
Previous Year Questions
1. Ponzi Scheme refers to ____ Scam. (NTPC 2016)
1. coal allocation
2. investment
3. fodder
4. food grain
Answer: 2
|
Source: Investopedia
