What's a Ponzi Scheme

“Ponzi scheme” is a term that has been used to describe many scams and financial frauds — ranging from the failure of large NBFCs in India in the nineties to the recent scam perpetrated by Bernard Madoff on Wall Street.

The scheme is named after Charles Ponzi, who duped people by promising quick returns from trading in discounted postal stamps. In a typical Ponzi scheme, as long as new entrants keep coming-in, earlier investors get good returns. But once that stops, the scheme collapses.

Charles Ponzi promised to double investors’ money in 90 days. The returns, he claimed were from exploiting the exchange rate difference on international postal reply coupons. He convinced people on the kind of extraordinary returns the arbitrage trade could give and amassed money. He then started his own company, employed agents to propagate the scheme and made millions in a short span. But Charles Ponzi kept it in the dark that investor “returns” actually came, not from profits, but from the capital brought in by new investors. The recent Madoff scam has been likened to a Ponzi scheme. Madoff, ex-chairman NASDAQ, founder of Bernard L Madoff Securities LLC was caught in the scam this December.

Madoff was alleged to be running a $50-billion Ponzi scheme through his securities firm. Not just lay investors but many big investment firms are said to have exposure to Madoff’s firms. Bernard L Maoff owned a securities firm (started in 1960) and an asset management firm (launched in 1990s).

His funds were delivering consistent returns every year, even as conventional mutual funds faced declining returns. Madoff claimed that his strategy was investing in blue-chip stocks and buying options simultaneously to limit downsides. Things went on smoothly till money kept pouring in.

The first sign of problem was visible in December last year when some of Madoff’s hedge fund clients wanted their money back. Appeals for withdrawal totalled $7 billion.

Madoff couldn’t arrange for redemption and admitted to a scam. Madoff told the senior employees of his firm on Wednesday, December 10 when he was arrested, “it’s all just one big lie…..basically, a giant Ponzi scheme”.