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What is a Ponzi scheme, and how to avoid it?

What is a Ponzi scheme, and how to avoid it?
Author: Rakshita Jain
27-Jun-2022

Key Highlights

  • A Ponzi scheme is a fraud scheme where the scammer pays the previous investors with the money he takes from the new investors.

  • It is named after a fraudster-Charles Ponzi, who duped investors in the 1920s

  • When the scammers fail to bring new investors, their Ponzi scheme collapses, and the investors face huge profits.

  • The Crypto market experiences many Ponzi schemes, and investors must be active in identifying them to avoid frauds and scams.

The surging interest of people in investments and greed to get higher returns has led to the existence of Ponzi schemes. People are losing millions of their hard-earned money in such fraudulent schemes. Hence, if there is anything worthy of your read before attempting random investments, it is this blog.

What is a Ponzi scheme?

A Ponzi scheme is a fraud scheme where the money is taken from new investors to pay off the previous investors. It promises high returns and low or no risk on the investments to attract people. The fraudsters who launch these schemes vanish with their money in most cases after their investment system collapses due to a lack of new investors. 

Why is it called "Ponzi"?

Well, such schemes got their name from a fraudster-Charles Ponzi, who duped investors in the 1920s. Though incidents like Ponzi schemes have also happened in the mid-to-late 1800s, Charles and his fraudulent scheme gave them a name. 

Charles promised his clients a 50% return on their investments within 45 days or a 100% return in 90 days. He presented an investment plan to its investors, stating that he buys cheap postal reply coupons in other countries with their money and redeems them with US postage stamps at a higher value. In other terms, he told them he earns profit from the price gap between the value of those postal coupons in the US and other countries. But in reality, he was only paying earlier investors using the investment money of the new investors, and there was no actual investment going on.

His scheme survived for a year, after which it collapsed due to the lack of enough new investors to pay off the old investors. It was a $20 million fraud at that time that equals $271 million in 2022. While similar schemes have taken place before also, Ponzi's scheme put such fraudulent plans under the spotlight.

How does a Ponzi scheme work?

Any Ponzi scheme begins with scammers telling a group of investors a complicated investment plan. These plans exhibit low risk and still high returns to attract investors to deposit money. But in reality, investors' capital goes into the pockets of the scammers instead of any actual investment. The scammers continue to attract new investors and use their money to pay dividends to previous investors. Like this, it creates a vicious circle where the plan earns no money, and only the invested amount shuffles between the investors.

These schemes go smooth only till the scammers continue to find new investors and use their money to pay the old investors. But when many investors demand their invested amount and profit together, the scammers run out of money. As a result, their scheme collapses in a blink of an eye. Neither the investors get their promised profit nor their investments.

What are Crypto-related Ponzi schemes?

The Crypto space is full of opportunities. It is well known for its high-profit potential and innovative technology. But the lack of public education and awareness about it sometimes leads to big fraud and scams. 

The scammers display a fake crypto enterprise and attract investors with a complex investment plan and big profit. Investors who do not bother to know about cryptocurrency's functioning and technical aspects fall very easily into such traps. There is either a new and less heard cryptocurrency or some crypto investment plan that fraudsters use to set up a trap for crypto investors. 

Examples of the biggest Ponzi schemes are -One coin, Bitconnect, and Gainbitcoin.

Here is a summary of them:

One coin
It was founded by Bulgarian fraudster Ruja Lgnatova who managed to continue it from 2014 to 2019. It was a fraud of $5.8 billion that marketed Onecoin as a "Bitcoin Killer" and big crypto innovation. It worked on a multi-level marketing model that pays its members cash and Onecoin each time they add new investors to the business. The coin was running without any blockchain and still managed to dupe many crypto investors. 

Bitconnect
Bitconnect, launched in 2016, was another biggest Ponzi scheme related to crypto. The investors of Bitconnect need to purchase BCC tokens and lock them on the platform. Then they were asked to wait for crypto trading bots to use their locked funds to trade and make a profit. The project promised an unsustainable return of 40% to its investors, which caused its decline in 2018.

GainBitcoin
India has one of the largest numbers of crypto investors, and fraudster Amit Bharadwaj took advantage of this fact. He launched Gainbitcoin in 2016 as an India-based cloud mining platform. It promised to generate monthly returns of 10% for 18 months regardless of the market conditions. The project collected over 395,000 to 600,000 bitcoins amounting to over Rs 1 lakh crore in only a year. In 2017, the authorities could not find any physical mining equipment or operations with him to support this elaborate scheme. This scheme is becoming the biggest Ponzi scheme in the crypto world as the authorities are inquiring about it.

How do you know if it is a Ponzi scheme?

It is essential to take time and ensure that the investment you are planning goes to a legitimate enterprise or person. Here are a few things you can consider for checking if the investment is genuine or a Ponzi scheme.

Abnormally high returns
Abnormally high returns and low risk is the first and most strong sign of an investment plan being a Ponzi scheme. Scammers prepare such schemes to tempt people with high paybacks and lower risks to attract more new investors easily. One should look out for these factors and avoid such investment plans.

Unclear Business Model
Scammers wrap their investment scheme with complex terms and procedures to ensure that none of their investors can find its loopholes. Investors who are technically challenged or lazy to find the functioning of an investment scheme easily trust an investment strategy without knowing much about it. Hence, stay away from those investments which you do not understand.

Guaranteed consistent returns
No investment based on market conditions can come with a "guarantee". So if you repeatedly see or hear such alluring words in an investment, avoid it. We all know the price of cryptocurrencies keeps fluctuating according to market conditions, so do not let your greed cover your common sense for overly assured returns. 

Non registered enterprises
Any business entity not registered under the SEC or state regulators can turn out fraudulent anytime. 

Reinvestment pressure 
If any scheme pressurizes you to reinvest to redeem your previous rewards, it can be a Ponzi scheme. Since Ponzi schemes require continuous inflow of money to reward their investors, reinvestment is a common strategy they use for it.

Blind trust in family and friends
Most regular people who fell into the trap of Ponzi schemes either trusted their relatives or some friends. Fraudulent businesses often create trust by using human relations, so they do not trust any friend or relative for investment if they do not know how it works.

How to avoid Ponzi schemes?

  • Trust only registered and verified financial institutions and advisors.

  • Always cross-question with the investment advisor till he clears all your doubts and his answers fully satisfy you.

  • Do not invest due to FOMO (fear of missing out) in the investment plans in which your friends and family members have invested.

  • Make sure to do thorough research about the background of the enterprise and its past performance before giving it your money.

What is the difference between a Ponzi and Pyramid scheme?

A Ponzi scheme involves money from new investors to pay the old investors. The scammers give the investors the illusion that they are making a profit, but in reality, the money is only shuffling from one investor to another. 

On the other hand, a pyramid scheme involves investors getting money by recruiting new investors into it. 

Let's consider an example-

PYRAMID SCHEME
Say "A" starts a pyramid scheme with Rs 1000. He charges people Rs1000/month to become a part of his earn plan in which they will get Rs900 for every new investor they bring who pays Rs1000/month. It means from every new investor, "A" takes Rs1000/month, out of which Rs900 he is paying to the investor who has brought that new investor and keeping Rs100 with himself. This plan works fine till the new investors keep coming, but once the investors stop joining, the existing investors will not make any money but still need to pay Rs1000/month to "A". As a result, they might quit, followed by a few more investors quitting, and the whole pyramid collapses.

PONZI SCHEME
In a Ponzi scheme, the scammers tell the investors they are making a legitimate profit. But in reality, they only use money from new members to pay the existing ones. This process runs smoothly until many investors demand their money and profit together, and the scammers run out of money because they have not generated any real profit.

Conclusion
Ponzi schemes take advantage of investors' greed and lack of awareness. Such fake schemes showcase high-profit margins and low risk to become the first choice for investors. But in reality, they make no profit and only operate by shuffling money from new investors to the old investors. Every crypto investment depends on the market conditions and hence can not guarantee returns. One should do good research and clear all doubts before giving them his hard-earned assets. 

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