Understanding Ponzi and Pyramid Schemes

Much has been talked about in the press about the Madoff scandal, and his use of a “ponzi” scheme. But what exactly is a “ponzi” scheme and how is it related to a “pyramid” scheme, and most importantly, how can I make sure I am not a victim of either?

First, there actually was someone named Ponzi, Charles Ponzi, an Italian immigrant who is known as one of the greatest swindlers in American history. He had quite the storied past before even arriving on U.S. shores.

Wikipedia has a much too long and involved explanation of Charles Ponzi and his infamous Ponzi scheme for my limited attention span. But in brief, Wikipedia defines a Ponzi scheme as:

[A] fraudulent investment operation that pays returns to investors out of the money paid by subsequent investors rather than from profit. The term “Ponzi scheme” is used primarily in the United States, while other English-speaking countries do not distinguish colloquially between this scheme and other pyramid schemes.

The Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going.

The system is destined to collapse because the earnings, if any, are less than the payments. Usually, the scheme is interrupted by legal authorities before it collapses because a Ponzi scheme is suspected or because the promoter is selling unregistered securities. As more investors become involved, the likelihood of the scheme coming to the attention of authorities increases.

Perhaps too simplistic, but I see a Ponzi scheme as robbing Peter to pay Paul.

Another term tossed about is “pyramid” scheme.  I’ve had various family members (who will remain nameless) that have participated in various “get rich quick” business opportunities that have turned out to be nothing more than a pyramid scheme or a “multi-level marketing” business (in most cases the same thing). 

To be clear, a pyramid scheme is

Pyramid schemes exploit greed and gullibility. A successful pyramid scheme combines a fake yet seemingly credible business with a simple-to-understand yet sophisticated-sounding money-making formula. The essential idea is that the mark, Mr. X, makes only one payment. To start earning, Mr. X has to recruit others like him who will also make one payment each. Mr. X gets paid out of receipts from those new recruits. They then go on to recruit others. As each new recruit makes a payment, Mr. X gets a cut. He is thus promised exponential benefits as the ”business” expands.

Such ”businesses” seldom involve sales of real products or services to which a money value might be easily attached. However, sometimes the ”payment” itself may be a non-cash valuable. To enhance credibility, most such scams are well equipped with fake referrals, testimonials and information. Clearly, the flaw is that there is no end benefit. The money simply travels up the chain. Only the originator and a very few at the top rungs of the pyramid make significant amounts of money. The amounts dwindle steeply down the pyramid slopes. Of course, the worst off are at the bottom of the pyramid: those who subscribed to the plan, but were not able to recruit any followers themselves.

Some network or multi-level marketing businesses, which sell real products and rely on the price differentials between the manufacturer’s dispatch ramp and the retail counter, may verge on the borderline between ”smart” and ”scam”.When a pyramid does involve a real product, such as Holiday Magic cosmetics in the United States in the 1970s, new “dealers” who’ve paid enrolling fees are encouraged, in addition to selling their products, to become “managers” and recruit more new “dealers” who will also pay enrolling fees. As the number of layers of the pyramid increases, new recruits find it harder and harder to sell the product because there are so many competing salesmen. Those near or at the top of the pyramid make a lot of money on their percentage of the enrolling fees and on commissions for the supplied products, but those at the bottom are left with inventories of products they can’t sell. However, most multi-level marketing businesses are not pyramid schemes.

And to be clear on the differences between the two:

Pyramid schemes are not to be confused with Ponzi schemes, named after Charles Ponzi, which also rely on greed and gullibility but are quite different. In a Ponzi scheme, all new money is paid to “Mr. Ponzi” for investment in his incredibly profitable business and he distributes a portion of it to other members as “interest” or “investment income” whereas in a pyramid, money is paid to the next level upward in the pyramid.

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