According to the U.S.

Securities and Exchange Commission (2011), a Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. What this means is that new money is only generated when new investors are found to add money to the system. Unlike traditional investments, the Ponzi scheme does not generate money on its own because it only purports to be an investment scheme, but the money is not used to invest in anything legitimate. Because of the unique structure of Ponzi schemes, they require a constant flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out (SEC, 2011). This is because the system is by its very nature unstable. The lure of a Ponzi scheme is usually the promise of an abnormally high and/or quick return on ones investment. This creates the drive for a quick influx of business capital. After a while, however, the system is either too large to make payments to those who are due, or has so long that it becomes too difficult to attract new investors. In either case, the inability of the scheme to generate a revenue stream of its own leads to its inevitable collapse. Dunn (2004) reveals that the Ponzi scheme obtained its names from Charles Ponzi, an Italian immigrant who convinced thousands of residents in Boston and the wider New England region invest in a postage stamp speculation scheme. Initially an arbitrage scheme, Ponzi convinced investors to take advantage of the arbitrage of international reply coupons for postage stamps (Dunn, 2004). What this means is that Ponzi was convincing investors that they could take advantage of the differences in exchange rates between countries to make money on postage stamp transactions.

To many people in the 1920s, Ponzis scheme seemed to be an incredible opportunity. Ponzi convinced them that he could double their investment in just 90 days, compared with the 5% interest that could be gained from leaving their money in a bank savings account (Dunn, 2004). With testimonials included in newspapers from real-life postal carriers and other investors, Ponzi was known to take in as much as $1 million in a three-hour period or less (Dunn, 2004). Eventually, however, the scheme began to fold in on itself as people wondered where the money was actually being generated. An investigation into the scheme found that Ponzi had only purchased approximately $30 worth of these mail coupons, with the rest of the money being generated by new investors who had no idea that Ponzi was just passing along money to make it look like his schemes was generating millions of dollars (Dunn, 2004). By the time Ponzi was convicted, he was over $2 million in debt. Over the course of his scheme, Ponzi managed to pocket about $20 million in only a few months, which when adjusted for inflation is over $200 million in todays dollars (Dunn, 2004). Although it would seem that more savvy investors today would beware of an investment that seems too good to be true, the scheme has grown more pronounced. Nowhere is this more evident than in the number of investors attracted to Bernie Madoff and his modern day Ponzi scheme. Madoff, over the course of several years, orchestrated a multi-billion dollar Ponzi scheme that swindled money from thousands of investors (SEC, 2011). The only reason that Madoff was eventually discovered was that a large number of investors wanted to redeem their accounts and Madoff suddenly owed $7 billion that he was unable to pay (Lenzner, 2008). By this time, Madoff still seemed legitimate, but investors were becoming wary about the secret trading system utilized by Madoff and his company Ascot Investments.

There was one subtle yet distinct difference between Madoffs fraud and the Ponzi schemes of yesteryear. Unlike the masterminds of many Ponzi schemes, Madoff did not promise spectacular short-term investment returns. Instead, his investors phony account statements showed moderate, but consistently positive returns even during turbulent market conditions (SEC, 2011). With this presentation, thousands of investors were attracted to what seemed to be both a plausible and stable investment opportunity. What they eventually discovered was that Madoff was paying off older investors with money from newer investors. Madoff repackaged the Ponzi scheme as a safe long-term investment, attracting thousands of investors who were looking for security in a sound investment rather than the promise of outsize returns (Creswell & Thomas, 2009). In an attempt to educate the public regarding the nature of Ponzi schemes, the SEC has released general warning signs that an investment could be a Ponzi scheme, the most noticeable of which are: high investment returns with little or no risk, overly consistent returns and secretive and/or complex strategies (SEC, 2011). Essentially, Ponzi schemes differ from traditional investments which tend to go up and down over time and involve registered investments that comply with laws concerning transparency and the ability to access information about the companys management, services and finances. An investment that generates regular, positive returns regardless of overall market conditions should be investigated more closely to validate its legitimacy (SEC, 2011).

References Creswell, J. and Thomas, L. (2009). The Talented Mr. Madoff. The New York Times: online edition. January 24, 2009. Retrieved from: http://www.nytimes.com/2009/01/25/business/25bernie.html?pagewanted=all Dunn, D. (2004). Ponzi: The Incredible True Story of the King of Financial Cons. NY: Broadway Publishing. Lenzner, R. (2008). Bernie Madoffs $50 Billion Ponzi Scheme. Forbes Magazine: Online Edition. Retrieved from: http://www.forbes.com/2008/12/12/madoff-ponzi-hedge-pf-iiin_rl_1212croesus_inl.html U. S. Securities and Exchange Commission. (2011). Ponzi Schemes Frequently Asked Questions. Retrieved from: http://www.sec.gov/answers/ponzi.htm