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What Does Ponzi Scheme Mean?

Last Updated on February 27, 2024

James Headshot
Written by
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Quick Answer:

A Ponzi scheme is a fraudulent investment scam that promises high rates of return with little risk to investors. It generates returns for earlier investors by acquiring new investors, rather than from legitimate business activities.

This type of scheme leads to a cycle where the money from new participants is used to pay the promised returns to older investors, creating the illusion of a profitable business. However, since the scheme relies on a constant influx of new investments to continue, it inevitably collapses when the flow of new investors dries up or when too many investors try to cash out their funds.

Ponzi schemes are named after Charles Ponzi, who became infamous for using this technique in the early 20th century. They are illegal and unethical, and they can lead to significant financial losses for investors when the scheme eventually fails.

It’s common knowledge that the creative nature of cryptocurrency projects and the revolutionary blockchain technology can yield high returns on investments. Alongside the fiat currency market, the crypto industry has established a new world of alternative investment opportunities where the integrity of financial documentation and transaction security are paramount aspects of investing, whether the assets are fiat or crypto

Unfortunately, some people or corporations purposefully distort and misrepresent accounting information and regulations to create a false picture of an organization’s financial soundness or to negotiate a lucrative deal at the expense of others. Investors’ hopes of becoming millionaires overnight, the potential of discovering the next super-valuable coin, as well as a general lack of information about the sector are all exploited by scammers who plot multiple fraudulent schemes.

Forging financial records, exaggerating revenue using one-time profits, and identity fraud are just a few examples of those scamming strategies. In this article, we’ll focus on one, in particular, a type of pyramid scheme known as The Ponzi Scheme.

Ponzi Scheme written on bitcoin

The Definition of Ponzi Scheme

The Ponzi scheme is a type of investment scam similar to a pyramid scheme since it makes money for existing investors by recruiting new ones. In essence, this scheme relies on a steady stream of fresh capital to keep supplying returns to the existing participants. 

Ponzi scheme promoters typically claim that they are investing the assets they acquire from new investors into a lucrative venture of some sort and that they can expect high profits.

The fraudsters also guarantee prospective investors a high rate of return from their fixed-term investments with no financial risk to their own assets from this successful venture. But, it is completely unrealistic for a Ponzi Scheme to expand, as it can never get more revenue than what its participants have supplied into it. That’s why all of the participants in a Ponzi Scheme can’t make a profit since the scheme only has the money they’ve contributed to it.

These scammers have no intention of investing the new money (money from new investors) into any legitimate venture. What they do instead is use it to compensate earlier investors, making them believe the enterprise is successful, and retain a part of the accumulated assets for themselves. The actual success of the scheme lies in continuing to attract new investors.

In the instance of the crypto Ponzi scheme, the scammers create fictitious crypto companies and entice investors with ‘become-an-overnight-millionaire’ stories and false figures. New investors who lack solid understanding or expertise in cryptocurrency trading are at a greater degree of risk of being involved in such an investment scam.

dollar bills pyramid

The Origins of the Ponzi Scheme

The Ponzi scheme is named after the Italian con artist and swindler Charles Ponzi. Namely,  Ponzi defrauded investors by employing a postage stamp speculating scam in the 1920s. Back in those days, the US Postal Service had devised international reply coupons that could be used worldwide. 

These coupons enabled a sender to pre-purchase postage and include it in their letter. The voucher could be taken to the local post office and redeemed for the priority airmail postage stamps required to send the response letter. In this way, Ponzi illegally profited from the disparities in prices of the same item.

Despite the fact that this approach is known as arbitrage, Ponzi grew too ambitious and expanded his activities in order to earn an illegal profit by misleading a large number of people for personal financial benefit, becoming infamous in the process. 

financial trap scam illustration

A Ponzi Scheme VS a Pyramid Scheme

What Is a Pyramid Scheme?

The Ponzi scheme is a type of pyramid scheme.

Pyramid schemes are investment scams that promise big and quick profits in return for the financial participation of an increasing number of investors. As the number of new participants in the scheme increases, it becomes increasingly difficult to attract new investors and fresh investments for paying off the later investors in this pyramid-shaped investment hierarchy.

As a consequence, the majority of participants in this financial scheme are unable to capitalize on their investment, which makes them aware that they will never get the promised returns.

The Main Difference Between the Ponzi Scheme and the Pyramid Scheme

The key distinction between a Ponzi scheme and a pyramid investment scam is that the latter’s investors are informed of the fact that they can only benefit if new investors are attracted to the investment scheme.

This is not the case in the instance of a Ponzi scheme, in which new investors think that they are investing in a secure and legitimate venture and that their profits are guaranteed and have no idea their money goes towards paying off earlier investors.

ponzi word on top of coins

What Are the Red Flags for a Ponzi Scheme?

While a more experienced investor on the crypto market could easily detect the market conditions that could lead to investment fraud, the average investor should be on the lookout for the following red flags that alert at a possible involvement in a Ponzi scheme:

  • A promise of an extremely low-risk investment, high rate of return,  as well as consistent returns, regardless of the market conditions. When something is too good to be true, it usually IS too good to be true. 
  • Unregistered investments. Prior to participating in an investment scheme, be sure the original investor is registered with the US Securities and Exchange Commission (SEC).  If all is in order, the prospective investor should be able to get additional information about the business to validate its legitimacy and reliability.
  • Unlicensed sellers. The state securities laws and regulators in many countries worldwide require investment consultants and the associated businesses to be licensed or authorized. Typically, Ponzi schemes involve unauthorized promoters of the investment scheme or unlicensed organizations. 
  • Obscure documentation on investments. Investors are not permitted to access the relevant documents regarding their payment. 
  • Investment strategies that are too hard to understand. When a set of rules is too complicated to follow, the venture is likely a scam. 

Finally, please note how the language combines unsupported, ambiguous claims or adjectives stressing the scheme’s greatest features in superlatives. It’s just another red flag for impending investment fraud. 

alert sign on laptop

A Few Words Before You Go…

Whenever there is the prospect of a lucrative deal, someone is always ready to flip things around – in the wrong direction. Fraudulent financial schemes are relatively uncommon in the world of finance. However, there’s been a notable rise of various scamming schemes that do necessitate considerable prudence on the part of the investors, particularly the less experienced ones. 

A Ponzi scheme is often an intricate investment scheme meant to entice investors with grandiose promises of profits as a return to their investment on behalf of a typically fake company. However, the fraudsters who plan such a scheme almost never invest these assets. Instead, they use them to pay off the early investors who are already a part of this fraudulent investment strategy – and take a big chunk of the funds themselves, of course.

Any investor should be well aware of the red flags pointing to such a scamming scheme, since they may be disastrous for the individual or the company, particularly in this day and age, when fraudulent practices can get even more intricate, thanks to the emergence of highly advanced computer software and banking algorithms.

About The Author

James Headshot
Written by

Crypto Technical Writer

James Page, previously the lead writer at Crypto Head and a registered psychologist, brings a unique perspective to the world of blockchain and cryptocurrency.

His extensive experience in the industry and ability to present complex concepts in an understandable manner make his articles a valuable resource for readers seeking to navigate the ever-evolving crypto landscape.

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