What Is a Ponzi Scheme?

A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors. A Ponzi scheme is a fraudulent investing scam which generates returns for earlier investors with money taken from later investors. This is similar to a pyramid scheme in that both are based on using new investors’ funds to pay the earlier backers.

Both Ponzi schemes and pyramid schemes eventually bottom out when the flood of new investors dries up and there isn’t enough money to go around. At that point, the schemes unravel.

Key Takeaways

  • The Ponzi scheme generates returns for older investors by acquiring new investors, who are promised a large profit at little to no risk.
  • The fraudulent investment scheme is premised on using new investors’ funds to pay the earlier backers.
  • Companies that engage in a Ponzi scheme focus their energy into attracting new clients to make investments, otherwise their scheme will become illiquid.
  • The SEC has issued guidance on what to look for in potential Ponzi schemes including guarantee of returns or unregistered investment vehicles with the SEC.
  • The largest Ponzi scheme was carried out by Bernie Madoff, conning thousands of investors out of billions of dollars.

Understanding Ponzi Schemes

A Ponzi scheme is an investment fraud in which clients are promised a large profit at little to no risk. Companies that engage in a Ponzi scheme focus all of their energy into attracting new clients to make investments.

This new income is used to pay original investors their returns, marked as a profit from a legitimate transaction. Ponzi schemes rely on a constant flow of new investments to continue to provide returns to older investors. When this flow runs out, the scheme falls apart.

Origins of the Ponzi Scheme

The term “Ponzi Scheme” was coined after a swindler named Charles Ponzi in 1920. However, the first recorded instances of this sort of investment scam can be traced back to the mid-to-late 1800s, and were…

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