Ponzi Scheme: A Big Red Flag🚩 (2024)

People might warn you to beware of the “Ponzi scheme” when it comes to investment and cryptocurrency.

Basically, a Ponzi scheme is a form of fraud where current investors are paid returns using capital acquired from fresh investors. Most people might mistake this for a Pyramid scheme, but in fact, these two scams are different. How so? Let’s take a look.

Where did this term come from?

Charles Ponzi was an immigrant to the United States, where he gained his undisputed reputation as the greatest con artist. He was born Carlo Pietro Giovanni Guglielmo Tebaldo Ponzi on March 3, 1882, in the municipality of Lugo in the northern region of Italy.

His parents, Oreste and Imelda Ponzi belonged to a prosperous Italian family that had fallen into financial hardship by the time of his birth. The young Ponzi took a job as a postal worker and still managed to enroll at Sapienza University in Rome, where he considered his time there a "four-year vacation” [1]. While at university, he came across tales of fellow Italians venturing to America to pursue fame and wealth, leading him to conclude that this was his sole viable path to “get rich quick”. Ponzi soon dropped out and boarded the S.S. Vancouver bound for Boston, Massachusetts, USA [2].

On November 15th, 1903, he finally arrived in America with only two dollars and fifty cents in his pocket (he gambled his life savings on the voyage). During his time of “four uneventful years” in the States, he worked numerous jobs, which he described were “invariably underpaid for my needs and overpaid for what I deserved” [3], he expressed his loathsome to his struggling life:

“I tried my hand at everything. From grocery clerk to road drummer. From sewing machine repair man to insurance salesman. From factory hand to kitchen and dining room help. In some of the jobs I lasted no time. In others, I lasted longer. Often, I would be fired. Oftener, I would quit of my own accord either disgusted or to avoid being fired. I shifted from one city to another. Sometimes by rail. Others, by foot. Pittsburgh, New York, Paterson, New Haven, Providence, and then Montreal, Canada.” - Charles Ponzi in his autobiography, “The Rise of Mr.Ponzi”.

However, in his account, Ponzi neglects to disclose the reasons behind his firings, such as theft and shortchanging customers. In the next few years, he continued filling in his records with many sentences for fraud and forgery as he wandered through cities including Pittsburgh, New York, New Haven, Conn., and Providence, R.I.

Ponzi eventually settled in Montreal, Canada, where he got a job as a bank teller. However, he lost this position when the bank collapsed. Typically enough, he resorted to criminal activities, leading to a three-year prison sentence in Quebec for forgery. Upon his release, he became involved in smuggling Italian immigrants into the United States, which ultimately resulted in another two-year prison term in Atlanta after being apprehended in the act.

Then sometime after, on the night before Memorial Day, he met a young beautiful girl while he was waiting for a street car at the Boylston Street subway station.

“One glance at her, at that picture of loveliness and kindness and clean vivacity! One look into her deep, dark, smiling eyes! At that pretty, round face, framed in a background of gorgeous curls! At her whole fascinating ensemble! And I was no longer able to remove my eyes from her. I remained there, staring so intently that, for my unre-pressed and evident feeling of respectful admiration, I might have appeared rude.” - Charles Ponzi describing Rose.

Her name was Rose Gnecco, and she lived in Somerville, not too far from where Ponzi was residing. Rose was swept off her feet by her older, seemingly sophisticated suitor. Eight months later, Rose and Ponzi were married at "a little church around the corner" in Vine Street, Somerville. In his own words, Rose was the greatest gift that America had ever given to him.

In 1919, following his establishment of a small export-import enterprise, Ponzi received a letter from a Spanish company soliciting an advertising catalog. Came along with the letter was an international reply coupon (IRC), which could be purchased in a Spanish post office for 30 centavos and exchanged for a U.S. postage stamp worth 5 cents, a redemption rate that was fixed by international treaty [4].

Ponzi, with his latent financial genius, immediately saw his opportunity to get rich fast, making “$15,000,000 in nine months out of a six-cent coupon”.

“Just think of it, ladies and gentlemen! Fifteen millions of golden simoleons! More money than you or I can ever hope to see! Can you picture what the bambino could do for the forgotten man in these depression times with a lone thousand dollar bill, instead of a six-cent coupon? He could pay the national debt half a dozen times, even after this administration gets through piling it up. He could pay it without batting an eye and still have more money left over than all the Morgans, and the Rockefellers, and the Mellons and the Fords put together!” - Charles Ponzi in his autobiography.

What he did with the IRCs was exchanging them for more expensive stamps in another country. To start implementing his plan, Ponzi pawned his wife's jewelry to establish his Securities Exchange Company.

At this point, Ponzi had uncovered the concept of arbitrage, which involves the simultaneous buying and selling of an asset in two separate markets. He would send money to agents working for him in other countries, where they would buy IRCs and send them back to the United States. Ponzi would then exchange the IRC for stamps worth more than he paid for them, and sell the stamps. Ponzi reportedly made more than 400 percent on some of these sales.

Feeling unsatisfied with his modest profitable scheme, Ponzi went out to seek investors, hoping to gain higher profits. The whole rack then turned to a new phase: Ponzi would entice investors with the promise of a 50% return on their investment within 45 days or a 100% return within 90 days. He assured them that he could achieve this by “exploiting the difference in international postal reply coupons' value” [5].

Six months later, he managed to turn everyone, from poor paperboys to Boston’s elite, into his investors, garnering $2.5 million in investments. As long as new investors continued to pour money in, Ponzi could pay off his older investors. This was somehow plausible, as he couldn’t rely on his IRC-trading business as it would require him approximately 53,000 of these coupons to cover 18 investors.

And so, the scheme was able to run for an incredibly long time, which enabled Ponzi to acquire a mansion in Lexington, Massachusetts, complete with air conditioning and a heated swimming pool. Allegedly, he was generating profits of $250,000 daily [6]. He managed to disarm every state officials to journalists with his charm and his ability to pay off anyone who wished to withdraw.

However, people soon started to question the validity of Ponzi’s business. The beginning of his end was about to be revealed.

The Downfall

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Ponzi and his empire started crashing down as fast as Ponzi built it.

Ponzi didn't use the increasing influx of funds from new investors to acquire more IRCs. Instead, he retained a portion of the money for himself and distributed the remainder to earlier investors. Many of these initial investors were delighted with their returns and reinvested their earnings into Ponzi's scheme, unwittingly perpetuating the scam. Whenever questioned about his operation, Ponzi evaded the questions, claiming the need to conceal such information from the public to prevent potential competitors from emerging.

As much as he enjoyed this newfound fame and wealth, his business became subject to increasing scrutiny. Ponzi filed a lawsuit against a financial writer who challenged the feasibility of his high returns within a short timeframe. Although he won the lawsuit, he and his scheme gained more attention. Another unsuccessful lawsuit was filed against him by a Boston furniture-maker further intensified the attention on his Securities Exchange Company. As a result, Richard Grozier, the publisher of The Boston Post at the time, requested reporters to investigate Ponzi in July 1920.

Financial journalist Clarence Barron discovered that Ponzi was not investing in his own scheme, despite offering extremely high returns to his clients. Ponzi had previously claimed to journalists that he invested his personal funds in real estate, stocks, and bonds, raising questions about why he favored traditional assets with maximum returns of 5 percent over his own scheme, which purported to offer returns as high as 50 percent.

Barron also calculated that covering the volume of investments made through Ponzi’s scheme would have required around 160 million coupons to have been traded, but only 27,000 coupons were actually in circulation.

Soon enough, the Post articles triggered a panic run on the Securities Exchange Company. Ponzi paid out $2 million in three days to a frenzied crowd outside his office. He mingled with the crowd, distributing coffee and doughnuts, and reassured them cheerfully that there was nothing to worry about. However, this drew the attention of Daniel Gallagher, the U.S. Attorney for the District of Massachusetts. Gallagher enlisted Edwin Pride to audit the Securities Exchange Company's books, which proved challenging due to Ponzi's bookkeeping system consisting only of index cards with investors' names [7].

Investigative journalists, the U.S. Attorney for the District of Massachusetts, and the Massachusetts Bank Commissioner were hot on his trail, aiming to uncover his true financial solvency. In the next month, Ponzi’s office was raided by regulators. At the same time, he received the Pride’s audit stating that he was approximately $7 million in debt.

Unable to retreat, Ponzi surrendered himself to the authorities, but he only pleaded guilty to one of the 86 counts of mail fraud. And so, he received a relatively lenient sentence of five years in prison.

The end.

Just kidding. After just three and a half years, Ponzi was released, only to face an additional 22 larceny charges. Representing himself for the initial 10 counts, he persuaded the jury to acquit him. The second trial, involving five counts of larceny, ended in a deadlock, but he was eventually found guilty in the third trial. This led to an additional seven to nine years in prison.

However, Ponzi managed to escape on bail and promptly launched another scheme called Charpon, which swindled people by selling them worthless swampland in Florida, promising 200% returns. He was indicted for this crime and was initially sentenced to one year in prison. Despite appealing and posting bail, he attempted to flee the country but somehow ended up being arrested. Consequently, he served the remainder of his seven-year prison term.

Upon release, Ponzi was deported to Italy but later found himself in Brazil, where he worked for an Italian airline [8]. Despite having stayed by his side from the beginning to the day he collapsed, Rose decided to divorce Ponzi in 1937 and remained in Boston, USA. And given Ponzi's financial situation, he was unable to provide for her anyway.

On January 18th, 1949, Charles Ponzi drew his last breath on his bed at Hospital Escola São Francisco de Assis in io de Janeiro at the age of 71, lonely and penniless [9].

Now, this is the end.

Most people who come across these two types of scams would typically mistake them as one. However, the only common thing these two share is that both of them are scams.

Now that we have learned how the Ponzi scheme gets its name. To sum up, the Ponzi scheme is where the scammer would require investment in something from its victims, with promised returns at a later pay date.

In specific, here’s how the Ponzi scheme would work: Investors provide funds to the portfolio manager - the person who runs the scheme, when investors wish to withdraw their funds, they are paid out with the incoming funds from new investors. That’s how Ponzi kept his company running, by inviting people to invest in his business.

The orchestrator of this scheme oversees the entire operation. However, instead of investing the funds to generate interest, they simply transfer money from one client to another, without engaging in any genuine investment activities.

According to Investopedia, there are telltale signs of a Ponzi scheme, such as:

• Promises of high returns: Be cautious if your portfolio manager promises returns significantly higher than those typically seen with traditional investments.

• Little to no risk: All investments carry some level of risk, so if your investment is guaranteed to be “completely risk-free and fully protected”, turn your heels, Cinderella.

• Lack of registration and licenses: Legitimate investments are regulated, and managers are required to hold licenses. Always ask to see relevant documents and credentials from anyone promising substantial returns on your investment.

• Complicated investment strategies: This should be the easiest sign you can see from afar. If you find it difficult to understand how your investment generates returns, RUN. The scheme is designed to confuse you.

• Missing paperwork and payments: If you're not receiving statements or the payments you were promised, that’s how you know they got you.

Pyramid Scheme

Unlike the Ponzi scheme, the Pyramid scheme works in the opposite way: Scammers promise investors the opportunity to “make” money by recruiting more people into the scam.

This scheme is structured so that the scammers must recruit other investors, who in turn recruit more investors, creating a chain of recruitment that continues indefinitely. Typically, the company that uses this structure would charge extremely high entry fees. Recruits are encouraged to invite more people to join the company, which could earn them commissions. Sometimes, there's a bonus offered that looks like a chance to invest, like getting permission to sell a specific product. Each investor must pay the person who recruited them for a chance to sell this product, and then the money they make has to be shared with those above them in the pyramid. Therefore, the people on the top are the ones that profit the most. With their higher earnings, they attract more participants to join the scheme. As the network expands, more capital flows into the pyramid, moving from new investors to those positioned higher up. However, those at the bottom tend to lose a lot, particularly if they struggle to recruit new participants.

According to Nasdaq, there are some warning signs that might spell out “Pyramid scheme” for you, such as:

• Nothing for sale: Fraudsters might use fancy names for their products or services to make their company seem legit. If you notice there's no real product or service being offered, or it's hard to figure out what it's worth, or it seems too expensive, just run.

• Recruiting or Buy-in is a must: If a company requires a very high entry fee to join a program or frequently emphasizes the utmost importance of recruiting employees, it’s a big NO.

• High returns in a short time: Apparently, this is what attracts people most. Therefore, if a program promises to make you rich quickly, it's wise to be skeptical.

• Complex commission structure: As I have said above, the more complicated it seems, the more likely it’s a scam. If commissions are not tied to actual sales of products or services to customers outside the program, it's a red flag.

• No documents or financial statements audited by CPA: If a business refuses to provide these documents, it's probably a pyramid scheme.

The world of crypto is lucrative yet rife with scams and frauds, that’s why it gained quite a bad impression with the public.

And it would not be too surprising if a crypto project implements the Ponzi scheme to rug-pull its investors. One of the biggest Ponzi scams in the crypto world is OneCoin.

OneCoin, a cryptocurrency established in Bulgaria in 2014, was purportedly designed as a means to purchase educational resources, particularly in financial management. However, its creator, Dr. Ruja Ignatova, primarily promoted OneCoin as an investment vehicle - a big red flag.

In 2017, financial authorities revealed OneCoin as an extensive Ponzi scheme, where initial investors were paid returns using funds from new investors. Although many leaders of the scheme were apprehended, Dr. Ruja Ignatova vanished with approximately $4 billion and remains a fugitive (her partner got a 20-year sentence though). The scheme is believed to have resulted in losses of nearly $25 billion for investors [10].

BitConnect

BitConnect was an open-source cryptocurrency released in 2016 [11] that has been exposed as a Ponzi scheme in 2018.

Satish Kumbhani, the founder of the cryptocurrency investment platform BitConnect, along with Glenn Arcaro, BitConnect’s director and primary promoter, face accusations of orchestrating what the U.S. Department of Justice (DOJ) describes as a "textbook" Ponzi scheme. This scheme allegedly fraudulently acquired $2.4 billion from investors [12].

According to DOJ’s press release, BitConnect operated by sustaining itself through payments to earlier investors using funds from subsequent investors. Arcaro and his collaborators allegedly ensured that up to 15% of the funds invested in BitConnect were directed straight into a slush fund, intended for the benefit of its owner and promoters [13].

Renowned for being “India’s Biggest Crypto Ponzi Scheme”, GainBitcoin has been listed as one of the worst crypto scams ever.

Emerging in 2016-2017, led by the late Amit Bhardwaj, along with his brother Ajay Bhardwaj and other family members, the scheme eventually collapsed like all other Ponzi schemes [14].

Under Bhardwaj’s scheme, an investor purchasing one bitcoin was promised a 10% return on its value each month for the subsequent year and a half. This meant that by the end of an 18-month period, the investor was supposed to receive almost double the value invested.

All transactions occurred in Bitcoins through Bitex, serving as a bank vault for the currency. Consequently, there was no involvement of Indian currency, and therefore, no tax liabilities [15].

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However, since there is a finite number of Bitcoins, the scheme's model was fundamentally flawed. Nonetheless, many investors had already committed their funds by the time they realized their grave error.

Amit Bhardwaj, the mastermind behind the GainBitcoin scam, passed away due to a heart attack. He is believed to have amassed anywhere between 395,000 to 600,000 Bitcoins, equivalent to over Rs 1 lakh crore.

Ajay Bhardwaj, Amit's brother, is currently under scrutiny and is the primary accused in the GainBitcoin fraud. In March, the Enforcement Directorate (ED) sought the Supreme Court's intervention to compel one of the accused to provide access, username, and password to his crypto wallet. The ED argued that the question of cryptocurrency's legality doesn't apply in this case, as it's a Ponzi scheme.

According to an article issued on December 18th, 2023, the Supreme Court has granted jurisdiction to the Central Bureau of Investigation (CBI) for cases related to the GainBitcoin Ponzi Scheme and has transferred the case trial to the CBI Court on Rouse Avenue in New Delhi [16].

After all, the Ponzi scheme remains a cautionary tale of financial fraud, reminding us of the dangers of greed and the allure of quick riches. Don’t let yourselves be fooled by the promises of high returns, especially in the realm of cryptocurrencies.

If you are uncertain of what you’re investing in, don’t.

If you find it too hard to understand the schemes, leave it.

Skepticism is always needed. Stay safe out there, folks!

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Reference:

[1] https://www.google.com/books/edition/SCAMS_and_how_to_protect_yourself_from_t/KNC_VRtss60C?hl=en&gbpv=1

[2] https://www.investopedia.com/who-is-charles-ponzi-5216783

[3] https://pnzi.com/

[4] https://www.smithsonianmag.com/history/in-ponzi-we-trust-64016168/

[5] https://www.entrepreneur.com/business-news/who-is-charles-ponzi-the-shocking-story-behind-the-scheme/450538

[6] https://biography.com/crime/charles-ponzi

[7] https://en.wikipedia.org/wiki/Charles_Ponzi#Collapse_of_the_scheme

[8] https://www.thequota.co/articles/how-charles-ponzi-sold-a-lie-and-had-a-scheme-named-after-him

[9] https://www.nytimes.com/1949/01/19/archives/ponzi-dies-in-rio-in-charity-ward-swindler-of-20-who-promised.html

[10] https://www.unit21.ai/fraud-aml-dictionary/ponzi-scheme#back-to-top-location

[11] https://en.wikipedia.org/wiki/Bitconnect

[12] https://www.bdo.ca/insights/cryptocurrency-execs-charged-for-2-4-billion-ponzi-scheme

[13] https://www.justice.gov/opa/pr/crypto-fraud-victims-receive-over-17-million-restitution-bitconnect-scheme#:~:text=In%20truth%2C%20however%2C%20BitConnect%20operated,of%20its%20owner%20and%20promoters.

[14] https://inc42.com/buzz/gainbitcoin-scam-supreme-court-orders-cbi-to-conduct-a-probe/

[15] https://theprint.in/theprint-profile/how-a-former-infosys-engineer-became-a-rich-bitcoin-miner-and-ultimately-a-fugitive/46329/

[16] https://primelegal.in/2023/12/18/gainbitcoin-ponzi-scheme-indias-biggest-cryptocurrency-ponzi-scam/