10 min read.Updated: 19 Apr 2021, 06:12 AM ISTVivek Kaul
Despite high-profile collapses, pyramid schemes continue to proliferate. What are the warning signs for investors?
Madoff’s demise is only the latest reminder of this ever-present, dark underbelly of finance. There are some key characteristics to these schemes, which hint at what to watch out for
If I was a writer with aspirations of serving up a web-streaming series, here’s the storyline that I would propose. It’s the mid-1920s. After a crippling pandemic, the United States is seeing the kind of prosperity that it has never seen before. The financial markets are rallying. There’s a lot of easy money going around. In this environment, Bernie Madoff travels back in time and meets Charles Ponzi. Both get together to run the biggest Ponzi scheme of all time and so the story goes.
Madoff, who died last week in prison, where he was serving a 150-year sentence, has of course never met Ponzi, given that they lived in different eras. Ponzi died in 1949. But Madoff was perhaps Ponzi’s most successful disciple ever. He, unlike Ponzi, ran a Ponzi scheme for many years.
At its peak, Madoff’s supposed “investment scheme" had $64.8 billion in it. He claimed that he was generating returns by using a trading strategy called the split-strike conversion. But, in reality, the money wasn’t invested anywhere to generate returns. All that Madoff ever did was take the money being brought in by new investors in order to pay off the old investors, while supposedly generating a return of 10% per year, year after year. The scheme went bust in December 2008.
At its heart, the Ponzi scheme—named after Charles Ponzi—is a very simple operation. It promises a much higher rate of return in comparison to the other options that are available in the financial system at a given point of time. Many Ponzi schemes also have a supposed “business model" to make it seem like a legitimate business generating revenues. The first lot of investors who get into the scheme and earn the high return on offer become its brand ambassadors, giving it a very strong word of mouth publicity, and attracting newer investors.
Nevertheless, at the end of the day, money is being taken from newer investors to pay off the older ones. This is how even Ponzi’s scheme worked. In August 1919, in the process of issuing an export magazine, Ponzi realized that a huge arbitrage opportunity was waiting to be exploited.
He made an offer to a person in Spain to subscribe to the magazine. The person sent him an international postal reply coupon. This coupon could be exchanged at the local American post office for American stamps, which could be used to send the magazine to Spain. Ponzi realized that the international postal reply coupon could be bought in Spain at a price which was equivalent of about one American cent. But when exchanged in the United States, he would get stamps worth six American cents.
Ponzi launched an investment scheme to exploit this arbitrage opportunity, promising to double a person’s investment in just 90 days. Investors got attracted by the 100% return in three months which was on offer. At its peak, the scheme had a total investment of $15 million, from 40,000 investors.
Ponzi started living a life of luxury. Nevertheless, his good life came to an end, with the Boston Post running an expose on 26 July 1920. On 10 August, Ponzi’s scheme collapsed.
Over 100 years have elapsed, but Ponzi schemes continue to proliferate, with Madoff’s demise only the latest reminder of this ever-present, dark underbelly of finance. In this piece, we will look at some characteristics of these schemes and why they continue to remain popular, which also hints at what to watch out for while investing one’s hard-earned money.
Anatomy of a Ponzi op
The most important characteristic of a Ponzi scheme is that they offer a high rate of return to investors. The question is how high is high. Charles Ponzi had offered to double investors’ money in 90 days. This implies a return of 100% in three months. If his scheme had lasted a year, it would have ended up giving a compounded annual return of a whopping 1500%.
In 2010, a Ponzi scheme called Speak Asia became the rage in India. This involved an initial investment of ₹11,000. Against this investment, the investors had to participate in two online surveys every week. For every survey, they were promised a payment of ₹500. This would mean an earning of ₹1,000 per week or ₹52,000 during the course of the year, an annual return on investment of 373% on the original sum of ₹11,000.
Stock Guru, a Ponzi scheme which was busted in 2012, offered a return of 20% per month for the first six months. The principal amount invested was repaid to the investor over the next six months. But nothing could beat the sheer chutzpah of MMM India, a Ponzi scheme which hit the country in 2013. The website of the company showed that an investment of just ₹5,000 could be turned into ₹3.4 crore by the end of the year.
No wonder these Ponzi schemes did not last for long. Given that they had promised very high returns, they needed many newer investors to keep bringing in money in order to pay off older investors. After a few rounds, Ponzi schemes promising very high returns tend to collapse under their own weight.
The smarter operators promise a rate of return which is higher than what the financial system is offering at that point of time, but not very high. Take the case of Madoff. His funds claimed to earn a return of 10% per year. This allowed him to keep running his Ponzi scheme for nearly two decades.
Rose Valley, a Ponzi scheme which ran for a few years in the early 2010s, primarily in West Bengal, promised an annual return of 11.2% to 17.65%. Around the same time, Saradha, another Ponzi scheme which was popular in West Bengal, offered a similar sort of annual return on its fixed deposits. As an April 2013, report in Business Standard points out: “In fixed deposits, for instance, [Saradha] promised to multiply the principal 1.5 times in two-and-a-half years, 2.5 times in 5 years and 4 times in 7 years."
If the principal multiplies four times in seven years, it means a return of 22% per year. If it multiplies 2.5 times in two-and-a-half years, it means a return of 20% per year. All this was happening in an era when fixed deposit returns were 8-10% per year.
The second most important characteristic of a Ponzi scheme is to assure the investors that their investment is safe. This is done by meeting the initial obligations very quickly. Let’s take the case of the emu Ponzi schemes, which involved the rearing of emu birds, and were fairly popular in Tamil Nadu.
Susi Emu Farms was the first scheme based on this idea. As an April 2013 report in The Hindu points out: “The scheme… promised a return of at least ₹1.44 lakh within two years for an initial deposit of ₹1.5 lakh."
There is a straightforward way to do this. A part of investors’ own money can be returned to them and the scheme can be kept going.
What this does is that it converts the early investors in the scheme into brand ambassadors of the scheme. It also plays on a very basic human emotion and that is greed. As the economic historian Charles Kindleberger wrote in Maniacs, Panics and Crashes: “There is nothing so disturbing to one’s well-being and judgement as to see a friend get rich." This brings in newer investors into the scheme and that keeps it going. Of course, after some time, herd mentality takeover.
As Nobel Prize winning economist Robert Shiller writes in Irrational Exuberance: “A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a Zeitgeist… a spirit of the times."
Many Ponzi schemes these days have some semblance of a business model, so as to make people believe that they are investing in a proper business rather than a financial scheme. In fact, many multilevel marketing (MLM) companies have turned this into an absolute art form. On the face of it, those who become a part of the MLM scheme are supposed to be selling a product, which can be anything from gold coins to health supplements or even washing power.
The real money is not earned by selling the products but by getting more individuals to join the MLM scheme and, thereby, making a commission in the process. This commission then flows up the hierarchy.
The 1990s saw a spate of plantation investment schemes which promised astonishingly high returns by planting and selling teak trees. Their assumptions around the volume of wood that each teak tree would end up generating were unrealistic, and they basically ended up rotating money like any other Ponzi scheme.
The emu Ponzi schemes promised that rearing emus could be a very profitable business. The Hindu news report mentioned earlier quotes an investor as saying: “We were told that an emu fetched ₹20,000 and its eggs ₹1,200 apiece. It was said that its skin, meat, feathers and even nails had a huge market… But we got cheated."
In the recent past, a new Ponzi scheme called Oksome has come to light. As a March 2021 report on Moneylife.in points out: “Oksome collects money from people under the pretext of liking videos and messages posted on YouTube, Facebook, and Instagram by ‘countless internet celebrities’." On an investment of ₹6,000 to buy a membership, an annual income of ₹91,800 is promised.
Over the years, many Ponzi schemes have successfully used brand ambassadors for brand building. The most famous example of this is hometrade.com, a sophisticated Ponzi scheme of the early 2000s. The company used cricketer Sachin Tendulkar and actors like Shah Rukh Khan in endorsement campaigns.
The portal was supposed to be a financial services portal. Among other things, the portal canvassed for and got money from cooperative banks and Seamen’s Provident Fund, promising them high returns by investing in short-dated government securities.
Money thus raised was often diverted into the stock market. When funds were due to one cooperative bank, money was raised from another cooperative bank to pay off the first bank.
When the scheme collapsed, the celebrity endorsers washed their hands off it by saying that they had no idea about the business model of Hometrade. Along similar lines, film star Mithun Chakraborty was the brand ambassador for the Saradha group of companies. In June 2015, Chakraborty surrendered the ₹1.2 crore he had received from the Saradha group to the Enforcement Directorate.
In some cases, people who run these schemes become their brand ambassadors as well. Other than Madoff himself, an excellent Indian example of this is C Natesan, who ran Anubhav Plantations. As he told Business Today magazine in an interview: “I always wanted to plant trees. As a child, I used to feel sad seeing trees being burnt down in my village at Govindaperi in Tirunelveli."
Such statements help build a halo around such individuals and their infectious optimism is transferred on to prospective investors.
To conclude, greed and herd mentality are the two main reasons why people keep falling for Ponzi schemes. The prospect of higher returns makes them not ask the most basic question: How will these returns be earned?
The late Reserve Bank of India deputy governor K.C. Chakrabarty believed that the fact that people repeatedly invested in Ponzi schemes is a reflection of the failure of the formal financial system. This isn’t always true.
States like Tamil Nadu and West Bengal, where Ponzi schemes have been popular in the recent past, are reasonably well penetrated when it comes to banks. Further, it’s not the poor but the middle class that end up getting stuck in these schemes.
Many scamsters behind these schemes are never caught or punished, encouraging more individuals to launch such schemes.
At the end of the day, the only simple explanation for why Ponzi schemes continue to proliferate and thrive might be philosophical. As the Latin phrase goes: “Mundus vult decipi, ergo decipiatur," meaning, “The world wants to be deceived, so let it be deceived."
Vivek Kaul is the author of Bad Money
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