A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going.
The system is destined to collapse because the earnings, if any, are less than the payments to investors. Usually, the scheme is interrupted by legal authorities before it collapses because a Ponzi scheme is suspected or because the promoter is selling unregistered securities. As more investors become involved, the likelihood of the scheme coming to the attention of authorities increases. While the system eventually will collapse under its own weight, the example of Bernard Madoff demonstrates the ability of a Ponzi scheme to delude both individual and institutional investors as well as securities authorities for long periods: Madoff's variant of the Ponzi scheme stands as the largest financial investor fraud in history committed by a single person. Prosecutors estimate losses at Madoff's hand totaling roughly $21 billion, as estimated by the money invested by his victims. If the promised returns are added the losses amount to $64.8 billion, but a New York court dismissed this estimation method during the Madoff trial.
The scheme is named after Charles Ponzi,[1] who became notorious for using the technique in early 1920. He had emigrated from Italy to the United States in 1903. Ponzi did not invent the scheme (Charles Dickens' 1857 novel Little Dorrit described such a scheme decades before Ponzi was born, for example), but his operation took in so much money that it was the first to become known throughout the United States. His original scheme was in theory based on arbitraging international reply coupons for postage stamps, but soon diverted investors' money to support payments to earlier investors and Ponzi's personal wealth.
Knowingly entering a Ponzi scheme, even at the last round of the scheme, can be rational economically if there is a reasonable expectation that government or other deep pockets will bail out those participating in the Ponzi scheme.
Suppose an advertisement is placed that promises extraordinary returns on an investment — for example, 20 percent on a 30-day contract. The objective is usually to deceive laymen who have no in-depth knowledge of finance or financial jargon. Verbal constructions that sound impressive but are essentially meaningless will be used to dazzle investors: terms such as "hedge futures trading," "high-yield investment programs," "offshore investment" might be used. The promoter will then proceed to sell stakes to investors — who are essentially victims of a confidence trick — by taking advantage of a lack of investor knowledge or competence. Claims of a "proprietary" investment strategy, which must be kept secret to ensure competitive edge, may also be used to hide the nature of the scheme.
Without the benefit of precedent or objective prior information about the investment, only a few investors are tempted, usually for small sums. Thirty days later, the investor receives the original capital plus the 20 percent return. At this point, the investor will have more incentive to put in additional money and, as word begins to spread, other investors grab the "opportunity" to participate, leading to a cascade effect deriving from the promise of extraordinary returns. However, the "return" to the initial investors is being paid out of the investments of new entrants, and not out of profits.
One reason that the scheme initially works so well is that early investors, those who actually got paid the large returns, commonly reinvest their money in the scheme (it does, after all, pay out much better than any alternative investment). Thus, those running the scheme do not actually have to pay out very much (net); they simply have to send statements to investors showing them how much they earned by keeping the money, maintaining the deception that the scheme is a fund with high returns.
Promoters also try to minimize withdrawals by offering new plans to investors, often where money is frozen for a longer period of time, in exchange for higher returns. The promoter sees new cash flows as investors are told they could not transfer money from the first plan to the second. If a few investors do wish to withdraw their money in accordance with the terms allowed, the requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent.
This simplistic notion of the Ponzi scheme is typically embellished with several (or many) feints that help prove seeming legitimacy to the ruse. For example, Madoff famously refused to accept some investors' money, even when they begged him to take it. To an outside observer, these sorts of often high-profile "exclusivity" acts tend to discredit doubts — if it were a fraud, why would Madoff refuse more cash? Such illusions of normal business-as-usual reinforce a Ponzi scheme as a real investment.
The catch is that at some point one of these things will happen:
The promoter will vanish, taking all the remaining investment money (minus the payouts to investors) with them.
The scheme will begin to collapse under its own weight as the investment slows and the promoter starts having problems paying the promised returns (the higher the returns, the greater the chance of the Ponzi scheme collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run.
External market forces, such as a sharp decline in the economy (e.g. Madoff and the market downturn of 2008), will cause many investors to withdraw part or all of their funds not due (at least initially) to loss of confidence in the investment, but simply due to underlying market fundamentals. In the case of Madoff, the fund could no longer appear normal after investors tried to withdraw $7 billion from the firm in late 2008 as part of the major worldwide market downturn affecting all investments
Source: http://en.wikipedia.org/wiki/Ponzi_scheme
