A Ponzi scheme is a form of investment fraud in which the facilitator promises extremely high returns with minimal risk. The schemer then focuses on taking on a new group of investors at which time he uses their money to pay back the initial investors, quite similar to a pyramid scheme. One key difference is that those who are in a pyramid scheme typically know they are in one, whereas a Ponzi investor is completely oblivious.
The schemer repeats this process over and over again. However, eventually they are no longer able to attract new investors and the scheme begins to unravel.
A Ponzi scheme, is named after the infamous con man Charles Ponzi. Although he was not the first person to run a scheme of this kind, his actions made such cons publicly known. In 1919, Charles Ponzi had been down on his luck. He had already endured multiple jail sentences for smuggling immigrants and writing himself a check from someone else’s checkbook. That is when he received a piece of mail that sparked one of the most infamous cons in history.
He had received a letter from Spain that contained an international reply coupon (IRC). An IRC is essentially a coupon that can be exchanged for postage stamps internationally. Ponzi then realized that he a stamps value can be considerably different from country to country, therefore he could purchase an IRC in one country, exchange it in another, and profit form the difference.
The idea in itself was not illegal. However, this was the investment strategy that he was pitching investors.. not what he was actually doing. He started the company “Securities Exchange Company” to promote his idea to the public and entice future investors. He promised returns as high as 50% in 45 days.
At its peak, the Securities and Exchange Company had received over $3 million (nearly $300 million in todays money), controlled majority ownership of a local bank, and controlled investments for nearly 75% of the Boston Police Force. All which came crashing down on August 11, 1920 when a local newspaper posted about Charles Ponzi’s past allegations on the front page. This caused his initial investors make “a run” on his company, demanding their money back. Needless to say the money was not there.
Ultimately Ponzi spent a few years in prison before be deported to Italy due to his history of crime.
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You can also read about a more recent Ponzi scheme with Bernie Madoff.