Ponzi and Pyramid Schemes Explained
Investors in Bitcoin and ICO events typically prioritize two concerns: ROI and investment risk. ROI represents the eventual profit from the initial investment, while risk relates to the likelihood of losing some or all of the investment and suffering a negative ROI. Although all investments carry some degree of risk, this risk is amplified when investors unknowingly enter illegal Ponzi or pyramid schemes. Therefore, investors must be able to recognize and comprehend these schemes.
What Is a Ponzi Scheme?
Charles Ponzi, an Italian con artist who migrated to North America, lends his name to Ponzi schemes, and fraudulent investment scams. In the 1920s, Ponzi defrauded hundreds of victims and operated his scheme for over a year. This scam operates by using money collected from new investors to pay earlier investors. Unfortunately, this structure causes investors on the backend to receive no payment at all.
A typical Ponzi scheme works as follows: A promoter of a Ponzi scheme secures an initial investment of $1000 from an investor, promising to repay the amount with a 10% interest after a specific period (e.g., 90 days). Before the period concludes, the promoter attracts two more investors and uses their $2000 to pay the first investor's promised $1100. The promoter urges the first investor to reinvest the $1000. By relying on new investors to cover the returns promised to previous investors, the scheme continues to expand.
As the scheme grows, the promoter must recruit more investors to sustain the system. When the fraud becomes unsustainable, the promoter either absconds with the funds or gets caught.
What Is a Pyramid Scheme?
A business model called a pyramid scheme or pyramid scam rewards members for not only joining but also for enrolling new members. Fraudulent promoters offer distributorship rights for a fee of $1000, where members can sell distributorships themselves and earn a share from every new member they recruit. Half of the collected amount is shared with the promoter.
Members are required to sell two distributorships each to recover their investment of $1000, passing on the burden of sales to their customers. Pyramid schemes usually collapse since more members are needed to keep the process going.
Pyramid schemes are illegal as they don't offer a product or service and are maintained solely by the money raised from the recruitment of new members. Some may present themselves as legitimate multi-level marketing (MLM) companies selling a product or service, but they use the same fraudulent business model to hide their underlying activities. Some MLM companies with questionable ethics are using pyramid models, but not all MLM companies are fraudulent.
Ponzi vs. Pyramid: Similarities and Differences
Financial fraud schemes are known as Ponzi and pyramid schemes share several similarities, as well as significant differences. In terms of similarities, both Ponzi and pyramid schemes rely on convincing investors to invest their money in exchange for promised returns. Both types of schemes need new investors to join and contribute funds for the scheme to remain operational. Furthermore, neither Ponzi nor pyramid schemes typically offer any tangible products or services to investors.
However, there are significant differences between the two types of schemes. Ponzi schemes typically present themselves as investment management services, where investors believe that their returns come from legitimate investments. In reality, the scheme operator uses new investors' money to pay off earlier investors, creating a fraudulent cycle.
On the other hand, pyramid schemes are based on network marketing and require participants to recruit new members to earn money. Each participant receives a commission before forwarding the money up the pyramid to the top of the scheme. Unlike Ponzi schemes, pyramid schemes require participants to actively recruit new members to earn money.
When considering an investment opportunity, skepticism is key. Any opportunity promising high returns for little investment is most likely fraudulent, especially if it is in a field you are not familiar with. If it seems too good to be true, it usually is.
Be wary of unsolicited investment offers, as they are typically a warning sign. If you are unsure about the legitimacy of an offer, investigate the seller. Registered and monitored financial advisors, brokers, and brokerage companies are more trustworthy.
Always verify the legitimacy of an investment before investing. Legitimate investments should be legally registered. If an investment opportunity is not registered, an explanation should be provided to justify this. It is also important to fully understand the investment and utilize all available resources before investing.
Be cautious of investments that are kept in secrecy. If you come across a pyramid or Ponzi scheme, report it to the relevant authorities immediately. By reporting fraudulent schemes, you can help protect other potential investors from falling victim to the same scam.
Is Bitcoin a Pyramid Scheme?
Bitcoin has been accused of being a pyramid scheme, but this assertion is false. Bitcoin is a form of currency that is secure and decentralized, using mathematical algorithms and cryptography. This cryptocurrency can be used for the purchase of goods and services just like traditional fiat currencies. While some may use Bitcoin for illicit activities or pyramid schemes, this does not mean that Bitcoin itself is a pyramid scheme.
Investors must be able to recognize and comprehend the differences between legal investments and illegal Ponzi or pyramid schemes. While both types of schemes rely on convincing investors to invest their money in exchange for promised returns, they differ in significant ways. Ponzi schemes rely on using money collected from new investors to pay earlier investors, while pyramid schemes reward members for enrolling new members. When considering an investment opportunity, it is important to be skeptical of opportunities that seem too good to be true and to always verify the legitimacy of an investment before investing. By being cautious and reporting fraudulent schemes, we can help protect potential investors from falling victim to the same scam.