Recently my attention was drawn to a legal case concerning a former trading tutor who was jailed for a not inconsiderable period of time for running a Ponzi scheme.
A Ponzi scheme essentially uses a portion of the deposits put up by new clients to fund the dividend/interest payments being made to previous clients. This creates the impression that the scheme administrator is indeed managing to obtain the often staggering returns claimed because clients are actually receiving the returns promised. In fact in the vast majority of cases the administrator is actually losing money in their trading but continues to make the interest payments from the new deposits coming in.
This situation can continue for many years as was the case with the Madoff scheme.
Ponzi schemes are very common whether they are created around property investments, collectables such as fine wines or classic cars or indeed forex or options on forex etc.
Because for a period of time the schemes are genuinely paying out the advertised returns it is almost impossible to positively identify a scheme is a Ponzi until it is too late and the whole house of cards is already falling down. By which time most of the money has been lost or spent.
Ponzi schemes are generally only ever uncovered when existing investors stop getting their promised payouts. In the Madoff case it was because significant falls in the markets took place and investors needed to withdraw funds to cover losses they were making elsewhere. This caused a “run” on the fund and the hole was just too big for him to plug with new investors money.
For smaller Ponzi schemes it is more commonly the case that the administrator spends most of the money on a combination of financing his own trading losses and funding the extravagant lifestyle necessary to create the veneer of success required to draw in yet more depositors.
My own view is that often with small Ponzi schemes they do not start out as Ponzi schemes but the trader genuinely believes he really can obtain those returns. As trading losses mount they take bigger and bigger gambles and compound the situation and cannot then face the consequences. So gradually what started as perhaps a genuine, albeit unrealistic, investment scheme morphs into a Ponzi scheme. Some have speculated that this was also the case with the Madoff scheme.
In truth most Ponzi schemes you can spot a mile away:
Either they offer incredibly high returns that are far and away better than you can obtain from any established institution. ie 5% per month every month and often “guaranteed” as well.
They offer relatively “modest” returns (maybe 1% per month) but the returns are incredibly smooth and lack the normal up and down volatility. Ie every month you receive around 1% irrespective of what the underlying markets are actually doing. Generally you will have no losing months. This is the method that Madoff used. The returns profile for such a Ponzi scheme will be far far smoother than is available from any of the established institutions.
Whilst we cannot with absolute certainty prove a scheme is a Ponzi ahead of its collapse the warning signs are always present which is that when you look at one aspect or another of the investment returns you draw in a sharp intake of breath and think “wow that is unbelievable” – and of course not only is it unbelievable but it is also not doable !