Ponzi Scheme

A Ponzi scheme is a variant of the centuries-old fraud popularly known as “robbing Peter to pay Paul,” which requires luring an initial group of gullible investors by offering them an improbably high return on their money, presumably made possible by investing their funds in a superbly profitable business venture. In reality, this great enterprise is either nonexistent or is merely a front, and the initial investors are actually paid with the funds provided by a second group of investors. These, in turn, are paid with the funds provided by a third group, and so on. The term Ponzi scheme is now used generically to describe all such swindles.

This type of fraudulent scheme takes its name from the Italian immigrant Charles Ponzi (1882–1949), who in 1920 promised a 50% profit in 45 days to investors in his newly created firm, the Securities Exchange Company. This generous offer implies an annual rate of return exceeding 2,500%, whereas banking interest rates at the time hovered around 5% per annum. The company's ostensible goal was to use those funds to profit from the even more fabulous arbitrage opportunities available by trading in international reply coupons. Each coupon was redeemable for a postage stamp in more than 60 countries belonging to the Universal Postal Union and, thus, effectively functioned as postal currency.

The geographical arbitrage Ponzi claimed to exploit sprang from the fact that the purchase price of a postal coupon differed across countries, after adjusting for currency exchange rates. Ponzi's company allegedly profited from these price disparities by purchasing international reply coupons in a country where they were cheap, exchanging them for stamps in a country where the coupons were expensive, and selling the stamps for cash.

The final step of this arbitrage cycle was the hardest to execute, and Ponzi never revealed how he managed to cash the stamps, saying only that the cashing mechanism was “his secret.” Furthermore, analysts noted that the necessarily small value of each coupon meant that Ponzi's company could only profit by purchasing an inordinately large number of them, far in excess of the relatively meager worldwide supply required for purely postal transactions. These and other contemporaneous objections did not deter the swarm of mostly small investors eager to exchange their hard-earned money for “Ponzi notes” issued by the Securities Exchange Company. Indeed, in less than 1 year, more than 30,000 individuals invested a total of nearly $10 million in the fledgling enterprise.

Alas, the arbitrage cycle described by Ponzi was just a ruse. In August 1920, Ponzi's scheme unraveled after the press revealed that Ponzi had served jail time in both Canada and the United States. As a result, the flow of fresh funds came to an abrupt halt, the Securities Exchange Company could no longer meet its financial obligations, and Ponzi was tried and convicted for fraud. After spending several years in jail, Ponzi was deported to Italy in 1934. He later went to Brazil, where he died penniless.