China's biggest Ponzi scheme: All you need to know about such scams

In 1919, Charles Ponzi duped thousands of investors, promising massive returns on international reply coupons.
In 1919, Charles Ponzi duped thousands of investors, promising massive returns on international reply coupons.PHOTO: BLOOMBERG
Bernard Madoff started his Ponzi scheme in 1986 under the guise of a successful hedge fund - and ran it successfully for 23 years.
Bernie Madoff started his Ponzi scheme in 1986 under the guise of a successful hedge fund - and ran it successfully for 23 years.PHOTO: BLOOMBERG

Nearly one million investors may have been fleeced in China's latest Ponzi scheme, which over the weekend saw 21 executives from its biggest peer-to-peer money lending platform being arrested on suspicion of stealing 50 billion yuan (S$10.8 billion).

The police allege that the senior management of Ezubao had stolen that much money from 900,000 investors nationwide, which would make it China's largest-ever case of investor fraud, by both cash value and the number of victims.

By number of victims, it would be the largest Ponzi scheme in the world.

Here's what you need to know about Ponzi scams:

 

What is a Ponzi scheme?

A fraudulent investment scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by using the cash from new investors. Such scams actually yield the promised returns to earlier investors, as long as there are more new investors.

But they eventually collapse on themselves when the new investments slow or stop.

Who is the scheme named after?

One Charles Ponzi, a clerk in Boston, who did not invent the scheme that came to bear his name, but whose scam fooled so many people and made him so much money that it brought the such a scheme into the national spotlight for the first time.

In 1919, the Italian immigrant duped thousands of investors, promising them a whopping 50 per cent return in 45 days, or 100 per cent in 90 days on international postal coupons, which he never actually purchased. The international reply coupons from other countries were supposed to be redeemable in the US for postage stamps, with the profit coming from the difference in prices between countries.

A steady flow of new investors initially allowed Ponzi to pay existing investors, while pocketing millions of dollars himself.

But soon enough, the scheme began to raise eyebrows because there were not sufficient international reply coupons for his investment plan to work. It collapsed, bringing six banks down with it. Collectively, his investors lost an estimated US$20 million - equal to US$222 million (S$416 million) in today's money.

Ponzi went to prison for several years but after his release, he launched another scheme where he sold real estate that was literally underwater. He was jailed yet again and ultimately died penniless in Brazil, working as a translator.

Is a Ponzi scheme the same as a pyramid scheme?

They are similar in that both are based on using money from new investors to pay the earlier ones.

But there is one important difference: In a Ponzi scheme, the mastermind gathers all the money from new investors and then distributes them. Pyramid schemes, on the other hand, allow each investor to directly benefit depending on how many new investors are recruited. The person at the top of the pyramid does not at any point have access to all the money in the scheme. Pyramid schemes are illegal in most but not all countries.

For both schemes, however, eventually there is not enough money to go around and the schemes unravel.

What is the biggest Ponzi scheme ever?

There have been many famous Ponzi conmen throughout history, especially in recent years. But the biggest schemer by far was Bernie Madoff.

Madoff stole US$65 billion from thousands of investors from the ordinary to the ultra-rich and famous. A respected former chairman of the Nasdaq stock market, Madoff started his Ponzi scheme in 1986 under the guise of a successful hedge fund - and ran it successfully for 23 years.

But the global financial crisis led to his undoing. In 2009, Madoff received redemption requests worth US$7 billion, which he was unable to meet. He confided his problems to his two sons, who reported him to the authorities.

Madoff is currently serving a 150-year prison sentence. One son hanged himself in 2010 on the two-year anniversary of his discovery of the fraud; the other died in 2014, blaming his cancer relapse on the stress and shame he suffered from his father's massive scam.

Sources: Investopedia, Bloomberg News, Time