Can Better Financial Regulation Prevent Investors from Being Defrauded?
- New Horizons in Money and Finance series
Chapter 2: How do Ponzi schemes work? Comparing them to other financial activities
A Ponzi scheme is a type of investment fraud in which returns are paid to investors either from their own money or out of money paid in by subsequent investors, rather than from profits generated by investment or any genuine business activity. In the words of Tamar Frankel, Professor of Law at Boston University, and a noted authority on the subject: Ponzi schemes are simple. A con artist offers obligations that promise very high returns at seemingly very low risk from a business that does not in fact exist or a secret idea that does not work out. The con artist helps himself to the investors’ money, and pays the promised high returns to earlier investors from the money handed over by these and later investors. The scheme ends when there is no more money from new investors. (Frankel, 2009, p. 2) Obviously, those initiating the scheme (often only one person) benefit from the profits that can be syphoned out of the operation. But not all investors are necessarily losers. As no (or few) real investments are actually made, the main sources of income are the initial investments augmented, necessarily and increasingly, by funds received from new entrants. Utilizing the principle of ‘robbing Peter to pay Paul’, the money of one victim is used to pay ‘interest’ or ‘returns’ to other victims. Thus, in a sense, the Ponzi promoters share the fruits of their fraud with the early investors who are paid the promised interest, along with those investors lucky enough to exit the scheme before its demise.
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