What is a Ponzi scheme and how can you recognize one?
What is a Ponzi scheme?
A Ponzi scheme is a form of investment fraud in which money from new investors is used to pay returns to existing investors. In a Ponzi scheme, no actual realized profits are paid out and there is no underlying value creation or profitable business model. You are essentially investing in hot air without realizing it.
To attract new investments, the organizer promises unrealistic and “too good to be true” returns. As long as enough new participants join, the system appears to function, but once the inflow stops or declines, there is no money left to pay participants and it becomes clear that it is a Ponzi scheme. Investors are left with losses, while the organizer and a few other early participants have profited and disappeared with your money.
Key Takeaways
- Ponzi schemes pay returns using money from new investors, not from real profits or value creation
- Guaranteed or extremely high returns with no risk are a major red flag
- Once the inflow of new participants declines, a Ponzi scheme collapses
- In crypto, Ponzi-like structures appear in, among other things, DeFi projects and fake ICOs without a transparent revenue model
- The difference from a pyramid scheme mainly lies in the structure: in a Ponzi scheme, the organizer recruits new investors, while in a pyramid scheme participants themselves must actively recruit new members
Why is it called a Ponzi scheme?
A Ponzi scheme is named after Charles Ponzi, an Italian-American fraudster who set up a large-scale scam in the United States in 1920. He was not the first person to carry out this type of fraud, but he became known worldwide because he promised investors a 50% return within 45 days through a supposed arbitrage strategy involving international reply coupons (postal reply coupons). However, little came of this; in practice, he used money from new investors to pay earlier investors.
Although similar forms of fraud existed before 1920, the model became globally known due to the scale and media attention surrounding Charles Ponzi and received his name.
How does a Ponzi scheme work?
A Ponzi scheme works by paying participants with funds coming from new participants. In this way, a certain pattern emerges. It often starts with presenting investment opportunities that offer high and 100% guaranteed returns, such as 50% within a certain number of days. New investors are brought in this way.
As the network grows, early investors are actually rewarded with the promised returns. This builds trust among investors and helps attract new investors. The catch: the payouts do not come from real profits, but from funds contributed by new investors.
The network grows to a certain size. In the meantime, the promised returns are neatly paid out, but to keep meeting these obligations, more and more new capital is required. When the hype fades and the inflow slows down, the system begins to collapse. Investors stop receiving rewards and the system eventually collapses completely.
The system therefore only works as long as there is constant, increasing growth.
Where does the Ponzi scheme originate from?
The Ponzi scheme only truly got its name after Charles Ponzi’s fraud case received widespread publicity in 1920, but the structure has existed for much longer. Historical versions of chain letters and fraudulent investment constructions show strong similarities to modern Ponzi schemes.
The idea remains the same: paying existing participants with money from new participants. The concept adapts to the times: from postal coupons in 1920 to real estate funds, hedge funds, and nowadays also crypto projects.
Examples of well-known Ponzi schemes
Throughout history, there have been various Ponzi schemes with major impact. From postal coupons to hedge funds and crypto. Below are three of the most well-known examples.
Charles Ponzi (1920)
The namesake of the scam, the Charles Ponzi scheme, was a well-known fraud trick in 1920, in which he promised investors a 50% return within 45 days through arbitrage (differences in buying and selling prices among different providers) in international reply coupons (postal reply coupons). He claimed he would do this by purchasing reply coupons cheaply abroad and selling them at a higher price in the United States.
However, he barely did this and paid the promised returns using money from new investors. The earlier you were in the system, the higher your return. Trust grew and within a few months millions of dollars were raised. At that time, an absolute goldmine.
When journalists and regulators began investigating the structure and investors massively wanted to withdraw their money, the system collapsed. Ponzi was arrested and convicted. His name has since become synonymous with this type of fraud.
Bernie Madoff (2008)
The largest Ponzi scheme scandal in modern times is that of Bernie Madoff in 2008. Through his investment firm Bernard L. Madoff Investment Securities, he promised clients consistent, stable returns regardless of market conditions.
According to a presented strategy, his firm would invest to generate returns, but in practice money from new investors was used to pay existing investors. He falsified account statements and trading reports to create the illusion of legitimate profits.
He kept this going for approximately 17 to 20 years (the fraud began in the early 1990s) and attracted pension funds, charities, wealthy individuals, and institutional investors, among others. The mask fell during the financial crisis in 2008, when many investors logically wanted to secure profits and therefore withdraw money. It turned out that Madoff could no longer meet his obligations and the truth came out. The estimated size amounted to approximately 65 billion dollars in reported balances, with actual losses of tens of billions of dollars. Madoff was sentenced in 2009 to 150 years in prison.
OneCoin (2014–2017)
A relatively recent example is OneCoin, a crypto project led by the so-called “Cryptoqueen,” Ruja Ignatova. Worldwide, seminars, events, and aggressive marketing campaigns were organized to attract investors. Investors could purchase packages in the then relatively unknown but exciting crypto market that entitled them to mining tokens, with which they could obtain OneCoins. However, there was no public, verifiable blockchain and the value of OneCoin was determined internally. It was not based on supply and demand.
The project consisted of a form of Ponzi scheme with pyramid scheme elements. Participants were encouraged through a commission model to recruit new participants. The higher in the hierarchy, the more commission one received. Also when your affiliates onboarded new participants. At the same time, payouts were made possible by new inflows of capital. Worldwide, it is estimated that more than 4 billion dollars were raised (some estimates even mention more than 4.5 billion dollars).
In 2017, Ignatova and other involved parties disappeared from view. Several leaders of the project were later arrested and convicted. OneCoin is considered one of the largest fraud cases within the crypto sector.
Ponzi schemes within crypto
The growing popularity of crypto has made the crypto market an interesting target for potential Ponzi schemes. The crypto sector is vulnerable to Ponzi-like structures due to a lack of regulation in certain areas, such as the DeFi market, the complex technology behind the crypto market, volatility, and fast and often low-threshold capital flows.
Within the crypto market, you therefore often see Ponzi-like structures in:
DeFi (Decentralized Finance)
DeFi platforms make it possible to earn interest, lend crypto, and trade without an intermediary, in a fully decentralized way. The possibilities and lack of knowledge among investors make it easy for projects to offer extremely high returns without proper justification. Protocols may finance payouts with new investments or by issuing new tokens. As long as new participants keep joining, the model appears profitable. When the inflow decreases or the token value drops, the system can quickly collapse. If returns are not generated from real economic activity, such as transaction fees or interest income, but from new deposits, this may indicate a Ponzi scheme.
Other examples within DeFi are yield platforms without a transparent revenue model and projects that promise extremely high, fixed returns without a clear underlying business model.
Fake ICOs (Initial Coin Offerings)
In ICOs, Ponzi schemes are sometimes involved because it is relatively easy to set up such a project. High expectations are created around a groundbreaking innovation, but behind the scenes little happens. In reality, there is no large team building a new and groundbreaking platform, or there is a lack of transparency and no realistic business model is outlined. Instead of creating value, the focus is on aggressive marketing and rapid price increases. In Ponzi-like variants, new capital is used to pay earlier investors or to artificially create trust in the project. Once the inflow stops, it becomes clear that there is no underlying value supporting the system.
How can you recognize a Ponzi scheme?
No one wants to invest in a Ponzi scheme. But how can you recognize one? Below are the most common characteristics:
- Promises of guaranteed or extremely stable returns
Ponzi schemes often promise stable and guaranteed returns. Legitimate projects clearly show the risks and state that returns are not guaranteed but depend on various factors. Guaranteed returns, regardless of market conditions, are a red flag. - Unrealistically high returns with “low risk”
Promising high returns, especially combined with certainty, is a red flag in itself. When an investment promises exceptionally high profits without significant risk, there is often deception involved. - Lack of clarity about how profits are actually generated
If it remains unclear where the returns come from, or if explanations are vague and evasive, there may be no real economic foundation. - Complex or secretive strategies that cannot be verified
Fraudsters try to lure you in with complicated and exclusive strategies without being truly transparent about them. Lack of transparency makes verification difficult and increases risk. - Problems or delays with withdrawals
Issues with withdrawing funds, or constantly changing requirements and conditions, may indicate a Ponzi scheme. This is often the case when a project starts having trouble attracting new participants. - Strong focus on recruiting new investors
Instead of building fundamental value, the project mainly focuses on attracting new investors. These are needed to pay earlier investors.
What is the difference between a Ponzi scheme and a pyramid scheme?
The difference between a Ponzi scheme and a pyramid scheme lies in the fact that in a Ponzi scheme there is often one or more organizers trying to attract new participants in exchange for high returns, whereas in a pyramid scheme investors are promised additional income if they recruit new investors.
Both systems create trust by referring to the high profits earned by early participants, but in a slightly different way. They therefore have a lot of overlap. Nevertheless, they differ fundamentally in structure and operation.
A Ponzi scheme is driven by high returns from your investment, while a pyramid scheme is driven by actively recruiting new participants who must pay an entry fee.
The biggest differences at a glance:
Final thoughts
A Ponzi scheme is a fraudulent structure that revolves around paying existing investors with money from new participants. As long as the inflow continues to grow, the system appears profitable and reliable. In reality, however, there is no real economic value creation, making collapse inevitable once growth slows down.
Throughout history, Ponzi schemes have continually adapted to new markets and technologies, from postal coupons and hedge funds to crypto and DeFi. Although the form changes, the core remains the same: high, often guaranteed returns without a transparent and sustainable revenue model.
For investors, critical thinking is therefore essential. Understand where returns come from, stay alert to unrealistic promises, and only invest in projects with a clear and verifiable business model. When returns depend on new inflows rather than real value creation, caution is advised.
