A Ponzi scheme is an investment scam that appears to be actually paying high returns by paying the supposed returns out of victims' own capital. Ponzi schemes are named after Carlo Ponzi who ran a huge Ponzi scheme in the US in the 1920s.
A typical Ponzi scheme promises investors a high rate of return in a short time. The money that is collected from investors is used to pay the return. This means the scam can run for some time, because investors appear to be making the promised return. Early participants can profit, as they can with a pyramid scheme.
How a Ponzi scheme works
The easiest way to explain this is with an example. Suppose the scheme promises a return of 10% a month. The scammer simply takes investors' money and returns a tenth of it at the end of every month.
The fact that investors appear to be getting the returns they were promised will encourage more people to put their money in the scheme, and even encourage the original wave of victims to reinvest. This growth is what makes Ponzi schemes successful.
After ten months the fraudster will have returned all the money invested by the very first investors (assuming they did not reinvest), but will have most of the money invested by later investors. At this point the fraudster simply takes the money and disappears.
Spotting Ponzi schemes
Common types of Ponzi scheme operate under a variety of names including “high yield investment program” and “high yield debentures”. Their common characteristics are very high returns with no clear underlying business to generate them.
More complex forms of Ponzi scheme can be harder to detect. They may well appear to be legitimate investments. They may even be part of an investment that includes both legitimate and Ponzi elements. An example of the latter is an investment or finance company that offers very high returns to depositors, and does lend the money (as a real finance company would) to make returns, but does so knowing that the return on loans will not suffice to cover the interest paid to depositors.
Returns that are too consistent are also a reason for suspicion. This was a characteristic of the fraudulent fund run by Bernard Madoff. Other characteristics of financial frauds in general displayed by the fund were making it invitation only, so clients felt privileged to be allowed to put their money in, and an element of affinity fraud in its marketing.
Anything that offers very high returns without correspondingly high risk should be regarded with great suspicion. Any investment sold through unusual channels (spam email or cold calling) or by a business that is not appropriately regulated (e.g., by the FSA or another national regulator) is also both suspicious and probably illegal. It is usually possible to check with regulators whether someone selling investments is regulated or not.