What is a ponzi scam? How to tell a Ponzi scheme from a genuine investment opportunity

Ponzi schemes are evolving, making it critical to know how to spot one

Multiple yellow warning signs reading "Scam Alert"
(Image credit: Getty images)

If you’ve ever come across an advert that promises incredible returns on your investment, then it's possible that you’ve just seen a Ponzi scheme.

The rise in DIY investing in recent years, as well as risky assets such as cryptocurrencies providing some investors with outsized returns, has fuelled a surge in financial investment fraud, with cases rising by 42% year on year, according (opens in new tab) to the Office of National Statistics.

Notably, there has been a 59% increase in Ponzi and pyramid schemes, and with the number of scams rising amid the cost of living crisis, it is more important than ever to be able to identify the risks of such scams to avoid losing your money.

WHAT IS A PONZI SCHEME?

A Ponzi scheme is a non-existent investment that promises large returns, typically well above what a regular investor could expect. Such investments typically promise to offer returns in a short timeframe. 

While many people would be naturally dubious about such a promise, Ponzi schemes hook victims in with a simple premise – a handful of them actually get the promised returns.

For example, a person sees an advert online for a new investment opportunity, promising to double their money within one month. They pay £100 into the scheme, and a month later, receive £200. 

The investor then tells friends and family about the opportunity, inflating the scheme’s credibility and encouraging more and more people to invest their money. On paper, the increasing flows of cash into the scam make it look like it is a legitimate company or operation doing well, undergoing a period of intense growth and profitability.

But behind the scenes, the scammers are preparing to make their move. The money ‘invested’ in the scheme does not go towards any kind of investment product, so it does not earn any returns. Rather, the £200 returned to the first investor comes directly from funds paid in by new investors.

Eventually, the fraudsters will vanish with the pot of money gathered from investors leaving people with no way of reclaiming their initial investment. Ponzi schemes are unauthorised and scammers go to great lengths to cover their tracks, meaning it is very unlikely a victim will be able to claim their money back.

Over the years, Ponzi schemes have taken many forms and targeted a range of people, including those on the highest incomes and global banks.

Where did Ponzi schemes come from?

Charles Ponzi is credited with the mainstreaming of Ponzi schemes after he ran a postal service scam in the 1920s, but the format dates back to the mid-1800s. Writer Charles Dickens even describes the scam in two of his novels.

Yet Charles Ponzi cemented the scam as a lucrative opportunity for fraudsters and a risk for investors. His scheme operated between 1919-1920, promising returns of 50% in 45 days, or 100% in 90 days. Ponzi’s legitimate business sold pre-paid postage stamps, allowing people to send a valid postage stamp alongside their letter for the recipient to use for their reply.

Ponzi encouraged investment in his company, Securities Exchange Company, but rather than using the funds to develop the growth of his business, he simply redistributed the money back to investors, under the guise that the business was making good returns. This attracted more and more investment, with ever-increasing flows of money into the scheme, deceiving countless victims.

The scheme was uncovered in 1920, and Ponzi was sentenced to five years in prison.

What’s the largest ever Ponzi scheme?

Despite being hundreds of years old, Ponzi schemes have remained relevant by piggybacking off new trends and technologies. The rise in power of Wall Street after the 1960s provided the backdrop to the largest Ponzi scheme in history, while new electronic trading methods allowed investors to be duped into the scam.

Bernie Madoff was a well-respected Wall Street trader and was Chair of the Nasdaq stock market – one of the most important jobs in finance. But the company he founded and gained his reputation through, Bernard L. Madoff Investment Securities, was the vehicle behind the largest Ponzi scheme ever recorded.

By promising incredible returns to everyday investors, wealthy celebrities, businesspeople, and institutions like Royal Bank of Scotland and Santander gave their investments to Madoff. As more and more cash started flowing into the scheme, investors would routinely receive the promised returns, inflating the scam until it held $64.8 billion in client assets. Madoff would use this money for himself by generating interest from regular savings accounts.

But the 2008 financial crisis saw investors wanting to pull their money out of the scheme, but Madoff’s setup simply did not have the cash to pay back investors what they had put in. In essence, their money was gone.

News of the scam went public, and Madoff was arrested.

A year later, he was sentenced to 150 years in prison. He died in 2021.

How do you spot a Ponzi scheme?

As scammers become ever-more sophisticated, and new products like crypto coins and NFTs flood the market, it can be hard to tell a Ponzi scheme from a genuine investment opportunity. But some key indicators separate Ponzi schemes from legitimate products.

Some key red flags include:

  • Being told you’ll get a guaranteed return with little or no risk.
  • Being pressured into making quick decisions with your money
  • Little information about the company being available online
  • Not being able to understand how the scheme works, or people being intentionally vague or confusing
  • Being pressured into not taking your money out of the scheme. 
  • The company is not registered with the FCA (opens in new tab) or other regulators.
  • Incomplete or inaccurate paperwork

What do you do if you’re a victim of a Ponzi scheme?

If you think you’ve been a victim of a Ponzi scheme, then it's vital to follow some key steps – many of which are true for any type of scam.

You must cancel all future payments, such as standing orders and direct debit transactions, to ensure that no more of your money ends up in the hands of fraudsters. Review things like credit card statements and online banking transactions to ensure that your details have not fallen into the wrong hands and your cards aren’t being used for fraudulent purchases.

Report the scheme organisers to the FCA on 0800 111 6768. Even if you’ve noticed something you may think is a scam but have not paid any money into it, report it immediately.

You can also check the FCA’s Warning List (opens in new tab), to see if the scam has already been identified.

Next, find and document any communications you’ve had with the company – this could be things such as letters, emails, brochures or social media messages. These will be useful in constructing the evidence you need. While doing this, cut off all communication with the scammers.

If scammers already have some of your personal details, such as an email address, phone number or banking information, they may attempt to target you again or sell your data to other fraudsters. Be mindful of unknown callers, dubious-looking emails or unusual letters. These can also be reported to the FCA.

Tom Higgins is a journalist covering all aspects of the financial world, from investing and sustainability to pensions and personal finance. He graduated from Goldsmiths, University of London in June 2020 and has since written online and in print for the Financial Times group, New Statesman media group, numerous trade magazines, and has worked with Bloomberg on social media projects. He has a deep interest in environmentalism, social change, and data-driven storytelling. He can be found tweeting at @tomhuwhig.