Most people who invest in Bitcoin or any other cryptocurrency, or who decide to participate in Initial Coin Offering (ICO) events, are generally concerned about two things. First, the return on investment (ROI), which represents the benefits you will obtain with the initial investment. Then, there is a second concern, which is related to the amount of risk involved with the investment. When the risks are too high, investors are more likely to lose their initial investment (partly or completely), resulting in a negative ROI.
Naturally, there is always some degree of risk involved with any investment. However, the risk increases considerably in cases where the investor unexpectedly becomes involved in Ponzi or pyramid schemes, which are illegal. Therefore, it is of great importance to be able to identify these schemes and understand how they work.
What is a Ponzi scheme?
The Ponzi scheme is named after Charles Ponzi, an Italian fraudster who moved to North America and became famous for his fraudulent money-making system. In the early 1920s, Ponzi managed to defraud hundreds of victims and his scheme lasted for more than a year. Basically, a Ponzi scheme is a fraudulent investment scam that works by paying older investors with money raised from new investors. The problem with this scheme is that the last investors will not receive any payment.
A Ponzi scheme in operation would look something like this:
A promoter of an investment opportunity takes $1,000 from an investor. It promises to repay the initial value along with 10% interest at the end of a predefined period (for example, 90 days).
The promoter can secure two additional investors before the 90-day period is completed. You will then pay $1,100 to the first investor out of the $2,000 raised from investors two and three. It is also likely to encourage the first investor to reinvest the $1,000.
By taking money from new investors, the imposter can pay the promised returns to early investors, convincing them to reinvest and invite more people.
As the scheme grows, the promoter needs to find more new investors to join the scheme, otherwise it will not be able to pay the promised returns.
Eventually, the scheme becomes unsustainable and the promoter either gets trapped or disappears with the money he has on hand.
What is a pyramid scheme?
A pyramid scheme (or pyramid scam) operates in the business sector as a model that promises payments or rewards to members who not only join the scheme but also manage to enroll new members.
For example, a fraudulent promoter offers Alice and Bob the opportunity to purchase distribution rights in a company for $1,000 each. So now they have the right to sell distributors, earning a cut from each additional member they manage to recruit. The $1000 raised from your own dealer sales is shared with the promoter on a 50/50 split.
In the above scenario, Alice and Bob would have to sell two distributors each to make up, since they earn $500 per sale. The burden of selling two distributors to recoup the initial investment is transferred to your customers. The scheme eventually collapses, as more and more members are needed to continue the process. The unsustainable progression of the scheme is what makes pyramid schemes illegal.
Most pyramid schemes do not offer a product or service and are supported solely by the money raised from recruiting new members. However, some pyramid schemes may present themselves as a legitimate multi-level marketing (MLM) company purporting to sell a service or product. But they usually do this only to hide the underlying fraudulent activity. Therefore, many MLM companies with questionable ethics are using pyramid models, but not all MLM companies are fraudulent.
Ponzi vs Pyramid
Similarities
Both are forms of financial fraud that convince victims to invest money by promising good returns.
Both need a regular influx of money from new investors to be successful and stay active.
Typically, these schemes do not offer actual products or services.
Differences
Ponzi schemes are usually presented as investment management services, where participants believe that the return they will earn is the result of a legitimate investment. The impostor basically robs one to pay the other.
Pyramid schemes are based on Network Marketing and require participants to recruit new members to make money. Therefore, each participant takes a commission before sending the money to the top of the pyramid.
How to protect yourself?
Be skeptical. An investment opportunity that promises quick or high returns with minimal investment is probably dishonest. This is especially true when investing in something that is totally unknown or difficult to understand. If it sounds too good to be true, it probably is.
Beware of unsolicited opportunities. An unexpected invitation to participate in a long-term investment opportunity is often a red flag.
Research the seller. The entity promoting the investment opportunity must be investigated. A reputable financial advisor, broker or brokerage company will be registered and supervised by the relevant governing bodies.
Do not trust. Check. Legitimate investments must be legally registered. The first course of action is to request registration information. If the investment opportunity is not registered, a good and reasonable explanation must be provided.
Make sure you understand the investment. You should never invest money in something you don't fully understand. Make sure you make use of available resources and be very cautious of investment opportunities shrouded in secrecy.
Inform. Whenever investors come across a pyramid or Ponzi scheme, it is important to report them to the proper authorities. This will help protect future investors from falling victim to the same scam.
Is Bitcoin a pyramid scheme?
Some may argue that Bitcoin is a huge pyramid scheme, but this is simply not true. Bitcoin is simply money. It is a decentralized digital currency that is protected by mathematical algorithms and cryptography and can be used to purchase goods and services. Like fiat money, cryptocurrencies can also be used in pyramid schemes (or other illicit activity), but that does not mean that crypto or fiat currencies are pyramid schemes.
