Pyramids and Ponzi Schemes Explained
Most people who invest in Bitcoin or any other cryptocurrency, or who participate in initial coin offering (ICO) events, usually worry about two things. First, return on investment (ROI), which is the profit they will ultimately receive from their initial investment. The second problem then arises, which is the amount of risk involved in the investment. When the risks are too high, investors are more likely to lose their initial investment (partially or completely), resulting in a negative ROI result.
Naturally, there is always some risk associated with investments. However, the risk increases significantly in cases where an investor unexpectedly participates in a Ponzi or pyramid scheme that is illegal. Therefore, being able to identify these circuits and understand how they work is of great importance.
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 continued for more than a year. Basically, a Ponzi scheme is an investment scam that pays older investors money collected from new investors. The problem with this arrangement is that not all investors will end up getting paid out.
A working Ponzi scheme would look something like this:
The promoter of an investment opportunity accepts $1,000 from an investor. It promises to return the initial amount along with a 10% profit at the end of a certain period (for example, 90 days).
The promoter is able to provide two additional investors before the completion of the 90-day period. He will then pay $1,100 to the first investor out of $2,000 raised from others. He will also most likely ask the first investor to reinvest $1,000.
By accepting money from new investors, the impostor can pay out the promised profits to early investors, convincing them to reinvest and invite more people.
As the system grows, the promoter must find new investors to join the scheme, otherwise he will not be able to pay the promised profits.
Eventually, the scheme becomes unsustainable and the promoter either gets caught or disappears with all the money.
What is a pyramid scheme?
A pyramid scheme (or pyramid scam) operates in the business sector as a model that promises payouts or rewards for participants who not only join the scheme, but also attract new ones.
For example, a fraudulent promoter offers Alice and Bob to purchase the company's distribution rights for $1,000. Thus, they now have the right to sell these distribution rights themselves, earning a cut from each new participant they manage to attract. $1,000 raised from own sales is split 50/50 with the promoter.
In the above scenario, Alice and Bob would have to sell the distributor rights twice to recoup the loss since they each earn $500 per sale. The burden of selling distribution rights to recoup the initial investment is passed on to their customers. The scheme eventually falls apart as more participants are required to continue the process. The unsustainable progression of this scheme makes it illegal.
Most pyramid schemes do not offer a product or service; they are supported solely by money generated from recruiting new members. However, some pyramid schemes may appear to be a legitimate multi-level marketing (MLM) company that intends to sell services or products. But they usually do this only to hide the underlying fraudulent activity. Therefore, many disreputable MLM companies use the pyramid model, but not all MLM companies are scammers.
Ponzi vs Pyramids
Similarities
They are forms of financial fraud that convince victims to invest money by promising good returns.
Requires 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 usually present investment management services where participants believe that the return they will receive is the result of an actual investment. As a result, the scammer takes money from one to pay another.
Pyramid schemes are based on network marketing, and in order to make money, you need to attract new members. Therefore, each participant takes part of the funds before transferring them 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 most likely a lie. This is immediately clear when investing in something completely unfamiliar or difficult to understand. If it sounds too good to be true, they're probably trying to scam you.
Beware of big opportunities. An unexpected invitation to participate in a long-term investment program is usually a red flag.
Research the seller. It is necessary to research the organization that is offering you to invest. A reputable financial advisor, broker or brokerage firm should always be registered and regulated by the appropriate authorities.
Don't trust. Wither. Legal investments must be legally registered. The first step is to request officially recorded information. If there is no registration then they should provide a good and reasonable explanation for it.
Make sure you understand the investment. You should never invest money in something you don't understand. Be sure to use the resources available and be very careful with investments shrouded in secrecy.
Report. When investors encounter a pyramid or Ponzi scheme, it is important to report it to the appropriate authorities. This will help protect future investors from becoming a victim of this scam.
Is Bitcoin a pyramid scheme?
Some may argue that Bitcoin is a big pyramid scheme, but this is an inherently false statement. Bitcoin is just money. It is a decentralized digital currency that is backed by mathematical algorithms and cryptography, and can be used to purchase goods and services. Just like money, cryptocurrencies can be used for pyramid schemes (or other illegal activities), but this does not mean that cryptocurrency or fiat money is a pyramid scheme.