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What's the difference between Ponzi and pyramid schemes?

A graphic image of a prisoner building a pyramid out of dice

It may surprise you to learn that the most common crime in Britain isn’t theft or assault. It’s fraud.

Annually, there are more incidents of fraud (4.6 million) referred to the police than both theft (3m) and violent crime (1.5m) combined. Each year it costs the UK economy more than £137bn. To say it’s rife would be an understatement.

There’s no need for huge alarm, though. The majority of these frauds are fairly low-level affairs. Be it online scams or in-person rip-offs, most grifts are for smallish amounts, most of which can be claimed back in some respect or another. That’s not to diminish the effects of any fraud, the emotional toll can be hefty.

The big losses are seen in investment scams, though. Specifically, pyramid and Ponzi schemes. Average losses are around the £50,000 mark. What’s worse is that we’re seeing an exponential rise in both kinds of investment fraud. According to the Office for National Statistics, the past year alone has seen an extremely worrying rise in both pyramid and Ponzi schemes of almost 60%.

With these sorts of investment rackets being more commonplace, it may pay for us all to be just that little bit wiser about what they are, how they work, and the best ways to spot and avoid them.

They’re the same thing, aren’t they?

Ponzi and pyramid schemes are pretty similar so it’s very easy to confuse the two. There are, however, key differences.

They’re both investment scams that promise things they very often can’t - and don’t - deliver. They’re both illegal and capable of ripping off huge numbers of people for quite substantial amounts of money.

In order to work, both swindles require the near-constant recruitment of new investors/victims and each begins to fail when new investors dry up. The main difference is just how active the investors are in the recruitment process.

What exactly are Ponzi schemes and how do they work?

Ponzis are named after the first man to set up and run one - Charles Ponzi, a scammer from Italy who swindled more than $20m from his marks in 1920’s North America. They offer people a business opportunity to invest in which, very often, doesn’t even exist.

Investors are attracted to a profitable-sounding idea that is sold with the promise of a hefty return on investment. How they’re so successful is that they very often do return on the initial investment.

So what’s the issue? Well, the money doesn’t come from the outlined business’ growth or assets increasing in value. The cash comes from other investors.

The easiest way to understand Ponzi schemes is with the old adage, ‘robbing Peter to pay Paul’.

Imagine you gave a Ponzi schemer £10,000. You’re promised £12,500 in return. An appealing 25% ROI.

Meanwhile, the ‘portfolio manager’ (PM) has also attracted nine others like you. He now has a fund of £100,000, with all ten people expecting £12,500 back. Soon, you and the other nine receive that amount. The PM has paid out £125,000. But only received £100,000, right? Well, not quite.

Unbeknownst to the first batch of investors, the PM has a second batch of investors, all of whom have also made the same investment and paid their £10,000. The PM actually has a fund of £200,000 before they pay back the first batch of ten. So they’ve made £75,000.

The £125,000 isn’t paid out to be nice. This is an investment from the PM. They now have ten very happy investors, all of whom are going around recommending the ‘investment’ to their friends. Each of the ten individuals recruits two friends to also pay into the scheme. This third batch now pays the PM a combined £200,000 between them. The pot now stands at £275,000.

To keep the second batch happy and liable to recruit a fourth batch, the PM pays them back the promised £12,500. That’s another £125,000 from the fund, which now sits at £150,000. Another significant pay-out, another significant investment. Batch #2 recruits 20 investors, forming Batch #4. So that’s another £200,000.

That’s if the investors take their initial investments out. Often, they’ll leave it in or reinvest to try and earn more off it. In that case, when it’s time to cash out, the PM has an even bigger pot to steal.

The number of investors grows and grows, but eventually, the scheme hits a breaking point and not everyone can get paid. They become disgruntled and stop talking up the investment and recruitment dries up. Later investors, of which there may be many, stop getting paid and the whole thing stops working. By this time the PM has absconded with a rather sizeable pot of money, none of which was ever invested in anything.

Extra mini scams can also exist within the main one, such as investors being charged ‘portfolio management fees’.

Payments aren’t just transferred from newer investors to older ones and the con artist’s current account, either. Often, the trail is intentionally complicated, labyrinthine and obfuscated. The more intricate and convoluted, the harder it is for the authorities to track.

How are pyramid schemes different from Ponzi schemes?

The main difference between the two is that it’s possible for a pyramid scheme to exist legally. Ethically, the structure may not be sound, with inequality rife, but at its heart, a pyramid scheme is just a multi-level marketing enterprise. That said, a substantial percentage of businesses that can be described as pyramid schemes are fraudulent.

Most pyramid schemes see an investor/victim pay to be able to sell a product. The person will be unsalaried, but earn money from commission. Generally, that commission is quite a small percentage. To supplement that income, additional money is offered for any further investors they can sign up for the scheme.

Every new sign-up must pay a fee to the person that recruited them. An ‘entrance fee’, in effect. The recruiter will then kick up a percentage of that payment to their recruiter, and so on and so on - all the way to the top. The higher up the pyramid you are, the more people you have under you, the more payments you receive, and the richer you get.

These recruitment fees are the bread and butter of such an operation. Sales figures are often inconsequential in comparison.

This hierarchical structure is where it gets its name. Another way of thinking of these kinds of scams is to imagine them as inverted funnels. Money gets funnelled upwards from the vast swathes of newer recruits to the few original investors and the main fraudster running the scam.

Get in ‘at the ground floor’ and investors can find pyramid schemes quite lucrative. If, however, it turns out that the enterprise is illegal and the authorities bust it, that money will likely be seized.

It’s important to point out that just because it’s possible to financially benefit from both types of schemes, the only criminal actor is the person who set the thing up in the first place. In almost all cases, everyone else is ignorant to the full truth of what’s going on.

When the house of cards collapses

Most schemes operate for a relatively short space of time. The conman behind them will often pull the plug and abscond with the funds. Many are experienced fraudsters and know when to call it a day before getting caught.

Another way a Ponzi or pyramid scheme may end is with the authorities getting wise and shutting them down. Or an economic downturn impacting people’s attitudes toward investing. Otherwise, the scheme will likely fail due to the activity of those involved in it.

To work, these schemes require the constant onboarding of new investors. When new recruits stop or even slow down, the income crawls toward a halt and people start asking questions. The huckster running the scam goes AWOL and the whole thing crashes in on itself, losing a lot of people a lot of money.