In a recent interview, the World Bank Group President Jim Yong Kim compared Bitcoins to a “Ponzi Scheme” that once again triggered questions on the legitimacy of the world’s most popular cryptocurrency.
“In terms of using Bitcoin or some of the cryptocurrencies, we are also looking at it, but I’m told the vast majority of cryptocurrencies are basically Ponzi schemes. It’s still not really clear how it’s going to work,” he said in an interview.
The cryptocurrency, that has been soaring since 2017, has seen not so great start in this year and had reduced to one-third of its peak value nearly in just two months.
The World Bank is looking closely at the blockchain technology and hopes that it could be used by developing countries to “follow the money more effectively” and regulate corruption.
Cryptocurrencies have been employed by scammers attempting a new generation of Ponzi schemes. For example, misuse of initial coin offerings, on the Ethereum blockchain platform have been one such method. (per the Financial Times, “smart Ponzis”). The novelty of ICOs means that there is currently no regulatory clarity on the classification of these financial devices, allowing scammers wide leeway to develop Ponzi schemes using these assets.
Now talking about the term “Ponzi Scheme” let’s bring a little clarity to it.
What really is a ‘Ponzi Scheme’?
Any investment operation in which an early investor’s revenue is generated through revenue paid by the new investors, rather than from any legitimate business activity or profit of financial trading, that is generated by the company are called as ‘Ponzi Schemes’.
The operators of a Ponzi Scheme can either be an individual or a group of people that generally offers investors short-term returns, which may be enormous or too consistent for a business.
Still don’t get it? Let’s simplify it!
Suppose ABC is a corporation(fraudulent) and is approaching an investor X for a certain investment and offers a three-times return within a week. This is pretty decent given the company is not operating at a larger scale. Now what this company will do, is that it will approach another investor(say Y) and once he invests the money, the company will pay investor X from Y’s money, and this chain continues.
Who was ‘Ponzi’?
The scheme is named after Charles Ponzi who became notorious for using the technique in United States during 1920s. However he was not the inventor of the idea. This idea was highlighted in Charles Dickens’ novels- Martin Chuzzlewit published in 1844 or Little Dorrit published in 1857, that described such an scheme, but Charles Ponzi actually performed them in the real life!
The scheme that Ponzi started was originally based on the practice of taking monetary advantage of the price difference between two or more markets, in this case- international reply coupons for postage stamps. In 1919, the Italian immigrant promised investors that they could yield great profits from international reply coupons from other countries and then redeeming it in the US for postage stamps.He even setup a company in Boston by the name ‘Securities Exchange Company’.
He attracted many investors and the money started driving into the system by them. Soon Charles Ponzi diverted investor’s money to clear payments of earlier investors and pay himself. Later, the investors raised questions at the scheme eventually collapsed, bringing 6 banks down with it. Collectively, his investors lost around $20 million.
A Ponzi scheme typically requires an investor at a nascent stage or its beginning. The investor is promised a high-return, where the person that intends to commit the fraud uses verbal guises like
“offshore investments” to describe as its income strategy. The promoter generally takes advantage of investors’ lack of knowledge or describe strategy that is out of investors’ knowledge domain. A Ponzi Scheme fraud promoter can be sensed if he is not willing or avoiding giving information about his strategy.
For investors- if someone is approaching you with a “very-handsome-return” in a very short term of time, and requires you to invest more money one after another- watch out,it may be a Ponzi scheme. He may provide you the promised return in starting, but once he/she gains your confidence, you will be swiped off!
Falling off of a Ponzi Scheme
If a Ponzi scheme is not checked at the starting, it eventually falls apart quickly, sinking investors money. The higher is the return a promoter in offering, the quicker the chances of a Ponzi Scheme to fail. It may happen in many ways like- the promoter, who started the business vanishes,taking all of investors’ remaining money along with him/her.
There may occur a liquidity crisis when the promoter fails to bring new investors in the company, thereby not being able to pay the current investors. This causes panic among the investors and everyone looks for a way to exit the system. It is then, that the promoter runs away!