The term Ponzi Scheme was first coined in the early 1900s, after Charles Ponzi, whom created a scheme to buy and exchange postage coupons internationally, Mr. Ponzi claimed profits in excess of 400% on particular transactions. Unsurprisingly, however, these profits could only be sustained whilst a strong inflow of new capital came into his scheme. During his height, Charles was collecting $250,000 daily. By 1920 curiosity was mounting around Mr. Ponzi and The Boston Post decided to investigate, ultimately exposing the fraudulent foundation, resulting in the complete collapse and loss to investors of ~$20m. (THE TELEGRAPH, 2016)
Whilst this was by no means the first example of what is now recognized as a Ponzi scheme, it was then, of an unprecedented magnitude, granting the scheme the prefix ‘Ponzi’.
In the context of finance, a Ponzi scheme lures would be investors with the promise of attractive returns, however, instead of investing the money, as proposed, the schemer transfers newly raised capital to pay off historical investors, after, of course, collecting a fee. Importantly, the schemes survival is dependent on the continued inflow of newly raised capital, | | which in turn exponentially increases the ultimate collective losses.
Perhaps what is most staggering is the prevalence of Ponzi schemes, even today. The FT reports that through the year 2016-17, in the US alone, 59 schemes were uncovered at a collective loss of $2.4bn. Reassuringly, regulators seem to be bringing such schemers to trial sooner, as the median size since 2012 has reduced from $6m to $3.5m, although an average of 65 schemes per year have been revealed since 2012. (LOVE, 2017)
Bernard Madoff’s unprecedented success arguably came from his distribution network, which through pursuit of above average annualized returns committed ~$20bn to the scheme, the remaining ~$45bn connected to the scandal was entirely fictitious, the product of Bernie’s fraudulent flair which purported returns of ~1% per month and more impressively never sustained an annual loss, a dependable consistency despite the changing market conditions and cycles.
This, however, could hardly have been achieved were it not for the almost 50-year endorsement of Wall St. which three times elected Mr. Madoff as Chairman of the NASDAQ, and collectively transferred several billion dollars via institutional investors and feeder funds, whom distracted(or incentivised) by passive management fees collectable after allocating client’s money, disregarded due diligence.
Fairfield Greenwich Advisors, an active investment management firm allocated ~$7.5bn (of their ~$14.1bn under management at the time) to the money management division of Bernard L. Madoff Investment Securities LLC. The second, third and fourth largest institutional investors each allocated >$2bn (~$8.27bn collectively) to the scheme, two of which were national banks (Banco Santander, ~$2.8bn; Bank Medici, ~$2.1bn). Further to this, the Madoff scheme was being marketed and sold by banks (EFG,.. et al) through third-party funds. (THE WALL STREET JOURNAL, 2009)
Moving forward, regulators such as the Securities and Exchange Commission fundamentally need to act on discrepancies and investigate with intent and be adaptable, especially as new technologies and de-regulated mechanisms are introduced to the world of finance, such as digital currencies. In the case of Madoff Securities LLC, the SEC dismissed six warnings identifying concerns about Madoff’s hedge fund and investigated at least 8 times over sixteen years to no avail. (Scannell, 2009)
Arguably, one of the SECs major shortfalls has been its lawyer focussed workforce, whom lacked the practical exposure of the everchanging financial instruments, markets and mechanisms, which often resulted in the SEC asking Mr. Madoff’s advice regarding certain market functionalities. (CRESWELL & THOMAS Jr, 2009). Increasing staff numbers and specialisations would facilitate more conclusive investigations.
References
CRESWELL, J., & THOMAS Jr, L. (2009, January 24). The Talented Mr. Madoff. Retrieved October 27, 2018 from The New York Times: https://www.nytimes.com/2009/01/25/business/25bernie.html
LOVE, B. (2017, March 30). Investors beware: the Ponzi scheme is thriving. Retrieved October 27, 2018 from ft.com: https://www.ft.com/content/000a2dc6-e322-11e6-9645-c9357a75844a
Scannell, K. (2009, January 05). Madoff Chasers Dug for Years, to No Avail. Retrieved October 27, 2018 from THE WALL STREET JOURNAL : https://www.wsj.com/articles/SB123111743915052731
SEC OFFICE OF INSPECTOR GENERAL. (2009). OIG-509: Investigation of Failure of the SEC To Uncover Bernard Madoff’s Ponzi Scheme. Washington D.C.: UNITED STATES SECURITIES AND EXCHANGE COMMISION.
THE TELEGRAPH. (2016, June 06). The Most Notorius Financial Frauds in History. Retrieved October 27, 2018 from The Telegraph: https://www.telegraph.co.uk/money/consumer-affairs/the-most-notorious-financial-frauds-in-history/charles-ponzi/
THE WALL STREET JOURNAL. (2009, March 06). Madoff’s Victims. Retrieved October 27, 2018 from wsj.net: http://s.wsj.net/public/resources/documents/st_madoff_victims_20081215.html
Seth