Why your money is NOT safe in Ponzi schemes

On May 25, 2011, United Overseas Bank, Speak Asia's banker in Singapore closed the accounts that the company had with the bank with effect from May 27, 2011.

In a statement issued to the press, the company said: 'We are approaching and evaluating various other banks in Singapore from where we will soon be able to disburse the payments to all panelists.'

This basically means that the payments to those who had invested in Speak Asia have been suspended.

'Further, we would like to put on record that no notice, letter or questionnaire has been received by us from any government agency/authority. In fact we have proactively approached the Ministry of Corporate Affairs and the Economic Offences Wings (EOW) of both Delhi and Mumbai Police and offered our fullest cooperation and information,' Manoj Kumar, CEO (India), Speak Asia, said in the media statement.

As I had said in my first piece on this topic (which you can read here) that ultimately all Ponzi schemes go bust. Speak Asia seems to have characteristics of being one, but how things pan out with it in the days to come remains to be seen.

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The company statement also said: 'We would like to reassure that the panelists' money is safe! Towards this, we are trying to open an escrow account in order to further protect their interests.'

In response to the first piece I got lots of emails and comments, agreeing and disagreeing with what I wrote. Some of you had some doubts, which I am trying to address through this piece.

In a Ponzi scheme no new wealth is created. It is a classic zero sum game.

I had made this point towards the end of the first piece. Some readers wrote in saying that how can this be correct. They had been members of Speak Asia and they got their money back, and hence it cannot be a zero sum game.

Let me get into a little detail on this point. A Ponzi scheme, as I had explained earlier, is essentially a fraudulent investment scheme where money brought in by the newer investors is used to pay off the older investors. This creates an impression of a successful investment scheme.

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Such a scheme can keep running only till the money entering the scheme is more than the money leaving the scheme. The most vulnerable investors are those who come at the end.

Also wealth gained by participants entering the scheme earlier is the wealth lost by those coming in later. Let us try and understand this through an example. Let us say someone decides to start a Ponzi scheme with the intention of defrauding people.

He gets 100 members to start with and each one of them contributes Rs 10,000 to become a member of the scheme. The members, in turn, are promised Rs 50,000 back in a period of one year.

Given that the scheme is a Ponzi scheme, there is no business model to generate returns and give out the Rs 50,000 promised to each investor. So the guy running the Ponzi scheme has to take the money being brought in by the newer investors to pay off these original investors.

Now every investor has been promised Rs 50,000. To enter the scheme Rs 10,000 is required. Hence to get Rs 50,000 to pay off one original investor, five new investors have to be roped in. Each one of them pays Rs 10,000 each and thus Rs 50,000 is raised to pay off the original investor.

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The point to note here is that the Rs 50,000 that each original investor gets is basically the money being brought in by five new investors. Hence, the money gained by the original investors is basically the money brought in by the five new investors. And that is what makes a Ponzi scheme a zero sum game.

The original investors gained only because the latter investors were willing to pay. No new wealth has been created.

This also means that to pay off the 100 original investors 500 new investors need to be brought in.

So that's the first level of the Ponzi.

What happens next? 

After the original lot has been paid off, the 500 investors who entered the second level of the Ponzi need to be paid off, to keep the scheme going. To pay off each of these investors five new investors are required, which in total means 2,500 investors.

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If the fraudster running the Ponzi manages to get 2,500 or more investors, the scheme continues.

Let us say the fraudster manages to get 2,500 investors and each of these investors pays Rs 10,000. The money thus collected is used to pay off the 500 investors of the second round.

In the third round 2,500 investors have to be paid, for which 12,500 investors need to invest money in the Ponzi scheme.

If the scheme continues successfully by the ninth round, nearly 19.5 crore (195 million) new investors need to be brought in to keep the Ponzi scheme going.

India's population as per the latest census is around 120 crore (1.2 billion). This means that for this hypothetical scheme to continue nearly 16 per cent of the population of India needs to invest in it.

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This is why primarily most Ponzi schemes soon fizzle out. The number of new investors required to keep the scheme going is simply too large.

Of course, the fraudsters carrying out the Ponzi scheme understand this, and at some point in time, they just take the money and scoot, instead of paying off the earlier investors.

Also at each of these levels, the money gained by the older investors is equal to the money brought in by the newer investors. And that's what makes it a zero sum game.

Is stock market a Ponzi scheme?  

Some readers wrote in saying that by this definition even the stock market is a Ponzi scheme. There logic is somewhat like this. Any investor looking to sell a stock that he has bought can be paid off only if there is a new investor willing to buy that stock.

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While this is correct, what one forgets in this argument is that the company whose stock you are buying or selling has a business model, on the basis of which the company earns money.

If you are buying the stock of Hindustan Unilever Ltd, you know that the company sells soaps and detergents among other things and makes money out of it in the process. So is the case with ITC. The company makes a major portion of its money from selling cigarettes.

Of course, that  is not always the case. There are times, when during a bull run, a lot of stocks with suspect business models hit the market just to raise money. Investing in such stocks is akin to investing in Ponzi schemes.

As Rober Shiller writes in his book Irrational Exuberance: 'When prices go up a number of times, investors are rewarded by price movements in these markets, just as they are in Ponzi schemes.' The high prices are not sustainable since they are driven by unrealistic expectations of further price increases. The bubble eventually bursts, and prices crash.

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Where is the business model?

Some readers wrote in saying that Speak Asia had a business model; it's just that the media does not understand it. The media in India has been time and again blamed for a lot of things.

However, if there was a business model, somebody would have figured it out by now and written about it.

Most people who wrote in were Speak Asia members and probably in a denial mode. There is a psychological explanation for this kind of behaviour. Most people rate themselves high on most of their positive personal traits.

People are also overconfident about their ability to make accurate estimates. They generally tend to be over optimistic when they are directly involved and have had no negative experience from the over optimism. They are over confident that they themselves will not be victims of financial frauds.

That is why they do not ask the obvious questions. Overconfidence and over-optimism together fuel Ponzi schemes.

The author can be contacted on shonalee.biswas@gmail.com