People in online crypto communities keep throwing around the term Ponzi scheme as though it is synonymous with scam. It is not, and contrary to the popular wisdom on the internet, just because you lost money on (or didn’t invest in) a specific crypto project doesn’t mean that it’s a scam, either, let alone a Ponzi scheme. However, that's not to say that these scams don't exist, or that people aren't falling prey to them.
So without further ado, here’s a brief history and primer on Ponzi schemes, and some brief hints on how to spot them.
What is a Ponzi Scheme?
Named for, but not invented by, a 1920s American scam artist called Charles Ponzi, a Ponzi scheme is a very specific financial crime that works by promising individual investors sizeable returns on financial investments in legitimate business activity, when in truth the only money in the scheme comes from the investors themselves. The investors take no active role in the scheme, and recruitment is done by the con artist and/or their team (who may or may not be aware that the project is a fraud).
Ponzi schemes do not involve the investors receiving or holding any goods, shares, products, or tangible assets. They are not sold fake or worthless goods because they are not sold any goods at all. From the investor’s perspective, they are putting their money into a very high interest savings account and expecting it to mature in a specific timeframe. It is not unusual for early “victims” of Ponzi schemes to make a profit, while later adopters will almost certainly have nothing to show for their trouble, not even a worthless token.
So, while a Ponzi scheme is a financial scam, not all financial scams are Ponzi schemes.
This is roughly how they work:
A con artist convinces a group of investors – often friends and family – to give them money in return for significant financial gains that can run up to 10x more than the banks promise in a reduced period of time – say six months.
The con artist might use this money to try and legitimately run a business but fails. More often they spend the lot on hookers and blow. When the time comes to pay back the investments plus the interest, the con artist decides against coming clean and works to pay out those first investors in full. As he doesn’t have any money, he instead seeks out new investors. The con artist will use the existence of their first investors to show that they are a legitimate businessman. They need more investors this time around so that they can cover the gains of the first group, but are somehow successful in getting people to part with their money.
The con artist pays investors in group one in full. Naturally they are very happy indeed, and many will reinvest their initial money plus their gains back in with the con artist. The con artist now has a nice stash of cash to blow on their poison of choice, but a lot of people who are going to expect big pay outs in 6 months. So they repeat the process by bringing in a third set of investors. And then a fourth. And so on. Every successful payout means increased credibility for the con artist, who then finds it easier to bring in more investors. Known as “robbing Peter to pay Paul,” the con artist just moves the money from one account to another, all the while pretending that the earnings come from legitimate business practice. They are also using this money to fund their lifestyle, justifying any extravagance as part of their “image”. The amounts get bigger and bigger over time, until suddenly the con artist can no longer cover them.
Maybe someone wants to withdraw a large amount and retire. Maybe the con artist couldn’t bring in enough new investors to cover a dividend payout. But once they fail to make one payment, word gets out among the investors and suddenly everyone is trying to regain their cash from accounts that are empty. The investors discover there’s no assets, no company, no money. The police are called, and the gig is up.
Why do Ponzi schemes work?
Because they do work – let’s not lie about that. Scam artists, even when caught, rarely have the money to return to their victims because they’ve spent it on consumables like drink, drugs and vacations.
Ponzi schemes work because people want to make money, but saying “greed” is too simplistic. As illustrated above, the first people pulled into a Ponzi scheme really do make money – sometimes a hell of a lot of it even if they were unaware it was a scam. It is believed around half of the people Bernie Madoff was conning actually made significant money on their investments; in fact, Bernie Madoff wasn’t even the biggest beneficiary of his illegal activities. Would you believe me that something was a scam if every single investor you spoke to could prove they’d made money?
Now let’s imagine the investors in the scheme were ones that you respected and trusted, or that they are the type of people you feel could sniff out a fraud at a thousand paces. Madoff’s clients were well-to-do members of his own elite community; he went to the country club with these people, most of whom had well educated, professional backgrounds. 75% of Boston’s police force invested with Charles Ponzi, as well as actual bankers. In the 1800s, a banker called Henry Fauntleroy was the darling of the London elite, despite the fact he was swindling them all.
Even when people do recognize a financial scam happening in real time, it’s not unusual for them to be ignored. Lawyers tried to bring down Madoff for well over a decade and had a ridiculous amount of proof, only to watch as Madoff was appointed chair of NASDAQ. When a financial journalist noted that Ponzi’s success was unfeasible and that he was likely running a fraud, Ponzi sued the man for libel, and won. More than that, both Madoff and Ponzi received a ton of positive press from their investors that countered the few who raised concerns. We’re all experts with hindsight, but realistically there are few people in this world who would successfully identify these schemes as they were happening, and fewer still who would successfully convince the rest of us.
So why does this matter?
It matters because words matter. I’ve seen the same online commenters who call a volatile but legitimate project a Ponzi scheme, turn around and aggressively shill a project that Bernie Madoff would have considered an unethical way to make money. Some of these are likely fake accounts, but some are definitely newbies just repeating what they’ve read elsewhere. Calling a project you don’t like a Ponzi scheme doesn’t just do your own credibility harm, but it makes it harder for future investors to parse the risky but legit crypto projects from actual cons.
How to identify a Ponzi scheme in crypto
If identifying a Ponzi scheme was easy then scam artists wouldn’t do them, because they can look like successful, legitimate operations right up until they collapse. However, the following flags should at least give you pause to do more research. If they all appear, then perhaps it’s time to reconsider investing.
Investors hand over money, but get nothing in return but a promise of future gains.
A worthless token is still an asset. It might be a scam, but it’s not a Ponzi. If the crypto project asks you to hand over money for a set amount of time, after which your original investment plus significant gains will be returned, you need to ask yourself if you trust this company any more that you would some random bloke who promises you the same thing.
This tactic is also used in other types of scams that can be highly sophisticated. It feels legit because this is how long-term saving accounts operate and how we save for retirement, so while this flag alone doesn’t mean there is a scam occurring, it does mean you should do some due diligence.
In my opinion, the most likely place for Ponzi schemes to occur in crypto is staking pools, and for every legitimate outfit there are going to be scam artists trying to reel you in. Remember, if you wouldn’t hand your money over to Brian from the pub to invest with some friend of his, don’t put it into an online staking pool just because Brian from Reddit said the website he uses is the real deal.
Future gains are guaranteed by the project directors.
Seriously, never trust anyone that guarantees you a 20% increase in the value of your investment in six months. The market doesn’t work that way, because if we could guarantee that kind of rise we’d all be freaking billionaires, and no financially responsible person would ever guarantee your returns, and definitely at a rate significantly higher than the market average.
Is your staking pool talks about anticipated gains, then dig a little deeper. If they guarantee them, ask yourself how will they pay up if crypto value quartered tomorrow? If they say “stake 10 coins and receive 11 in the same currency back in three months” then ask yourself the opposite – if that crypto did a moon shot, would they actually be able to cover your gains?
Are the current investors consistently making profits at a rate 10X higher than comparable projects?
If all the major crypto currencies are up somewhere between 5 and 25% in value then fine, making 20% on a random coin in less than 6 months can, does, and hopefully will continue to happen.
If one lone crypto rockets in value 300x for some notable reason, like mainstream adoption or a major technological advancement, then it is likely legitimate as many memecoin millionaires out there can attest.
But a project that consistently increases at a steady pace, never drops and always makes investors money at a rate higher than the average return of every comparable asset is at best heavily manipulated and at worst an outright Ponzi. Crypto, and assets in general, do not behave that way. You might make consistent small gains on a diverse portfolio, but no one asset is going to bring in above-average gains for a prolonged period without someone manipulating it for nefarious reasons.
Again, this flag alone does not mean a scam is definitely at play, but any asset that is behaving unnaturally for the market should be treated with both skepticism and caution. If it’s too good to be true, then it probably is.
Does the project documentation match what the directors say?
Take a look at whoever is running the show. Set aside their credentials and personality – Ponzi was extremely charismatic, Fauntleroy was born to wealth, and Madoff was extremely intelligent – and look at whether their statements match the documentation. It doesn’t matter if they are anonymous or trying to hog all the glory, your DD should be the same. This is where reading the white papers and understanding the structure of the crypto project you are investing in really matters, because it helps you work out whether things are adding up. Madoff and Fauntleroy cooked the books, but the fraud was obvious to those who looked at them. Ponzi didn’t even have books, he just talked vaguely but enthusiastically about international reply coupons and people just nodded along. Anyone who knew about IRCs very quickly realized he was talking nonsense. The only way to know if you are being lied to is know the product you’re investing in well enough to spot the lies.
So if their charts or payouts are going up but you can’t see what’s coming in, get suspicious. If they answer questions with vague comments about blockchain, proof of stake or defi without showing how they relate to this specific project, get very suspicious because they are trying to fool someone. Don’t let that be you.
How long have those amazing gains being going for?
Lastly, and the most counter-intuitive one of them all – if the project has had a perfect score on making people obscene amounts of money for a couple of years, be extremely suspicious that it’s a mid-to-late stage Ponzi scheme. If you’ve left your money in a project and you’ve had years of over-average gains without a single deviation, be extremely suspicious and at the very least consider withdrawing your initial investment. Remember that innocent people can make a lot of money in a Ponzi scheme, so long as they manage to jump ship before the storm hits. Unfortunately, if you’re at a stage where you’ve noticed it getting a little breezy outside, it’s probably too late and all your money is gone.
Thus ends today’s lesson. Remember: All Ponzi schemes are scams, but not all scams are Ponzi schemes. Pyramids, Boiler Rooms, Crypto “forex” schemes, pump & dumps, gambling cons, and advance fee schemes are also ways people on reddit and on the interwebs will try and part you from your crypto and your fiat, but they operate differently and target different groups. Don’t make the mistake of thinking they are all the same; just because you’re unlikely to fall for one (*smiles smugly at gambling cons*) doesn’t mean you won’t be burned by another (*glares at pump & dump*).
