The Madoff scam in the USA is thought to have cost people up to £50 billion, and there’s talk of similar schemes having been operated in the UK.
Yet I’ve read a lot of confusion about what’s happened. Sometimes it’s called a pyramid scheme; other times a Ponzi. So I thought I’d do a quick blog to explain the difference between the two (Madoff is a ponzi not a pyramid).
- Pyramid Scam. While fundamentally flawed, pyramid schemes are the more honest of the two, as the participants in them know what’s happening.
Essentially they’re networking schemes: each person who’s recruited is then expected to recruit more people, and as long as that happens people make money.
For example, you pay £1,000 to join, on the promise that you’ll get £5,000 back, providing you recruit six people yourself (with some money going up the pyramid). You usually don’t get their £1,000s directly, and are distributed some money as your recruits pay up, and some more as the people they recruit pay up… and so on.
These schemes rely on continued redistribution of income. No new money is being created, it’s just being moved, and is by its nature a zero sum game. The problem is it doesn’t take long before you need to be recruiting the entire world’s population for the thing to continue.
Tier 1: Needs 1 person
Tier 2: Needs 6 people
Tier 3: Needs 36 people
Tier 4: Needs 216 people
Tier 5: Needs 1,296 people
Tier 6: Needs 7,776 people
Tier 7: Needs 46,656 people
Tier 8: Needs 279,936 people
Tier 9: Needs 1,679,616 people
Tier 10: Needs 10,077,696 people
Tier 11: Needs 60,466,176 people (every adult & child in UK)
Tier 12: Needs 362,797,066 people
Tier 13: Needs 2,176,782,336 people
Tier 14: Needs 13,060,694,016 people (2x every adult & child in the world)
So a pyramid isn’t innately dishonest, as everyone knows how it works. It is, however, pretty immoral, as it only works out well for the people at the top, and they do it in full knowledge the entire scheme MUST break down at some point, and that’ll happen quite quickly. Yet in the meantime they can make a fortune.
- Ponzi Scam.
These are much more dishonest, and much more plausible, hence they can draw in more sophisticated investors. Unlike pyramid schemes, the entire premise is based on a lie, but it’s a plausible one. The best way to explain how it works is to give you an example.
I’m going to use a gambling Ponzi, which has often been the underlying proposition, though Madoff is being accused of running an investment Ponzi, working in a very similar way.
Honest Paul is a mate of a mate’s mate. He says he’s got this sure fire gambling system, and if you put money in, he will give you FIVE TIMES it back in just two months. You’re sceptical, but your mate’s done it and got the cash to show for it…. so has his mate.
So you put £100 in, to dip your toe in the water, and guess what happens… you do get £500 back. The gambling system is WORKING.
So you get asked to put £2,000 in and to recruit your friends too… who will also get commission. You’re more than happy to do this as you’ve made so much money and now KNOW they system works and have the information three times down the line.
The problem is, what’s really happening underneath this is a pyramid scheme. Your money (or most of it) isn’t coming from successful gambling (or investing), it’s coming from other new recruits’ pockets.
And the whole system will only keep working as long as people can keep recruiting. However, here there’s the advantage that as it’s dressed up like a legit investment, so more people are fooled into it, and it carries on going until the whole thing goes kaput. Plus if you lower the returns e.g. the Ponzi-master only says you’ll get 30% on your ‘investment’ then it can keep going longer, as each new recruit can subsidise three people up the tree.
Yet ultimately this is a zero sum game too. And after a number of levels it stops and everyone loses. And of course the longer its gone on for, the more people are at the bottom step of the pyramid losing.