Pyramid and Ponzi Schemes Explained, Plus 6 Ways to Protect Yourself

People who invest in Bitcoin or in assets not listed on major markets usually worry about two things. The first is the return on investment (ROI) they can get from their initial investment. The second is the level of risk involved, in other words, the chance of losing money. If the risk is too high, you could lose your entire initial investment.

Of course, every investment always carries some risk. But if you get caught up in a pyramid or Ponzi scheme, that risk becomes far greater. That's why it's so important to recognize these scams and properly understand how they work.

What is a Ponzi scheme?

The name Ponzi comes from Charles Ponzi, an Italian con artist. Ponzi, who emigrated to North America, deceived hundreds of victims for over a year around 1920. Essentially, he ran an investment scam that collected money from new investors and passed it on to earlier investors. The problem with a Ponzi scheme is that once new investors stop coming in, the latecomers can no longer get their money back.

Here's an example of a Ponzi scheme. Ponzi pitches a great investment opportunity and gets $1,000 from one investor. He then promises to pay back the principal plus 10% interest after 90 days. Before the 90 days are up, Ponzi manages to bring in two new investors. He receives $2,000 from the two new investors and then pays $1,100 to the first investor. He might also encourage the first investor to reinvest the $1,000.

The scammer can keep raising money from new investors, pay early investors the promised returns, and encourage reinvestment to draw even more people in. As the scheme grows, it needs more and more new investors, and if it can't find them, problems arise with paying people back. This is usually around the time scammers disappear with the money.

What is a pyramid scheme?

A pyramid scheme is a scam with a business model that promises rewards to members not only for joining but also for recruiting new members.

For example, let's say a scammer offers Changpeng and Justin the chance to buy a distributorship in the company for $1,000 each. The two of them now have the right to sell distributorships themselves and can earn money from the members they recruit. The proceeds from selling distributorships are split 50:50 with the scammer.

In this case, Changpeng and Justin earn $500 per sale, so they need to sell two distributorships to break even. The burden of selling two distributorships to recover the initial investment is passed on to the customers. But just like a Ponzi scheme, this process requires more and more members to keep going, so in the end a pyramid scheme can't be sustained.

Most pyramid schemes don't offer any product or service and run solely on money raised by recruiting new members. However, some pyramid schemes may present themselves as legitimate multi-level marketing companies that claim to sell services or products. But this may simply be a way to hide the fraud.

Ponzi schemes vs. pyramid schemes

1) Similarities

Both Ponzi schemes and pyramid schemes are types of financial fraud that lure victims into investing money by promising good returns. For a Ponzi or pyramid structure to survive, money from new investors has to flow in regularly. Typically, these scams don't offer any real product or service.

2) Differences

A Ponzi scheme usually poses as an investment management service, and participants believe the returns they receive are the result of legitimate investments. The scammer is essentially paying some people back with other people's money.

A pyramid scheme is based on network marketing, and participants must recruit new members to make money. Each participant passes money up to the top of the pyramid and receives a commission.

6 ways to avoid falling for a Ponzi scheme

1. Be skeptical. Investment opportunities that promise quick or high returns on a small amount of money are likely to be scams. This is especially true when you're investing in something very unfamiliar or hard to understand. If it seems too good to be true, it's probably a scam.
2. Watch out for unexpected opportunities. Claims that you mustn't miss out on an incredibly good long-term investment opportunity are mostly lies.
3. Research the seller. Look into whoever is promoting the investment opportunity. Well-known financial advisors, brokers, or brokerage firms are registered with the appropriate regulatory authorities and are monitored.
4. Don't trust. Verify. A legitimate investment should be legally registered. The first step you should take is to ask for its registration details. If an investment opportunity seems questionable, demand a proper and reasonable explanation.
5. Make sure you fully understand the investment. You should never put money into something you don't completely understand. Make use of the resources available to you, and be very cautious with any suspicious investment opportunity.
6. Report it. Whenever you come across a Ponzi or pyramid scheme, it's important to report it to law enforcement. This helps protect future investors from falling victim to the same scam.

Is Bitcoin a pyramid scheme?

Some people claim that Bitcoin is a large-scale pyramid scheme. But that isn't true. Bitcoin is simply a currency. Bitcoin is a decentralized digital currency that is secured by mathematical algorithms and cryptography and can be used to buy goods and services. Just like fiat currency, crypto assets can be used in pyramid schemes (or other illegal activities), but that doesn't mean crypto assets or fiat currency are pyramid schemes themselves.