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What is a Ponzi scheme?

You may have heard of a financial crime called a Ponzi scheme but not know exactly what it is or how it operates. Ponzi schemes have made headlines in recent years, with Bernard Madoff being one of the most prominent figures convicted for a scheme that defrauded financially savvy people and ran up to 50 billion dollars, making it one of the largest ever in dollar terms.

So, how does a Ponzi scheme work, and where does it get its name? What are the penalties for people who orchestrate these types of financial frauds? Learn more about this classic white-collar crime.

The first Ponzi scheme

The Ponzi scheme takes its name from an Italian immigrant named Charles Ponzi, who made this type of fraud famous in 1920 because he perpetrated one of the largest up to that point. In his operation, he sold postal coupons and promised investors that he would increase their money by 50% in just 45 days. Despite the far-fetched nature of his proposal, he reaped investments totaling more than 8 million dollars from 30,000 investors in just seven months. He eventually served 14 years in prison and was deported back to Italy.

How the Ponzi scheme operates

Ponzi schemes operate by paying initial investors with money from subsequent investors, thus "proving" the veracity of the promised returns to investors. As the "returns" come in and investors begin spreading the word, the scheme generally grows and more investments roll in. However, by its very nature, a financial fraud scheme like this is eventually bound to fall apart once new investors can no longer be found or the person running the scheme simply runs off with investors' money.

Financial fraud, such as the Ponzi scheme, is alive and thriving in today's world. The FBI, which investigates financial fraud, advises people to be cautious of where they are putting their money and with whom, because Ponzi schemes are still widespread. However, perpetrators of this type of white-collar crime often risk lengthy prison sentences and large fines.

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