Saturday, March 10, 2018

Pulling A Ponzi

Author: Kevin Kuriakose


In the early 1920s America, Charles Ponzi[1] promises his clients (then just 18 of them) 50% profits in 45 days or 100% profits in 90 days by buying discounted reply coupons internationally and selling them at face value in the US, in a bid to make quick money through arbitrage.

Spring of April 1992, a limited liability company by the name Caritus[2], in Romania, is to start attracting millions of depositors from across the country (about 50% of households) to invest more than five billion USD for the next two years.  

With a croak in his voice, and index finger curled within the thumb, Donald Trump hurls into the cameras that he means nothing other than enormous tax breaks[3]. Playing into Reagon’s old and seemingly dusted trickle down economics, the veiled intentions of the President of the United States share a common characteristic with Charles Ponzi and Caritus, according to some observers[4].
All of them involve the emotive beliefs of a Pyramid Scheme-and luckily, we have a better word for them. Ponzi Scheme.

Charles Ponzi’s grandiose scheme ran for over a year, swindling its ‘investors’ worth of 20 million USD.  In Romania, Caritus went bankrupt with a staggering debt of 743 million USD in August 1994, reaping great political and economic havoc in the state[5]. And Donald Trump is still president. Though to be fair to him, he’s not a textbook Ponzi Schemer, only so far showing the affections of one for the upper ranked in the pyramid.

Although Ponzi Schemes at first impression might seem as simple fraudulent activities, their scope lies much beyond. To put it very traditionally, how the mechanism works is, a Ponzi entrepreneur uses the money invested by new investors to pay old ones, rather than using that(investment) money to productive/ investing activities. To explain this further I would use the help of the following table:

New Investment (in dolllars)
Interest to be payed (10% of investment)
Investments left after payment
100
0
100
200
10
390 (190+100)
400
30
790 (400+360)
600
70
1320(720+600)
Figure 1 A similar example cited in Ponzis : the science and mystique of a class of financial frauds, Kaushik Basu. 2014

In this example, I am assuming that the ‘entrepreneur’ approached a client with a proposal that he will pay 10% interest rate to the client for his investment every month. Hence in the first month, the entrepreneur has 100 US dollars with him. In the second month he invited two more investors to invest 100 dollars each. Out of the 200 dollars that they invest, the entrepreneur pays away the first investor his due of 10 dollars(10% of 100 dollar investment). So now our smug entrepreneur is left with 390 dollars. And the scheme goes on.

This is a very simplistic, and often narrow way of studying the scheme. However, it helps us understand some important features. To begin with, the Ponzi entrepreneur though has no interest in real investment, he does honour his interest dues. This is in some ways a sort of redistribution of income-though in the opposite direction of welfare. This helps him building reputation in the industry, and bank on the trusts of short-run gladdened investors who get their “low risk, high returns”.

He is also not in for a predetermined amount of period- for all we know it can extend theoretically to eternity. Fortunately, and perhaps not so much, the real world does account for a tipping point which is unknown to both the investors and the entrepreneur. For if there were the slightest inkling of funds sinking, any rational investor would pull out his investment one period before. Knowing this, no one would invest one period before, since they know investments won’t come the next period. Ultimately such a rationale would translate to a backward induction case where no one invests in the first place [6]. But Ponzi is a success largely because of a lack of defined point of crash. And, like every other bubble, this too has an end, and a destructive one at that. Of course, there is wide evidence to suggest that micro level Pyramids scheme are much more popular in developing countries, namely India, where people are often lured for investing small amounts of funds for “high returns”[7], we must be wary of the larger picture.

With this very rudimentary explanation of a Ponzi scheme, we must delve deeper into the larger consequences of letting word of mouth popularity and returns of investments get the better of our financial markets. After all, that is what Ponzis feed off.

From the housing market bubble of the US, to the frequent Gold price bubbles (most recent of 2009-11)[8], and to now the speculations of the wildly discussed crypto currencies, we see manifestations of Ponzi, only fail to recognise. Owning multiple homes, or kilos of Gold is of no interest to the larger population, except because others hold them and seem to be earning well. This principle added with the Ponzi’s affliction for crash when extended to Bitcoins, is terrifying.

On those lines, the traction that Bitcoin has garnered world over is not just related to its low transaction costs, and easy access, but its “self-fulfilling prophecy”. [9] With lack of regulation, and cross border recognition, Bitcoin and other virtual currencies are making space for scammy activities. [10] But is it only about regulations? A portion of the academic world is often cited to say that the Ponzi problem is not so much about economics, but market speculation. However, we forget that Ponzis can often be nondeliberate in nature. [11] That is, perhaps, Bitcoin is a Ponzi horcrux we did not intend to create.




Figure 2 Bitconnect Prices from Jan'17 to Jan '18: Source  https://www.coingecko.com/en/price_charts/bitconnect/usd#panel

Bitconnect a platform which started in December 2016 over the course of its year was treated suspiciously by the crypto community. This anonymously run currency platform was shut down this January, for allegedly running a Ponzi scheme. It is interesting to note how from a price value of less than a dollar when it started, it clocked a price of 450 USD in Jan 2018.


As economies persist on being sceptical of cryptocurrencies, the new Ponzi in town, we must also deal with problems far beyond that we signed up for. As is with all such schemes, the lowest in the ‘pyramid’ are the worst hit, and with the impression that Governments are ever-ready to bail out sinking ships, its only getting a pat on the back. And the living thumping Ponzi, Donald Trump, is the greatest example we got.
  
References:


[6] “Ponzis: The Science and Mystique of a Class of Financial Frauds” Kaushik Basu. 2014. Policy Research Working Paper
[9] “Ponzis: The Science and Mystique of a Class of Financial Frauds” Kaushik Basu. 2014. Policy Research Working Paper

No comments:

Post a Comment