Ponzi Schemes

Ponzi Scheme | Causes Of Ponzi Schemes Fraud | Implications Of Ponzi Schemes

Kolkata Police Commissioner is questioned by the CBI in connection with the Sardha ponzi scam and Lok Sabha has passed a bill to curb the fraudulent ponzi schemes. Hence hereby discussing the concepts and issues related to Ponzi Scheme.

What is a Ponzi Scheme?

  • The scheme is named after Charles Ponzi who became notorious for using the technique in the early 1920s in the USA.
  • A typical ‘ponzi’ scheme involves the operator collecting a large amount of money from investors and paying them returns from their own money or the money collected from subsequent investors, rather than from profit earned by the person or the entity operating such a scheme.
  • The basic premise of the scheme is to gain continuous flow of money by attracting new clients. The scheme falls when this flow of money is stopped.
  • Firstly, these schemes promise an abnormally high rate of return. Secondly, they promise a guaranteed return. In the realm of the real world, high return and guaranteed return don’t go hand in hand.
  • In 2017, a total of 63 companies which were involved in “chit fund/MLM (Multi-Level Marketing)/ponzi activities” have been assigned to the SFIO for detailed probes.
  • The most famous examples are the Saradha chit fund and the Rose Valley chit fund scams. These were ponzi schemes in which investors lost millions of rupees.

  • What are the causes of ponzi schemes fraud?

    • The companies or institutions running Ponzi schemes have been exploiting the regulatory gaps and a lack of administrative measures to dupe the gullible people of their hard-earned money.
    • The issue is that regulators like RBI only regulate entities like banks and NBFCs. The SEBI-regulated collective investment schemes do not cover co-operative societies.
    • Investors who are gullible to such schemes are generally the one who are not exposed to formal investment products other than fixed deposits and saving schemes. Hence financial illiteracy and inexperience plays the major role.
    • Human greed on part of both the investors and deposit takers. This is also due to rising materialism in the society especially in the age of capitalism and globalization.
    • Poverty of the people also forces them to take recourse to such financial short-cuts.
    • Political backing is also responsible as seen in the case of Sardha scam.
    • Endorsements by celebrities also provide legitimacy e.g. Sardha.
    • Many of these schemes are run across states and hence become even more difficult to detect e.g. Sardha covered West Bengal, Odisha, Assam and Tripura.
    • Lack of financial inclusion is also the reason why people succumb to informal financial schemes.
    • The declining level of morality is also the reason for such frauds.

    • What are the implications of ponzi schemes?

      • A well-functioning financial system is based on trust. Fraud can undermine confidence, and the result will be less saving, less investment, less wealth and less income.
      • They divert finances of depositors from competent and productive investments. Hence productivity of capital decreases.
      • Many will slip back to poverty and huge losses may also result into socio-political instability.
      • Some of this money also finds its way towards political donations to solicit political backing and hence malign the electoral process
      • It also is accompanied by tax evasion and leads to loss of revenue for the government.

      • What are the mechanisms to address the menace of ponzi schemes?

        • The Indian Penal Code contains law pertaining to fraud. Proving a fraud takes a lot of time and the penalties are also not high. The existing deterrents are inadequate to stop these schemes.
        • The Finance Minister in the Budget Speech 2016-17 had announced that a comprehensive central legislation would be brought in to deal with the menace of illicit deposit taking schemes.
        • In order to put a curb on such fraud schemes, the Lok Sabha has recently passed the Banning of Unregulated Deposit Schemes Bill, 2018.
        • According to the Bill, all deposit-taking schemes are required to be registered with the relevant regulator, failing which the “Deposit Takers” will be considered “unregulated” and hence be banned.
        • The Bill creates three different types of offences, namely, running of Unregulated Deposit Schemes, fraudulent default in Regulated Deposit Schemes, and wrongful inducement in relation to Unregulated Deposit Schemes.
        • The Bill provides for severe punishment and heavy pecuniary fines to act as deterrent.
        • A ‘Competent Authority’ will be appointed which has the powers similar to a civil court, including powers to attach properties of the deposit takers.
        • The Bill also approves creating designated courts to tackle such cases.
        • The Bill enables creation of an online central database, for collection and sharing of information on deposit taking activities in the country.
        • The Union Cabinet has given its approval to introduce the Chit Funds (Amendment) Bill, 2018 in Parliament to amend the Chit Funds Act, 1982. It aims to protect small investors and facilitate orderly growth of chit fund sector.

        • What is the way ahead?