Charles Ponzi and Bernie Madoff Would Have Been Proud of the Ponzi Schemes of 2021

Bernie Madoff, the man who ran the biggest Ponzi scheme of all time, died in jail on April 14, 2021, fifteen days shy of turning 83.

A Ponzi scheme is a fraudulent investment scheme in which older investors are paid by using money being brought in by newer ones. It keeps running until the money being brought in by the newer investors is greater than the money being paid to the older ones. Once this reverses, the scheme collapses . Or the scamster running the scheme, runs away with the money before the scheme collapses. 

The scheme is named after an Italian American, Charles Ponzi, who tried running such an investment scheme in Boston, United States, in 1920. He had promised to double investors’ money in 90 days, which meant an annual return of 1500%. At its peak, 40,000 investors had invested $15 million in Ponzi’s scheme.

Not surprisingly, the scheme collapsed in less than a year’s time, under its own weight. All Ponzi was doing was taking money from newer investors and paying off the older ones.

Once Boston Post ran a story exposing his scheme in July 1920, many investors demanded their money back and Ponzi’s Ponzi scheme simply collapsed, as money being brought in by newer investors dried up, while older investors had to be paid.

Madoff was smarter that way. His scheme gave consistent returns of around 10% per year, year on year. The fact that Madoff promised reasonable returns, helped him keep running his Ponzi scheme for decades. But when the financial crisis of 2008 struck, it became difficult for him to carry on with the pretence and the scheme collapsed.  

As I wrote in a piece for the Mint newspaper yesterday, Madoff was Ponzi’s most successful disciple ever. While Ponzi’s investment scheme started in December 1919, it collapsed in less than a year’s time in August 1920. On the other hand, documents suggest that Madoff’s scheme started sometime in the 1960s and ran for close to five decades.

Nevertheless, both Madoff and Ponzi, would have been proud of the Ponzi schemes of 2021. The only difference being that the current day Ponzi schemes are what economist Nobel Prize winning Robert Shiller calls naturally occurring Ponzi schemes and not fraudulent ones like the kind Ponzi and Madoff ran.

A conventional Ponzi scheme has a fraudulent manager at the centre of it all and the intention is to defraud investors and take the money and run before the scheme collapses. A naturally occurring Ponzi scheme is slightly different to that extent.

Shiller defines naturally occurring Ponzi schemes in his book Irrational Exuberance: 

“Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasize the positive news and give less emphasis to the negative.”

Basically, what Shiller is saying here is that the stock markets enter a phase at various points of time, where stock prices go up simply because new money keeps coming in and not because of the expectations of earnings of companies going up in the days to come.

Ultimately, stock prices should reflect a discounted value of future company earnings. But quite often that is not the case and the price goes totally out of whack, for considerably long periods of time. 

A lot of money comes in simply because the smarter investors know that newer money will keep coming in and stock prices will keep going up, and thus, stocks can be unloaded on to the newer investors. Hence, like in a Ponzi scheme, the money being brought in by the newer investors pays off the older ones. In simpler terms, this can be referred to as the greater fool theory.

The investors buying stocks at a certain point of time, when stock prices do not justify the expected future earnings, know that greater fools can be expected to invest in stocks in the time to come and to whom they can sell their stocks.

Of course, this is not the story that is sold. If you want money to keep coming into stocks, you can’t call a prospective fool a fool. There is a whole setup, from stock brokerages to mutual funds to portfolio management services to insurance companies selling investment plans, which benefit from the status quo. Their incomes depend on how well the stock market continues to do. 

They are the deep state of investment and need to keep selling stories that all is well, that stocks are not expensive, that this time is different, that a new era is here or is on its way, that stock prices will keep going up and that if you want to get rich you should invest in the stock market, to keep luring fools in and keep the legal Ponzi scheme, for the lack of a better term, going.

 — Bernie Madoff 

This is precisely what has been happening all across the world since the covid pandemic broke out. With central banks printing a humongous amount of money, interest rates are at very low levels, forcing investors to look for higher returns. A lot of this money has found its way into stock markets. The newer investors have bid stock prices up, thus benefitting the older investors. The deep state of investment has played its role.

Of course, the counterpoint to whatever I have said up until now is that unless new money comes in, how will stock prices ever go up. This is a fair point. But what needs to be understood here is that in the last one year, the total amount of money invested in stocks has turned into a flood. Take the case of foreign institutional investors investing in Indian stocks.

They net invested a total of $37.03 billion in Indian stocks in 2020-21. This was almost 23% more than what they invested in Indian stocks in the previous six years, from April 2014 to March 2020. This flood of money can be seen in stock markets all across the world.

Clearly, there is a difference, and the stock market has worked like a naturally occurring Ponzi scheme, at least over the last one year.

This Ponziness is not just limited to stocks. Take a look at what is happening to Indian startups…oh pardon me…we don’t call them startups anymore, we call them unicorns, these days. A unicorn is a startup which has a valuation of greater than billion dollars.

How can a startup have a valuation of more than a billion dollars, is a question well worth asking. I try and answer this question in a piece I have written in today’s edition of the Mint newspaper.

As mentioned earlier, there is too much money floating all around the world, particularly in the rich world, looking for higher returns. Venture capitalists (VCs) have access to this money and thus are picking up stakes in Indian startups at extremely high prices.

Many of these startups have revenues of a few lakhs and losses running into hundreds or thousands of crore. The losses are funded out of money invested by VCs into these unicorns.

The losses are primarily on account of selling, the service or the good that the startup is offering, at a discounted price. The idea is to show that a monopoly (or a duopoly, if there is more than one player in the same line of business) is being built in that line of business and then cash in on that through a very expensive initial public offering (IPO).

As and when, the IPO happens, a newer set of investors, including retail investors, buy into the business, at a very high price, in the hope that the company will make lots of money in the days to come. Interestingly, IPOs which used to help entrepreneurs raise capital to expand businesses, now have become exit options for VCs. 

If an IPO is not possible, then the VC hopes to unload the stake on to another VC or a company and get out of the business.

In that sense, the hope is that a newer set of investors will pay off an older set, like is the case in any Ponzi scheme. Of course, this newer set then needs another newer set to keep the Ponzi going.

The good thing is that when investors buy a stock of an existing company or in a new company’s IPO, they are at least buying a part of an underlying business. In case of existing companies, chances are that the business is profitable. In case of an IPO, the business may already be profitable or is expected to be profitable.

But the same cannot be said about many digital assets that are being frantically bought and sold these days. There is no underlying business or asset, for which money is being paid. Take the case of Dogecoin which was created as a satire on cryptocurrencies.

As I write this, it has given a return of 24% in the last 24 hours. An Indian fixed deposit investor will take more than four years to earn that kind of return and that too if he doesn’t pay any tax on the interest earned.

Why is Dogecoin delivering such fantastic returns? As James Surowiecki writes in a column: “There is no good answer to that question, other than to say Dogecoins have gotten dramatically more valuable because people have decided to act as if they’re more valuable.”

As John Maynard Keynes puts it, investors are currently anticipating “what average opinion expects the average opinion to be.” Carried away by the high returns on Dogecoin, the expectation is that newer investors will keep investing in it and hence, prices will keep going up. The newer investors will keep paying the older ones. That is the hope, like is the case with any Ponzi scheme, except for the fact that in this case, there is no fraudulent manager at the centre of it all.

Of course, the only way the value of Dogecoin and many other cryptocurrencies can be sustained, is if newer investors keep coming in and at the same time, people who already own these cryptocurrencies don’t rush out all at once to cash in on their gains.

If this does not happen, as is the case with any Ponzi scheme, when existing investors demand their money back and not enough newer investors are coming in, this Ponzi scheme will also collapse.

– Charles Ponzi 

Given this, like is the case with people who are heavily invested in stocks, it is important for people who are heavily invested in cryptos to keep defending them. Of course, a lot of times this is technical mumbo jumbo, which basically amounts to that old phrase, this time is different.

But this time is different is probably the oldest lie in finance. It rarely is.

And if dogecoin was not enough, we now have investors going crazy about non-fungible tokens (NFTs), which in simple terms is basically certified digital art. As Jazmin Goodwin points out: “For example, Jack Dorsey’s first tweet is now bidding for $2.5 million, a video clip of a LeBron James slam dunk sold for over $200,000 and a decade-old “Nyan Cat” GIF went for $600,000.” The auction house Christie sold its first ever NFT artwork for $69 million, in March.

In a world of extremely low interest rates and massive amount of printing carried out by central banks, there is too much money going around chasing returns.

There aren’t enough avenues and which is why we have financial and digital assets now turning into naturally occurring Ponzi schemes, giving the kind of returns that the original Ponzi scamsters, like Ponzi himself and his disciple Madoff, would be proud off.

Madoff’s scheme delivered returns of 10% returns per year. Ponzi promised to double investors’ money in three months or a return of 100% over three months. As I write this, Dogecoin has given a return of more than 600% over the last one month.

Here’s is how the price chart of Dogecoin looks like over the last one month.

Source: https://www.coindesk.com/price/dogecoin.

 

Bitcoin Without Monetary Ambition is Just Another Ponzi Scheme

There has been a lot of talk around the government banning bitcoin and other cryptocurrencies.

In fact, as the finance minister Nirmala Sitharaman recently told the Rajya Sabha: “”A high-level Inter-Ministerial Committee (IMC) constituted under the Chairmanship of Secretary (Economic Affairs) to study the issues related to virtual currencies and propose specific actions to be taken in the matter recommended in its report that all private cryptocurrencies, except any virtual currencies issued by state, will be prohibited in India.”

There is no scope for confusion in this statement. It’s saying that the government is gearing up to ban all cryptocurrencies including bitcoin. The only cryptocurrencies it will allow are those issued by it. (A government issuing a cryptocurrency is a joke, but then let me not go there for the time being. We will tackle it as and when it happens).

If bitcoin and other cryptocurrencies are banned by the government then all the bitcoin brokers through which investors trade, will need to shut down. Hopefully, the government will allow investors some sort of an exit option.

Of course, if you are trading bitcoin through a broker then you are speculating and do not really believe in the philosophy with which bitcoin was designed and launched (even if you think you do).

Satoshi Nakamoto, the creator (or creators for that matter, given that we don’t know), didn’t like the ability of the government and the central banks to create paper money out of thin air by printing it (or creating it digitally for that matter).

As he wrote on a message board in February 2009: “The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”

This happened in the aftermath of the financial crisis that broke out in September 2008, after which the Western central banks started printing massive amounts of money to drive down interest rates, in the hope of people and businesses, borrowing and spending money, in order to revive their respective economies.

Nakamoto looked at a central bank’s ability to debase paper money (by creating it out of thin air), as an abuse of the trust people had in it. And Bitcoin was supposed to be a solution for this breach of trust; a cryptocurrency which did not use banks or any third party as a medium and the code for which has been written in such a way that only 21 million units can be created.

The moment you are using a broker to buy bitcoin, you become a part of the conventional financial system and you really don’t remain anonymous anymore as was the idea originally.

A few bitcoin believers who have interacted (a fairly euphemistic word) with me on the social media have told me that there are ways of continuing to buy and sell bitcoin, even if the government bans them. So, they are really not perturbed by the idea of the government banning bitcoin.

The trouble with this argument is that if you continue to trade bitcoin after the ban, you are breaking the law. You might feel that the law isn’t fair, but a law is a law. One way of continuing to trade bitcoin is to legally move money abroad (up to a limit of $2,50,000) and use that money to trade bitcoin.

While this is possible, at some point of time the need to bring money back to India might arise, so, under what head of income will one declare it? If the gains are substantial, won’t the taxman come calling in these days of big data? (Or even if you regularly keep moving a good amount abroad every year).

Believers might still figure out ways to get around the system, but for most normal souls this is not worth the trouble. This is something that the bitcoin believers haven’t gotten their heads around to (yes, yes, yes, have fun stay poor).  Like one individual told me that he can simply bribe the taxman (I mean, yes, you can also do hawala and get your money in cash).

Another factor that needs to be kept in mind here is that the government in the next few years is going to be desperate for tax revenues. I guess I will leave this point here.

The bitcoin brokers in India are desperately trying to spin the usefulness of bitcoin in many interviews in the mainstream media. In fact, in one interview, Sumit Gupta, CEO & Co-Founder of CoinDCX, pointed out that there are 75 lakh bitcoin investors in India. A report in The Times of India puts the number at 1 crore. No source has been provided for these numbers.

The interesting thing is that Gupta feels that “there is a lot of confusion in calling bitcoin as cryptocurrency and not calling it an asset.” He wants bitcoin in India to be considered as an asset and be regulated. He doesn’t want it to be considered as money.

If something like this where to happen, it changes quite a few things.

When an investor buys a company’s stock, he is buying a share in the future earnings of the company. When he buys mutual funds, he is indirectly buying stocks or other financial securities issued by companies or even something like gold. When he buys gold, he buys gold.

When he buys derivatives, he is either hedging against price fluctuation or speculating on the price of a certain commodity. When he buys real estate he buys a home to live in or as a physical asset to profit from in the years to come. I mean one can go on and on here.

(Charles Ponzi on whom the Ponzi scheme is named). 

What does one buy, when one buys bitcoin as an investment asset? Nothing. It would be fair to say that if you take out bitcoin’s or for that matter any other cryptocurrency’s ambition to emerge as a parallel form of money out of the equation, it simply becomes a Ponzi scheme. (Don’t think Gupta realised this while making the point that he did). (You can read why I think bitcoin will never be money, here and here).

A Ponzi scheme is a financial scheme, where a fraudulent promoter promises very high return in a very short period of time to investors. He has no business model to earn this money in order to deliver returns.

The money being brought in by the second set of investors is used to pay off the first set. Or they are encouraged to roll over. As the news of high return spreads, more and more investors get sucked into the scheme, with the greed of earning potentially very high returns driving their investment.

This continues until the money being brought in by the new set of investors is less than the money being redeemed to the older set. Then the scheme collapses. Of course, most promoters disappear with the money before reaching such a stage.

Bitcoin without monetary ambitions is exactly like that. Money being brought in by newer investors pushes the price up, given the limited supply and prices go up very quickly, allowing existing investors to benefit.

As long as money being brought in by fresh investors is higher than money being taken out by existing ones, bitcoin keeps going up. When the equation changes, just like in a Ponzi scheme, bitcoin price crashes.

It’s basically the Ponzi scheme structure of bitcoin which explains its huge volatility on the price front. On February 21, the price of bitcoin was $57,434. Six days later on February 27, it was down by nearly a fifth to $46,345. Or take the period of six days between February 15 and February 21, when the price of bitcoin rose by a fifth (or 20%) to $57,434.

Of course, unlike normal Ponzi schemes, there is technology and thinking behind bitcoin and other cryptocurrencies. But that doesn’t make them any less a Ponzi scheme.

Given this, it’s time that the government steps into ban bitcoin and other cryptocurrencies. India has enough Ponzi schemes to deal with already. There is no point in adding more to the list.

India’s Ecommerce Ponzi Scheme Has Started to Unravel

flipkartA spate of newsreports in the recent past clearly show that Indian ecommerce companies are in trouble.

A newsreport on Moneycontrol.com points out: “With an aim to cut costs, struggling e-commerce firm Snapdeal is likely to downsize its team by around 1,300 employee.” This is around one-third of the company’s total workforce of 4,000 employees.

On the other hand, Flipkart has shutdown its courier service and hyperlocal delivery project, less than a year after launching it. There are other examples as well. The question is why are companies doing this? They are trying to cut down their costs and at the same time conserve on all the money they have raised from investors.

Over and above this, investors have made a spate of mark-downs to their investments in these firms. A January 27, 2017, newsreport on Reuters points out that Fidelity Investments has marked down its investment in Flipkart by around 36 per cent. In December 2016, Morgan Stanley, had marked down its investment in Flipkart by 38 per cent.

The Japanese investor Softbank recently marked down the combined value of its shareholding in Ola and Snapdeal by $475 million. What does all this mean? It essentially means that these investors do not accept these ecommerce firms to be as successful as they expected them to be in the past. And given this, they have been writing down the value of their investments.

In a column, I had written early last year I had called Indian ecommerce firms a Ponzi scheme. Of course, this had led to a lot of abuse on the social media and I was told that I do not understand the business model of these firms. I wrote what I did because I understood the business model of these firms. Allow me to explain.

A look at the profit and loss numbers of these firms will tell you that the losses of these firms go up at the same time as their revenue.  Take the case of the market major Flipkart. As a report in the Business Standard points out, for the financial year ending March 31, 2016, the losses of the firm stood at Rs 2,306 crore. The company’s losses for the year ending March 31, 2015, had stood at Rs 1,096 crore. Where did the revenue of the firm stand at? It jumped from Rs 772.5 crore to Rs 1,952 crore, during the same period.

Or take the case of Snapdeal run by Jasper Infotech Private Ltd. A report in the Mint points out that for the financial year ending March 31, 2016, the losses of the firm stood at Rs 3,316 crore. For the financial year ending March 31, 2015, the losses had stood at Rs 1,328 crore. During the same period, the revenue of the firm increased from Rs 933 crore to Rs 1,457 crore.

What sort of a business model is this—where the losses of a company go up at the same time as its revenue? In fact, in case of Snapdeal, the losses have gone up at a much faster rate than its revenue.

What explains this basic disconnect? As Gary Smith writes in Standard Deviations—Flawed Assumptions, Tortured Data and Other Ways to Lie With Statistics: “A dotcom company proved it was a player not by making money, but by spending money, preferably other people’s money… One rationale was to be the first-mover by getting big fast… The idea was that once people believe that your web site is the place to go to buy something, sell something, or learn something, you have a monopoly that can crush competition and reap profits.”

What was true about American dotcoms is also true about Indian ecommerce companies. This isn’t surprising given that many investors in Indian ecommerce firms are American.

I discovered Flipkart one day in 2009. Back then it was simply an online bookstore. It had a reasonably good collection of books. It even had books which bookstores did not. And the deliveries were on time.

What else did one want? Discounts. It had good discounts on offer as well. Hence, out went the bookstore and in came Flipkart. The loyalty was to discounts and nothing more. Sometime later, when other websites like Homeshop18 and even Amazon, started offering higher discounts, I moved to ordering from these websites.

Nevertheless, one did wonder, how would these websites ever get around to making money, given the huge discounts that they offered. The way businesses run traditionally it never makes any sense to sell a product below the cost all the time, because that way the business is never going to make any money.

But these websites did not fit into the traditional way of doing things. At least, that is way they thought. The best way to explain this is through the example of a telephone. As James Evans and Richard L. Schmalensee write in Matchmakers: The New Economics of Multisided Platforms: “A telephone was useless if nobody else had one. Even Bell and Watson started with two. A telephone was more valuable if a user could reach more people.”

The point being that more the number of people who had a telephone, more the number of people who would want to have a telephone. The economists call this the phenomenon of the direct network effect. This essentially means that more the number of people who are connected to any particular network, the more valuable it is to people who are already a part of it.

Take the case of app-based cab services. When they launched, they offered rock bottom rates. This was done to attract customers. Once customers came on board, it was easy to attract more and more drivers on to the network as well. And over a period of time, the price of these app based services has gone up.

Of course, it is not easy as I make it sound. But that is the basic logic. Then there are apps which deliver food from restaurants. They also offered discounts initially in order to build a critical mass of customers to be able to attract good restaurants on the platform.

As economist John Kay writes in Everlasting Last Bulbs—How Economics Illuminates the World: “The company that is first to create the largest network denies access to competitors and establishes an unassailable monopoly…Connectedness is vital, and it is best to be connected to the largest network.”

So, the ecommerce game is centred around building a monopoly and cashing in on it. As Ray Fisman and Tim Sullivan write in The Inner Lives of Markets in the context of network externality: “The bigger a company gets, the more valuable it is to each successive customer, there’s a huge premium on expanding your customer base.”

And this explains the discount led model. In case of Flipkart, the discount led model was first offered on books to build a critical mass of customers, and then the company gradually got into selling many other products. The hope was that once the consumer was comfortable buying books from the website, he would become comfortable buying other products as well, over a period of time. The logic worked on the supply side as well, as more and more vendors got comfortable selling online, more vendors came in.

Of course, the discount led model leads to losses. Hence, any company following this model, needs money from investors to keep running. And this is where the structure of Indian ecommerce companies becomes similar to that of a Ponzi scheme.

A Ponzi scheme is essentially a financial fraud in which investment is solicited by offering very high returns. The investment of the first lot of investors is redeemed by using the money brought in by the second lot. The investment of the second lot of investors is redeemed by using the money brought in by the third lot and so on.

The scheme continues up until the money being brought in by the new investors is greater than the money being redeemed to the old investors. The moment the money that needs to be redeemed becomes greater than the fresh money coming in, the scheme collapses.  How does this apply in case of Indian e-commerce companies?

Indian ecommerce companies have managed to survive because of investors bringing in fresh money into the scheme at regular intervals. It is worth mentioning here that every time investors bring in more money, they bring it in at a higher valuation. This essentially means that the price at which shares of the company are sold to the investors are higher than they were the last time around. This increases the market capitalization of the company.

This increase in market capitalization comes about because the company has managed to increase its revenue. As long as the money being brought in by the investors keeps subsidising the losses being accumulated by the e-commerce firms, these firms will keep running. The moment this changes, the firms will start to shut-down. The structure of the Indian e-commerce companies is that of a classic Ponzi scheme.

Nevertheless, as we have seen earlier in this column, this increase in revenue typically comes at the losses increasing as well. This is a fact that investors of these firms have started to realise as well. And that is why they have marked down the value of their investments.

An investor who is marking down his investment is unlikely to invest more money into the firm. If he actually goes about investing more money in the firm, then he is likely to do it at a much lower valuation. Given this, the Indian Ecommerce Ponzi scheme is now unravelling. The trouble is that everyone wants to be build a monopoly. But everyone cannot be a monopoly.

As Smith writes in the context of the American dotcom bubble: “The problem is that, even if it is possible to monopolize something, there were thousands of dotcom companies and there isn’t room for thousands of monopolies. Of the thousands of companies trying to get big fast, very few can ever be monopolies.”

This basic logic applies to the Indian ecommerce as well. And given this, if fresh investor  money stops coming into these firms, as it has in many cases, these companies will soon start going bust.

To conclude, it’s time we got ready for the ecommerce bloodbath.

The column was originally published on Equitymaster on February 15, 2017

Why Indian E-commerce Is A Ponzi Scheme

flipkartIt is that time of the year when the business media is publishing the financial results of Indian ecommerce companies for the financial year 2014-2015(i.e. the period between April 1, 2014 and March 31, 2015). The numbers are being taken from the filings that the ecommerce companies have made with the Registrar of Companies(RoC).

And the results make for a very interesting reading. As can be seen from the accompanying table compiled from various media reports, the losses of the major ecommerce companies have gone up multiple times during the course of the year.

It needs to be stated here upfront that it is difficult to estimate the exact numbers of the ecommerce companies given that they have complex holding structures as regulations in India currently do not allow foreign direct investment in online retail, but allow it in case of an online marketplace.

chart

The combined losses of the five companies in the table stood at Rs 5524 crore in 2014-2015. In 2013-2014, the losses had stood at Rs 1338.1 crore. This is a jump of a whopping 313%. How does their combined revenue number look? In this case a direct comparison cannot be made given that the revenue numbers of Snapdeal for 2014-2015 are not available.

As a recent news-report in the Mint newspaper points out: “Snapdeal reported a loss of Rs.1,328.01 crore for the same year, compared with Rs.264.6 crore in the previous year, RoC documents show. It didn’t disclose revenue numbers.”

Hence, we will have to adjust for Snapdeal numbers before we compare revenue earned by the companies with their accumulated losses. The revenue for 2014-2015 for four companies other than Snapdeal stood at Rs 11,827 crore. The revenue for 2013-2014 for these four companies had stood at Rs 3,445.8 crore. This is a jump of 243% over the course of one year.

In the normal scheme of things a jump of 243% in revenue in one year would have been deemed to be fantastic, but the losses of these companies have gone up at a much faster rate. In 2013-2014, the losses of the four companies other than Snapdeal stood at Rs 1073.5 crore. In 2014-2015, the losses had jumped by a whopping 291% to Rs 4,196 crore.

Hence, a 243% jump in revenues has been accompanied by a 291% jump in losses. This analysis is skewed to some extent given the huge size of Flipkart in the sample. If we had known Snapdeal revenue numbers for 2014-2015, the results would have been more robust.

Nevertheless, even the small companies in the sample, show the same trend as the broad trend is. Take the case of Paytm. In 2013-2014, the company made a profit of Rs 5 crore on a revenue of Rs 210 crore. In 2014-2015, the revenue jumped to Rs 336 crore and the losses jumped to Rs 372 crore. Shopclues also showed a similar trend. The revenue of the company went up by 155% between 2013-2014 and 2014-2015, whereas the losses went up by 163%.

What sort of a business model is this—where the losses of a company go up at a faster rate than its revenue? The answer lies in the fact that the Indian ecommerce companies have adopted a discount model in order to lure customers. This means selling products at a loss in order to build a customer base.

This strategy of acquiring customers has been directly copy-pasted from what many American ecommerce companies did during the dotcom boom towards the turn of the century.  As Gary Smith writes in Standard Deviations—Flawed Assumptions, Tortured Data and Other Ways to Lie With Statistics: “A dotcom company proved it was a player not by making money, but by spending money, preferably other people’s money…One rationale was to be the first-mover by getting big fast…The idea was that once people believe that your web site is the place to go to buy something, sell something, or learn something, you have a monopoly that can crush competition and reap profits.”

The major Indian ecommerce companies seem to be following a similar strategy of trying to build a monopoly by offering products on substantial discounts. The trouble with this strategy is that it needs a lot of money. Up until now, the Indian ecommerce companies have managed to survive because international hedge funds and private equity investors have made a beeline for investing in them.

With returns from financial securities all over the world drying up over the last few years, Indian ecommerce companies have offered an iota of hope. The trouble is that every reasonably big Indian ecommerce company with access to funding seems to be following the same strategy of offering discounts and wanting to build a monopoly. And once they are there, they hope to cash in.

Having said that, the current structure of the Indian ecommerce companies is akin to a Ponzi scheme. A Ponzi scheme is essentially a financial fraud in which investment is solicited by offering very high returns. The investment of the first lot of investors is redeemed by using the money brought in by the second lot.

The investment of the second lot of investors is redeemed by using the money brought in by the third lot and so on.

The scheme continues up until the money being brought in by the new investors is greater than the money being redeemed to the old investors. The moment the money that needs to be redeemed becomes greater than the fresh money coming in, the scheme collapses.

How does this apply in case of Indian ecommerce companies? Up until now the companies have managed to survive because of investors bringing in fresh money into the scheme at regular intervals. It is worth mentioning here that every time investors bring in more money, they bring it in at a higher valuation.

This essentially means that the price at which shares of the company are sold to the investors are higher than they were the last time around. This increases the market capitalization of the company.

This increase in market capitalization comes about because the company has managed to increase its revenue. But as we have seen earlier in this column, this increase in revenue typically comes at the losses increasing at a much faster rate. I wonder why all these fancy investors do not take something as basic as this into account?

Having said that, as long as this money keeps coming in and is greater than the losses being accumulated by the ecommerce firms, these firms will keep running.

The moment this changes, the firms will start to shut-down. The structure of the Indian ecommerce companies is that of a classic Ponzi scheme. In fact, a news-report in The Economic Times suggests that FabFurnish, a furniture retailer, is likely to shutdown given that its German investor does not want to burn any more money to finance its losses.

The trouble is that everyone wants to be build a monopoly. But everyone cannot be a monopoly. As Smith writes in the context of the American dotcom bubble: “The problem is that, even if it is possible to monopolize something, there were thousands of dotcom companies and there isn’t room for thousands of monopolies. Of the thousands of companies trying to get big fast, very few can ever be monopolies.” While the word thousands does not really apply in the Indian case, the overall logic still remains the same i.e. everyone cannot be a monopoly.

This means that many of today’s fledging ecommerce companies will shutdown in the years to come as investors pull the plug. In fact, the companies with the deepest pockets are likely to survive. Meanwhile, dear reader, enjoy the discounts until they last.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column originally appeared on SwarajyaMag on January 28, 2016

Why smart people fall for Ponzi schemes

ponzi
Sometime back a friend called and had a rather peculiar question. He wanted to know how he could go about stopping one of his friends from peddling a Ponzi scheme.

This was a rather tricky question. Just explaining to someone selling a Ponzi scheme that he is selling a Ponzi scheme, does not really work. The first question I asked my friend was how was his friend doing in life? “He is doing well for himself,” said my friend with a chuckle. “He works in a senior position with a corporate and has managed to sell the scheme to at least ten people in the housing society that he lives in.”

“If he is working at a senior position, why is he doing this?” I asked my friend, and immediately realised that I had asked a rather stupid question. “I was hoping you would be able to answer that,” my friend replied.

This column is an outcome of that conversation.

Over the last ten years of writing on Ponzi schemes I have come to the realisation that many people who sell and in the process invest in Ponzi schemes are not just victims of greed or a sustained marketing campaign, as is often made out to be.

There is much more to it than that. Many individuals selling and investing Ponzi schemes (like my friend’s friend) come from the upper strata of the society, are well educated and know fully well what they are doing. In case of my friend’s friend he was selling a multilevel marketing scheme for which the membership fee is more than Rs 3 lakh. So, the scheme is clearly aimed at the well to do.

On becoming a member you are allowed to sell products, some of which cost as much as a lakh. Of course, you will also be making new members as well. The bulk of the membership fee paid by the new members you make, will be passed on to you. Hence, the more people you get in as members, the more money you make. Selling products is just incidental to the entire thing, given that a membership costs more than Rs 3 lakh.

This is a classic Ponzi scheme in which money being brought in by the new investors (through membership fee) is being used to pay off old investors (who had already paid their membership fee), with the business model of selling products providing a sort of a façade to the entire thing.

So, the question is why does the smart lot fall for Ponzi schemes? As John Kay writes in Other People’s Money—Masters of the Universe or Servants of the People: “Even if you know, or suspect, a Ponzi scheme, you might hope to get out in time, with a profit. I’ll be gone, you’ll be gone.”

People feel that the money will keep coming in. Or what the financial market likes to call ‘liquidity,’ won’t dry up. And this is the mistake that they make.
Kay defines liquidity as the “capacity of the supply chain to meet a sudden or exceptional demand without disruption…This capability is achieved…in one or both of two ways: by maintaining stocks, and by the temporary diversion of supplies from other uses.”

Kay in his book compares the concept of liquidity to the daily delivery of milk in the city of Edinburgh in Scotland where he grew up. As he writes: “In the Edinburgh of fifty years ago fresh milk was delivered everyday…At ordinary times our demand for milk was stable. But sometimes we would have visitors and need extra milk. My mother would usually tell the milkman the day before, but if she forgot, the milkman would have extra supplies on his float to meet our needs. Of course, if all his customers did this, he wouldn’t have been able to accommodate them.”

What is the important point here? That people trusted the milkman to deliver every morning. And given that they did not stock up on milk, more than what was required on any given day. If the trust was missing then the system wouldn’t have worked.

Take the case of how things were in the erstwhile Soviet Union. As Kay writes: “In the Soviet economy there was no such confidence, and queues were routine, not just because there was an actual insufficiency of supply – though there often was – but because consumers would rush to obtain whatever supplies were available.”

And how does that apply in case of Ponzi schemes? As I mentioned earlier, the individual selling Ponzi schemes feel confident that the money will keep coming in. Those they sell the scheme also become sellers. And for the Ponzi scheme to continue, the new lot also needs to have the same confidence.

In the milk example shared above, if people of Edinburgh had started hoarding milk, the liquidity the system had would have broken down. The confidence that milk would be delivered every day kept the system going. Along similar lines, the confidence that money will keep coming into a Ponzi scheme, gets smart people into it as well.

Of course, this confidence can change at any point of time. And if a sufficient number of people stop feeling confident, then the scenario changes. The money coming into the Ponzi scheme stops and the moment the money coming into the scheme becomes lesser than the money going out, it collapses. So that’s the thing with liquidity, it is there, till it is not there.

In my friend’s friend case, members down the line would stop making more members. Also, members who had bought the membership from my friend’s friend are likely to turn up at his doorstep and demand their money back.

And given that he has told membership to many people in his housing society, he can’t just get up and disappear, given that he is essentially not a scamster. He is a family man with a wife, children and parents, who stay with him.

Hence, he will have to refund them, if he has continue living in the housing society in a peaceful environment. How will he do that? Let’s go back to the definition of liquidity as explained above. Liquidity is maintained by “by maintaining stocks, and by the temporary diversion of supplies from other uses.” So my friend’s friend can pay up from the money he has already accumulated by selling these Ponzi schemes. If that is not enough, he can dip into his savings. And if even that is not enough, he can hopefully take the money being brought in by the new members (if at all there are people like that) and hand them over to the members demanding their money back.

Of course, by doing this he will only be postponing the problem, given that he would have to later deal with the new members.

Long story short—he is screwed!

The column originally appeared on The Daily Reckoning on Oct 13, 2015