Dear KC Chakrabarty, here’s the real reason why people invest in Ponzi shemes

Vivek Kaul 
A standard explanation that seems to be emerging about why Ponzi schemes keep occurring in different parts of the country is that India does not have enough banks. And this lack of banks leads people to invest in fraudulent Ponzi schemes.
A Ponzi scheme is a fraudulent investment scheme in which the illusion of high returns is created by taking money being brought in by new investors and passing it on to old investors whose investments are falling due and need to be redeemed.
K C Chakrabarty, the deputy governor, is the latest individual who has jumped onto the more banks equals fewer Ponzi schemes, bandwagon. “The fact that people have to rely on such entities for their saving needs indicates a failure on the part of the formal financial system to reach out to such groups and earn their trust and confidence through a transparent and responsive customer service regime,” Chakrabarty said yesterday.
“The need of the hour is to ensure that our unbanked population gains access to formal sources of finance, their reliance on informal channels and on the shadow banking system subsides and, in the process, consumer exploitation is curbed,” he added.
So what Chakrabarty is effectively saying is that only if people had a bank in their neighbourhood they would have stayed away from a Ponzi scheme like Saradha. While it simple to come to this conclusion which sounds quite logical, the truth is not as simple as it is being made out to be.
Lets consider a few Ponzi schemes that have done the rounds lately. MMM India which promises to double the investment every month, needs prospective investors to have bank accounts. So here is a Ponzi scheme which is using what Chakrabarty calls the ‘formal financial system’ to flourish.
Before that there was the Speak Asia Ponzi scheme. In this scheme investors needed to fill online surveys. Anyone who has access to internet in India is most likely to have access to a bank account as well. So people who invested in Speak Asia, did so because they wanted to not because they had no banks in their locality.
Then there are Ponzi schemes which involve investments in gold coins. People who can buy gold coins won’t have access to a bank account?
Or lets take the case of Emu Ponzi schemes which had become fairly popular in parts of Tamil Nadu. The pioneer among these schemes was Susi Emu Farms. It promised a return of at least Rs 1.44 lakh within two years, after an initial investment of Rs 1.5 lakh had been made. This was the model followed by nearly 100 odd emu Ponzi schemes that popped up after the success of Susi.
Again anyone who has Rs 1.5 lakh to invest in a Ponzi scheme will not have access to a bank? That is rather difficult to believe. As Dhirendra Kumar of Value Research puts it in a recent column“Could it be that all those people who put money into Saradha wouldn’t have done so if they had a bank in their neighbourhood? Very unlikely. A lot of the deposits seem to have come from towns where there would have been banks. Moreover, almost every ponzi scheme that has come to light in the last few years has actually flourished in towns and cities. The investors who fell for StockGuru or the Emu farms or other schemes all had access to legitimate alternatives.”
So what is it that gets people to put their hard earned money into Ponzi schemes rather than deposit it into banks? The simple answer is ‘greed’. We all want high returns from the investments we make. And Ponzi schemes typically offer significantly higher rates of return than other investment options that are available at any point of time.
Having said that ‘higher returns’ are not the only reason that lures people into Ponzi schemes. There are other factors at work, which along with the lure of higher returns, ends up making a deadly cocktail.
Typically people do not like handing over money to someone they do not know. In small towns, people end up investing money into a Ponzi scheme through an agent they happen to know. So even though they have no clue about the company they are investing in, they feel they are doing the right thing because they know the agent.
In the case of Saradha, agents of Peerless General Finance and Investment were used to collect money. Peerless had a good reputation among the people of West Bengal, having been in the business of collecting small savings since 1932. This helped Saradha establish the trust that it needed to, during its initial days of operation.
As a report in The Indian Express points out “The selection of agents, a crucial link in the chain, was done very carefully by Saradha. Those picked were generally ones who wielded influence in their locality and in whom people had confidence.”
What also helps is the fact that agents are paid reasonably high commissions, leading to a higher level of motivation and thus better service. The agents typically come to homes of prospective investors to get them to invest money. So clearly there is better service on offer unlike a bank. There is very little need for documentation ( PAN No, Address proof etc not required) as well, unlike is the case with a bank.
Let us briefly go back to the more banks fewer Ponzi schemes argument. As the Indian Express report cited earlier states “One important reason for chit funds mushrooming(they are really not chit funds, but Ponzi schemes) in West Bengal is the absence of easy access to banks and other financial institutions. According to an estimate of the state Finance Department, of the 37,000 villages in the state, nearly 27,767 have no bank branch.”
While villages may not have access to a bank, they do have access to post offices. And India Post runs many small savings schemes, in which people can deposit money. But in West Bengal people seemed to have stayed away from these schemes. A report published in December 2012, in The Hindu Business Line quotes 
Gautam Deb, a former housing minister as saying “small savings and post office collections in West Bengal during the April-October 2012 period were merely Rs 194 crore, against the targeted amount of Rs 8,370 crore.”
So why did people stay away from the post office schemes and get into Ponzi schemes? For one the returns offered on Ponzi schemes were significantly higher. The second reason obviously is the significantly better level of service that Ponzi schemes offer with agents getting higher commissions.
In fact, there are no commissions on offer for selling post office savings schemes. As Kumar points out in his column “The post office offers excellent schemes with a huge reach in rural and semi-urban areas but can it compete on sales and marketing? In fact, when the government eliminated commissions on PPF and other deposits in post offices in 2011, it effectively eliminated whatever little sales muscle there was.”
The formal financial system thus finds it very difficult to compete with unscrupulous operators like Saradha. It is not easy for it to offer higher commissions as and when it wants to simply because it has got rules and regulations to follow. As Kumar puts it “They (i.e. the Ponzi schemes) spend much more on sales commissions, on offices, keeping politicians happy and getting media coverage because they can just dip into the deposited money for all these expenses. Therefore, even if legitimate financial services are available passively, they won’t be able to compete.”
Another reason why the people of West Bengal fell for Saradha was the fact that the Ponzi scheme came to be very closely associated with Trinamool Congress, the party that rules the state. The ‘formal financial system’ cannot afford to do anything like that.
When we take all these reasons into account it is safe to say that the more banks fewer Ponzi schemes argument doesn’t really work. Even if more banks are established, the banks will not be able to compete with the level of service and commissions that Ponzi schemes can offer. Hence, it is very important that unscrupulous operators who are caught running Ponzi schemes are punished and justice is delivered as soon as possible. This will ensure that anyone who wants to start a Ponzi scheme will think twice before he acts. And that is the best way to protect people from Ponzi schemes.
The article originally appeared on on May 3, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Saradha and Ponzi schemes: Why there will be more suckers


Vivek Kaul

In Ek Thi Daiyan, the latest horror flick to come out of Bollywood, the dying daiyan (witch) says something to the effect of “main wapas aaongi (I’ll be back).” Ponzi schemes are a tad like that. They keep coming back one after the other. 
Only sometime back we were talking about the Stockguru Ponzi scheme. Before that the emu ponzi scheme and Speak Asia had been in the news. More recently the MMM Ponzi scheme and Saradha chit fund have taken up a lot of news space.
MMM India recently put itself into what it calls a calm regime where operations like money transfer will remain suspended and hence those who have put money into the scheme won’t be able to withdraw it. The Saradha Chit fund has collapsed. 
The question is why do Ponzi schemes keep occurring over and over again in India? A popular explanation is that India is an under-banked country and that gets people to invest in Ponzi schemes rather than deposit money in the bank.
The Economic Times points out in an editorial “the repeated sprouting of dubious Ponzi schemes across the country points to a failure of the formal saving and banking system.” This maybe true to some extent but does not really explain why Ponzi schemes keep cropping up all the time and why people invest in them. 
Take the case of MMM India Ponzi scheme. To participate in it, an individual needed to have a bank account. To be a part of Speak Asia an individual had to participate in two online surveys per week. An individual who has access to an online connection is more than likely to have a bank account as well. 
So Ponzi schemes are not just about India having fewer banks. There is a clear mental dimension at play which makes individuals invest in Ponzi schemes over and over again. And this makes sure that there are always scamsters looking to cash in. 
Robert Shiller, an economist, defines a Ponzi scheme in a research paper titled 
From Efficient Market Theory to Behavioural Finance as follows: A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors. It creates a false perception of high returns for initial investors by distributing to them money brought in by subsequent investors. Initial investor response to the scheme tends to be weak, but as successive rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. Finally, the scheme collapses when new investors are not prepared to enter the scheme. 
The phrase to mark in this definition is “high returns generate excitement”. Very recently, MMM India promised returns of 100% per month to prospective investors. The prospect of high returns pushes individuals to take on the risky bet of investing in a Ponzi scheme. 
As Robert Shiller writes in 
Finance and the Good Society“The mere presence of uncertainty in a positive direction creates a pleasurable sensation (in the brain), and so the reward system creates an incentive to take on risky positive bets…This human tendency also helps explain why people like to gamble, and why many people will return every day to bet a small sum in a lottery. It also helps explain why people are willing to speculate aggressively on investments.” 
This gets individuals to invest in a Ponzi scheme. And after one lot of investors has invested in a Ponzi scheme it tends to take on a life of its own. The initial lot of investors then become the advertisers for the scheme. 
If a person wants to invest, the chances are he will look around to see what his acquaintances, neighbours or relatives are doing with their money. If the people around the potential investor invest in a certain way, there might be a tendency for him to follow them. Much like the ‘circular mills’ of ants. The mill is created when an army of ants find themselves separated from their colony. Once they are lost they obey a simple rule: Follow the ant in front of you.
Decisions of investors, much like the circular mills of the ants, are not made at the same time but in a sequence. People who invest in the Ponzi Scheme assume that the scheme is a good bet simply because some of the people they know have already invested in it. So everyone ends up making the wrong decision because the initial investors get into the scheme by chance.
This happens because the attraction of easy money is something that investors cannot resist. Ponzi Schemes offer the prospect of huge returns in a short period of time vis a vis other investments available in the market at that point of time. Greed also results when investors see people they know make money through the Ponzi Scheme. As Charles Kindleberger wrote in 
Manias, Panics and Crashes “There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”. 
Overconfidence also has a part to play. Most people are confident that they won’t become victims of financial frauds. This also leads them to invest in Ponzi schemes. Ove
rconfidence is also at play when investors understand that they are getting into a Ponzi scheme, but they are still willing to enter the scheme, because they feel that some greater fools could be depended on to enter the scheme after they have and this would give them handsome returns on their investments.
The contract effect is also at play. It becomes relevant in the context of a Ponzi Scheme when the prospective investor starts comparing the returns on the various other investment avenues available in the market for investment at that point of time. The high returns of offered by a Ponzi scheme stand out clearly and attracts investors.
So a Ponzi scheme just doesn’t spread only because of a weak banking structure though that might be true in case of Sahara or even Saradha chit fund. Also it is important to remember the first sentence in Shiller’s definition of a Ponzi scheme, which is: “
A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors.”
So people running Ponzi schemes spend a lot of time in building a ‘supposed’ business model and building a great brand. The Saradha chit fund had built a huge media empire in West Bengal. It had also purchased a motorcycle company, to give some semblance of a business model to its investors. 
Sahara is similarly into a lot of businesses and even sponsors the Indian cricket team. Similarly, 
Speak Asia was in the magazine and survey business. It also advertised majorly in the publications of The Times Group, to build credibility. Emu Ponzi schemes were in the business of rearing and selling emus. And Stockguru helped investors make money by investing in stocks. 
MMM, in its original Russian avatar, sponsored the Russian football team in the 1994 football worldcup. When questions were raised about the huge returns, it had promised, MMM stated that it had solid investments, but did not want to disclose them as its competitors might imitate its investment strategy. 
Over the years, investors have been fooled into investing their money into Ponzi Schemes which keep appearing in various forms. They ignore the most fundamental principle of investment theory: You cannot expect to make large profits without taking risk. Whenever a large amount of money is at stake, individuals should logically seek large amounts of information on where they should invest. But most investors do not do so. Few ask the right questions at the right time and are naïve enough to believe in what is communicated to them by the people carrying out the fraud. 
Indeed, many Ponzi Schemes do not get reported as people do not like to admit that they have been fleeced because of their greed. The ones, which are reported and investigated, get stuck in the quagmire of our legal system. This encourages more people to run Ponzi Schemes. And every time a Ponzi scheme is exposed, the confidence of the investor in the financial system goes down.
The most commonly suggested solution for prevention of Ponzi Schemes is sharing more and more information with the investing public. But research in psychology shows that more information does not necessarily improve judgement. Any extra information is helpful only if it comes without any bias. But that is rarely the case. Moreover, the ability of the common man to assimilate information is limited.
Rather than assuming investors are knowledgeable about investment opportunities, the best solution to the problem of Ponzi schemes might be ensuring swift legal mechanisms to punish the unscrupulous masterminds behind the Ponzi Schemes. This will ensure that every prospective fraudster will think twice before launching another Ponzi scheme.

The article originally appeared on on April 23, 2013

 (Vivek Kaul is a writer. He tweets @kaul_vivek)



Wiser after Stockguru: 5 ways to spot a Ponzi scheme

Vivek Kaul
So a Ponzi scheme is in the news again. Last time it was the emu Ponzi scheme. Before that there was Speak Asia. Now it’s the turn of Stock Guru to take investors across the county for a ride. The modus operandi as is the case with all Ponzi schemes is the same: the lure of high returns. In the end more than the frauds who ran Stock Guru it’s the investors who invested in the scheme have only themselves to blame.  There greed did them in.
While one Ponzi scheme differs from another, but despite the details changing, the structure abides. Let’s first try and understand what exactly is a Ponzi scheme and why is it so called.
Charles Ponzi
Chalres Ponzi was an Italian immigrant who landed in America in 1903. Sometime in August 1919, in the process of starting an export magazine, he realised that there was money to be made through an arbitrage opportunity that existed. Ponzi sent an offer to a person in Spain requesting him to subscribe to the magazine. The subscriber agreed and sent Ponzi an international postal reply coupon. This coupon could be exchanged at the post office for American stamps which would be needed to send the magazine to the Spanish subscriber. The coupon in Spain cost the equivalent of one cent in American currency. In America when Ponzi exchanged the coupon, he got six cents worth of stamps. And this set Ponzi thinking.
What was the plan?
The plan was very simple. Ponzi could buy international postal reply coupons convert them into American stamps and sell those stamps and make money. So he would need one cent to buy an international postal reply coupon in Spain. That coupon could be exchanged for stamps worth six cents in America and those stamps could then be sold for six cents. Hence there was a clear profit of five cents, assuming there were no other charges, to be made on every one cent that was invested. The trouble of course was that Ponzi needed money to get started.
Double your money in 90 days
So Ponzi launched an investment scheme asking people to invest. He promised them that he would double their money in 90 days. Ponzi would make a profit of five cents for every one cent that he invested. That meant a profit of 500%. As far as investors were concerned he was only promising to double their money and that meant a return of 100%. Hence, on the face of it looked like a reasonably safe proposition. At its peak, the scheme had 40,000 investors who had invested around $ 15 million in the scheme.
What went wrong?
As if often the case what sounds great in theory cannot be put into practise. The idea was brilliant. But Ponzi had not taken into account the difficulties involved in dealing with various postal organizations around the world, along with other problems involved in transferring and converting currency. Also with all the money coming in Ponzi couldn’t stop himself from living an extravagant life and blowing up the money investors brought in.
But soon doubts started arising on the legitimacy of the scheme. The Boston Post newspaper ran a story on July 26, 1929, and within a few hours, angry depositors lined up at Ponzi’s door, demanding their money back. Ponzi settled the obligations of the people who had gathered. The anger subsided, but not for long.  On Aug 10th, 1920, the scheme collapsed. It was revealed that Ponzi had purchased only two international postal reply coupons and was using money brought in by the new investors to pay off old investors.
So what is a Ponzi scheme?
Robert Shiller, an economist at Yale University in the United States defines Ponzi schemes as “A Ponzi Scheme involves a superficially plausible but unverifiable story about how money is made for the investors and the fraudulent creation of high returns for initial investors by giving them money invested by subsequent investors. Initial investor response to the scheme tends to be weak, but as the rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. ( Adapted from Shiller 2003).” Hence, a Ponzi scheme is essentially a fraudulent investment scheme where money brought in by the newer investors is used to pay off the older investors. This creates an impression of a successful investment scheme. Of course as long money entering the scheme is greater than the money leaving it, all is well. The moment the situation is reversed, the scheme collapses.
This kind of financial fraud happened even before Ponzi’s name came to be attached to it. And it continues to happen more than ninety years after Charles Ponzi ran his scam.
Any Ponzi Scheme will differ from another Ponzi Scheme. But if one may borrow a French phrase, Plus Ca Change, Plus C’est La Meme Chose, the more things change, the more they remain the same. The details might change from scheme to scheme, but the structure abides. Here are some characteristics of Ponzi schemes.
The instrument in which the scheme will invest appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors.
In case of the emu Ponzi scheme an investor was supposed to rear emus and then sell their meat, oil etc. In order to become a member of Speak Asia one had to invest Rs 11,000. This investment was for subscribing to the electronic magazine issued by the company called “Surveys Today”.
This also allowed the member to participate in two online surveys every week and make Rs 500 per survey or Rs 1000 per week. This when converted into a yearly number came to Rs 52,000 (Rs 1000 x 52). So an investment of Rs 11,000 ensured that Rs 52,000 was made through surveys, which meant a return of 373% in one year.
And this was basically the main selling point of the scheme.  So the business model of the company was pretty vague. The legal advisor of the company Ashok Saraogi said at a press conference “The company is not selling any surveys to panellists but e-zines (electronic magazines) to its subscribers. Surveys are offered as additional benefit and can be withdrawn anytime if the company’s contract with clients comes to an end.”
Stock Guru also worked along these lines. The company claimed to be making money by investing in stocks and had this to advise to its customers: “We advise our clients to buy shares at a low price and sell them at a higher price. Selecting the right share at the right price and entering the capital market at the right time is an art. We help all our clients to make huge profits by investing in good shares for very short/short/medium/long term depending upon the client’s requirements.” Very sane advise when it comes to investing in the stock market but nothing specific about how the company plans to help its clients make a huge profit.
Most of the Ponzi Schemes start with an apparently legitimate or legal purpose.
Let’s take a look at some of the Ponzi schemes of yore. Hometrade started off as a broker of government securities, Nidhis were mutually beneficial companies and Anubhav Plantations was a plantations company. They used their apparently legitimate or legal purpose as a façade to run a Ponzi Scheme. Same stands true for the present day Ponzi schemes. Speak Asia was in the magazine and survey business. Emu Ponzi schemes were in the business of rearing and selling emus. And Stock Guru helped investors make money by investing in stocks.
The most important part of a Ponzi scheme is assuring the investor that their investment is safe.
This is where the meeting of initial obligations becomes very important. Early investors become the most important part of the scheme and spread it through word of mouth, so that more investors invest in the scheme and help keep it going. Ironically enough, in many cases it is their own money that is being returned to them. Let us say an investor invests Rs.100 in a scheme that promises 20% return in 60 days. So Rs.20/- can be paid out of investor’s own money once every two months up to ten months. The Ponzi scheme can keep going by essentially returning the investor his own money. Speak Asia did this by returning around Rs 250 crore to the investors from the Rs 2000 crore it had managed to collect. This gave the scheme a greater legitimacy.
Stock Guru also worked along similar lines. As an article in the Money Life magazine pointed out “You pay Rs10,000 as investment and Rs1,000 as registration fees. There is no limit on the maximum amount one can invest. offered a return of 20% per month for up to six months and the principal amount invested is returned in the next six months. It also gave post-dated cheques of the principal and a promissory note as security.”
As a story in The Times of India points out “People invested between Rs 10,000 and Rs 60 lakh at one go in Stock Guru India as Ulhas promised to double their capital…He (i.e.Ulhas Khaire who ran the scam) also returned money to some investors to win their trust so that they would recommend Stock Guru to others,” said an officer. In fact this initial lot of investors become brand ambassadors and passionate advocates of the scheme. When this writer wrote about Speak Asia being a Ponzi scheme he got stinkers from a lot of people who had invested their money in Speak Asia at the very beginning and made good returns.
The rate of return promised is high and is fixed at the time the investor enters the scheme. So the investor knows in advance what return he can expect from the scheme. The promised returns were substantially higher compared to other investment avenues available in the market at that point of time. The rate of return was also fixed in advance. So there was no volatility in returns as is in other forms of investment. This twin combination of high and fixed returns helps in attracting more and more investors into the scheme.
In Speak Asia the investor knew that he would get paid Rs 1000 per week for conducting surveys. And by the end of the year he would earn Rs 52,000 on an initial investment of Rs 11,000.
In case of Stock Guru a minimum of Rs 10,000 was to made as an investment. And Rs 1,000 was the registration charge. The company promised a return of 20% per month against the investment for the first six months. For a person investing Rs 10,000 that would mean a return of Rs 2,000 per month or Rs 12,000 after the first six months. The principal amount of Rs 10,000 would be returned over the next six months. Hence on an investment of Rs 11,000, a profit of Rs 12,000 was being made in a very short period of time. These were fantastic returns.
Brand building is an inherent part of a Ponzi Scheme.
MMM, a Russian Ponzi scheme marketed itself very aggressively. In the 1994 football World cup, the Russian soccer team was sponsored by MMM. MMM advertisements ran extensively on state television and  became very famous in Russia.  Hometrade also used the mass media to build a brand image for itself. It launched a  high decibel advertising campaign featuring Sachin Tendulkar, Hrithik Roshan and Shahrukh Khan. When the company collapsed, the celebrity endorsers washed their hands off the saying that they did not know what the business of Hometrade was. Anubhav Plantations also ran a huge advertising campaign. Film stars also advocated investing in the emu Ponzi schemes.
Speak Asia ran a huge ad campaign. The irony was it advertised extensively in newspapers which dealt with personal finance. Stock Guru did its level of brand building as well. As a report in the Times of India points out “ Ulhas Prabhakar Khaire andRaksha Urs, masterminds of the multi-crore Stock Guru fraud, would organize their promotional events in Macau, Malaysia, Mauritius and several other countries, taking only a few premium investors on expenses-paid trips, say Delhi Police sources. The events were reportedly organised regularly in five-star hotels, and Ulhas made all the arrangements, including booking flights for investors and celebrities. Ulhas is learnt to have named two Bollywood celebrities he invited to his promotional events.”
All these things lead to people investing in these schemes. The attraction of easy wealth is something that investors cannot resist. Ponzi schemes offer huge returns in a short period of time vis a vis other investments available in the market at that point of time. With good advertising and stories of previous investors who made a killing by investing in the scheme, investors get caught in the euphoria that is generated and hand over their hard earned money to such schemes going against their common sense. Greed also results when investors see people they know make money through the Ponzi scheme. As economic historian Charles Kindleberger  once wrote  “ There is nothing so disturbing to one’s well being and judgment as to see a friend get rich.”
Given this, even though a lot of questions can be asked they are not asked. Ponzi schemes have not been eliminated. This is sad because for the economy as whole, they are undesirable. The world has not learned from its experience. “Mundus vult decipi-ergo decipitaur-The world wants to be deceived , let it therefore be deceived ”. (Winkler 1933 as quoted in Kindlberger 2000).
All Ponzi schemes collapse in the end once the money leaving the scheme becomes greater than the money entering it. Stock Guru was no different.
To conclude, any investment scheme promising more than 15% return a year has to be a very risky proposition. It may not always be a Ponzi scheme, but the chances are that it is more often than not.
The article originally appeared on on November 15, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])